The COVID-19 pandemic has changed life in the United States and around the world, to say the least. It has caused illness, quarantines, cancellation of events and travel, business shutdowns, record unemployment and overall economic and financial market instability. While Virginia banks have generally been permitted to continue operating despite state and local “stay-at-home” orders, the pandemic has resulted in material disruptions to financial institutions and will likely continue to have an adverse impact. While pivoting to ensure the safety of its employees, customers, and communities, banks have also been forced to prioritize capital preservation and ensure sufficient liquidity.
Despite the fact that many banks entered the pandemic with strong capital buffers and remained well capitalized through the second quarter, there has been an increase in capital raising by banks. In fact, banks raised more capital in May than any month since 2009. Senior debt and preferred equity were the most common form of capital raise; however, there has also been a spike in the issuance of subordinated debt since the beginning of the pandemic, due to the current low interest rate environment. Banks should consider subordinated debt as a practical alternative for efficiently raising capital.
Subordinated debt is an unsecured borrowing, where, in the case of default, it ranks after other debts (but above equity). In other words, the subordinated debt would be paid after all other corporate debts and loans are repaid, but before payment to shareholders. For this reason, rating agencies typically view subordinated debt as riskier in a default scenario.
Subordinated debt has several benefits, which we wanted to highlight here:
- May qualify as Tier 2 capital – For bank holding companies that are not subject to the Small Bank Holding Company Policy Statement (generally those with over $3 billion in assets), subordinated debt may count as Tier 2 capital if certain criteria are met (e.g., must be subordinated to depositors, unsecured and have an original maturity of at least five years). For bank holding companies that are subject to the Bank Holding Company Policy Statement, Tier 2 treatment isn’t formally analyzed, but examiners would still determine the impact of the subordinated debt on the bank holding company.
- May downstream as Tier 1 capital – The proceeds from a subordinated debt offering may be downstreamed to a bank subsidiary as Tier 1 capital.
- May allow for additional customer assistance – The additional capital from a subordinated debt offering could allow banks to have additional options to help customers with nonperforming loans or troubled debt restructurings, as banks continue to provide extensions and deferrals to loan customers in light of the pandemic.
- Allows for potential growth opportunities – If banks emerge from the pandemic with extra capital, there may be growth opportunities through strategic mergers, or organically.
- Enhances return on equity – Unlike equity, the issuance of subordinated debt will not dilute existing shareholders. Additionally, it does not give investors voting or investment power, allowing them to influence management as equity would. Finally, the low interest rate environment makes subordinated debt an attractive alternative to equity, particularly for publicly-held banks whose stock prices have fallen since the beginning of the pandemic.
- No operating or financial covenants – Unlike traditional debt, subordinated debt does not carry with it the same types of operating or financial covenants with which banks must remain in compliance.
- Interest payments tax deductible – The interest payments on subordinated debt are tax-deductible by the issuer.
Please note, however, that if a bank holding company is under an enforcement action, it will likely be required to obtain the prior written approval of the Federal Reserve Bank and the Virginia Bureau of Financial Institutions, as well as regulatory approval to make interest payments on and redeeming debt. The Richmond Fed, in an alert published last month, noted that they “closely scrutinize these requests, so [they] should receive [any request] at least 30 days in advance.” The Richmond Fed has also warned that bank holding companies should ensure that their subsidiary banks are not harmed by excessive parent debt that could require significant bank dividends to service those obligations. Examiners will ensure that there is adequate cash to make the interest payments.
The COVID-19 pandemic has caused extensive disruptions in the United States as well as around the world, and business, including banks, have taken swift and decisive action to mitigate its effects. Bank holding companies should consider whether a subordinated debt offering would be a useful and effective alternative to an equity offering during these challenging and unprecedented times.