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Peru: Understanding subordinated debt

Juan Luis AvendañoNydia Guevara
Banks' subordinated debt and its impact on regulatory capital are still regulated in Peru under the Basel II standards. Since their inception in 2009, Peruvian banks have issued tier 1 and tier 2 hybrid instruments in the form of subordinated bonds.

The basic features of Peruvian banks' subordinated debt instruments for purposes of qualifying as regulatory capital are that they: i) are unsecured; ii) rank junior to all other obligations and senior only to equity; iii) have loss-absorption capabilities; and iv) have a minimum term to maturity of five years.

However, the degree to which a subordinated instrument is capable of absorbing losses will determine whether it qualifies as a component of tier 1 or tier 2 capital. In other words, the more the debt instrument equals the features of an equity instrument the more chance it will have to qualify as a tier 1 component.

The typical subordinated debt instruments issued by Peruvian banks in the last six years have the following characteristics:

  • Tier 1 hybrid bonds: (a) have a 30-year (or longer) term to maturity; (b) have a non-call period of 10 years with a step-up on year 10 capped at 300bp; (c) include the issuer's right not to pay interest coupons under certain circumstances on a non-cumulative basis (holders are not entitled to collect those coupons ever); (d) include loss absorption capabilities on an ongoing-concern basis; and (e) provide that interest payments are tax deductible expenses.
  • Tier 2 redeemable bonds: (a) have a non-call period of between five and 10 years with a step-up on year 10 capped at 300bp; (b) provide that the issuer does not have the ability to suspend interest payments; (c) include loss absorption capabilities upon a bankruptcy event.

The law mandates that upon the existence of a creditor's plan to restructure a bankrupt bank, and subject to regulatory approval, any remaining portion of the nominal value of such bank's subordinated debt securities (which has not been used to absorb losses) will be converted into equity.

The Peruvian banking regulator has given no indication of when it expects to change the existing rules to conform to Basel 3 standards (which would require approval from Congress). However, based on what has happened in other countries and the precedent of past changes to Peruvian banking rules, it is expected that the existing rules should grandfather any such changes for a certain period of time to allow a transition period.

Juan Luis Avendaño and Nydia Guevara

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