Over the past five years, banks in the GCC have raised about $12.2 billion of capital using listed hybrid instruments, and an additional about $8 billion were raised using over-the-counter hybrid instruments. These instruments are generally perpetual and callable after five years or every following year at the issuer's option. Moreover, issuers typically have the capacity to defer coupon payment with investors having no recourse in such circumstances. The dual shock of COVID-19 and declining oil prices is raising several questions about these instruments among investors.

What type of instruments were issued?

Over the past five years, most of the capital-raising exercises were through hybrid instruments. GCC banks raised $12.2 billion of listed additional Tier 1 (AT1) capital instruments with $5.5 billion of Tier 1 sukuk and $6.7 billion of conventional instruments. They raised an additional $8 billion of unlisted instruments, as well during this time. Banks issued these instruments, because they qualified under local regulation as Tier 1 capital instruments and their cost was relatively competitive compared with banks' cost of equity (see chart).

What are the typical terms and conditions of these instruments?

Although S&P Global Ratings does not rate most of these instruments, we have incorporated some of them in the total adjusted capital (TAC, S&P Global Ratings' main capital measure defined as the amount of capital a financial institution has available to absorb losses) of some of the banks we rate.

We have observed the following characteristics in most of the instruments we included in TAC:

• They are generally perpetual and callable at the option of the issuer after five years and then every following year if the issuer decides not to exercise the first call. If an instrument is called, there is typically a requirement to replace it with at least an equally ranking instrument.

• Generally, the issuers of these instruments have the option to cancel the payment of the coupon (which explains their loss absorption on a going-concern basis, in addition to the flexibility accorded by the perpetual maturities, and the inclusion in our TAC for rated banks). If the issuer decides to cancel the coupon payment, investors have no recourse. However, generally, such a cancellation would activate an ordinary dividend stopper.

• The instrument is typically writtendown in full or in proportion if the issuer reaches the point of nonviability or if its regulator declares the issuer nonviable. Nonviability would generally mean a breach of the local minimum regulatory capital adequacy requirements. It is not clear if the nonviability includes receiving public sector funding for recapitalization. However, in our opinion, regulators would probably push for a write-down in such a scenario.

In our view, some of these instruments were priced extremely competitively, with some coupon rates in the 4%-5% range. We understand that part of this pricing owed to expectations that government support would be forthcoming under most circumstances, given GCC authorities' long and strong track record of doing that. In cases where we rate such hybrids, we do not consider them as eligible for government support in our methodology, noting their role as regulatory loss-absorbing capital, and we typically use the banks' stand-alone creditworthiness as a starting point for rating them. That explains, for example, why we rate the Tier 1 instruments issued by First Abu Dhabi Bank seven notches below the long-term issuer credit rating on the bank.

In our view, investing in AT1 instruments is not for the faint hearted. They are perpetual instruments and coupon payments are optional. Investors face a variety of risks, including: noncall risk; coupon nonpayment risk; conversion or write-down risk; and regulatory risk (for example, that an instrument may be redeemed earlier than investors' expect because of shifting regulatory standards or expectations).

Given the double whammy of COVID-19 and the oil price shock, do you expect issuers to suspend coupon or write down principal on these instruments?

We expect GCC banks will see significantly reduced revenue and credit growth in 2020. The sharp drop in oil prices and measures implemented by regional governments to contain transmission of COVID-19 will hit the important real estate, hospitality, and consumer-related sectors, among others.

In response, GCC governments have also announced several measures to help corporations and retailers, including reduced taxes and levies and requests that banks extend additional subsidized loans to affected clients. We therefore think that risks will continue to build and ultimately weigh on banks' financial profiles if the crisis worsens.

Nevertheless, we view the crisis as a profitability event rather than a capital event. That means we still expect most of the banks to generate positive net income in 2020. Therefore, we do not foresee that banks will systematically skip the payment of the coupon on their hybrid instruments or write down the principal amounts.

But banks with high exposure to riskier countries (for example, Turkey or Egypt) could be tempted to do just that if the exposure results in significant losses. In addition, if the crisis lasts longer than expected and we start to observe an impact on banks' capitalization, there may be some stress circumstances when banks could consider using these instruments to absorb losses.

Do you expect instruments with 2020 call dates to be called?

Some issuers have been proactive and have already refinanced some of their instruments with the first call dates coming up in 2020. They benefited from what were at the time still supportive market conditions.

For such banks who have already "replaced" the hybrids that are coming up to a call date, we therefore think they will call the hybrids, unless the regulator prevents them from doing so, or that the management of these banks will decide to extend the call dates by another year to see how the effects from COVID-19 and the oil price decline unfold.

We expect banks that have not already replaced existing hybrids will be more likely to consider not calling at the optional call dates, with their decision influenced by the regulatory stance and their views on the duration of the market stresses and pricing conditions.

Market conditions have now shifted, and investors' appetite for risky instruments has reduced significantly. Therefore, for banks that did not refinance their instruments before the crisis, we think the decision to call their instruments in 2020 or not will be purely motivated by the perceived economic impact on the bank.

That includes the impact of market conditions and how new pricing benchmarks arising from investor appetite for risk influence the cost of issuing new hybrids. If the bank knows it can refinance at a lower or similar cost because the instrument has been entirely or partly subscribed by a related investors (for example, a government-related entity), it will probably call the instrument.

Otherwise, we expect banks to consider rolling these instruments over until conditions in the financial markets are better. There are already several precedents in Europe in which banks decided not to call their hybrid instruments. For example, Santander did so in February of 2019 (see "Will Santander's Decision Not To Call Reset The Market For AT1 Instruments?," published Feb. 13, 2019, on RatingsDirect).

Is it an event of default if a bank does not call the instrument?

A bank's decision not to call the hybrid instrument on its optional call date does not constitute a default under our ratings criteria. We view an issuer's ability not to call such a hybrid as a key feature that enhances its flexibility to manage its capital. Indeed, our view of hybrids' ability to be on the balance sheet to absorb losses when needed remains an essential and enduring component of our criteria for assigning equity content to hybrid capital instruments.

A material and persistent adverse investor reaction to an issuer's decision not to call its hybrid instrument could reflect a reputational problem with wholesale investors. This population is more important to some GCC banks than to others, particularly in Qatar where dependence on external wholesale funding is high. Such a reaction could lead us to review our opinion of the bank's access to cost-effective refinancing. — S&P Global Ratings