A Subordinated Debt Discussion

According to research firms, subordinated debt offerings by bank holding companies (BHCs) have grown significantly in the past few years. There appear to be two main drivers of this trend. First, low interest rates made high dollar issuances with longer terms more appealing. Second, in 2018, the asset threshold to qualify for the Small Bank Holding Company Policy Statement was raised from $1 billion in consolidated assets to $3 billion. When BHCs meet the criteria for the Policy, certain incentives are created, such as the ability to finance up to 75% of the purchase price of an acquisition.

It is interesting, and perhaps counterintuitive, that regulators appear favorable of subordinated debt. In fact, since the mid- 1980s there have been at least 14 proposals to require large banking organizations to regularly issue subordinated debt on the open market. The main reason for this is that subordinated debt poses less of a risk to the insurance deposit fund. Subordinated debt is inferior to all other creditors, including depositors. As such, in the event of a failure, the subordinated debt is eliminated along with the shareholders, but there is more capital in the institution from said debt. Thus, regulators do not need to worry about the claims made by subordinated debt holders in a liquidation.

Compared to issuing new shares, issuing subordinated debt can be an attractive tool to raise capital. For example, issuing subordinated debt will not dilute current shareholders’ interest, and interest payments on subordinated debt are tax deductible. With that said, subordinated debt may not be available to BHCs struggling financially, as there will be less demand for their debt. Compared to a bank stock loan, there can be a benefit to either depending upon your needs. Some benefits of a bank stock loan are that they are more negotiable, fees are typically much lower, interest payments are also tax deductible, and there is no prepayment penalty. Subordinated debt may also look more favorable at the outset; however, as noted by the FDIC, “subordinated debt is often issued at a fixed rate for the first five years before converting to a variable coupon rate. Therefore, if interest rates rise over the instrument’s life, servicing costs may increase.”

In order to qualify as subordinated debt, the transaction must contain certain features such as:

  1. Be subordinated to depositors and general creditors;
  2. Not be covered by a guarantee or subject condition that improves the seniority of the instrument;
  3. Have a minimum original maturity of at least five years; and,
  4. Must not have any terms or features that create significant incentives for the banking organization to redeem the issuance prior to maturity.

So, if an organization is looking to carry debt for a long period of time and assume risks with long-term interest rates, then subordinated debt can be an attractive option to finance growth or an acquisition. If the organization wants to prioritize the ability to pay down debt quickly and take less risk on long-term rates and upfront fees, then a bank stock loan might be the better option.

I would be remiss if I did not conclude by mentioning that TBB can accommodate both bank stock loans and subordinated debt offerings. Bank stock loans have been a primary product for TBB to help institutions and individual investors for decades. We also have an ownership interest in First Bankers Bank Securities, Inc. which can help broker subordinated debt transactions. Make sure to let us know if you are interested in either product. We are happy to work through the options.