Complex financial instruments revisited

Back in 2015, local investors were taken by surprise by new procedures being implemented by local financial intermediaries with respect to the subordinated bond issue by Bank of Valletta plc (BOV). This was one of the first instances whereby the notion of complex financial instruments was publicly discussed. Almost four years down the line, BOV issued another bond that is also categorised as a complex financial instrument. It is therefore appropriate to revisit the factors that determine whether a financial instrument is classified as complex or non-complex and the applicable procedures to be followed when subscribing to such complex securities.

The 3.75% BOV subordinated bonds which mature between 2026 and 2031 are classified as complex on various counts, namely the callability feature, its subordinated nature and also since they are subject to the Bank Recovery and Resolution Directive (BRRD) regime. The callability feature gives the issuer of the bond, in this case BOV, the right to redeem the bond prior to the final maturity date. This is probably the most widely known complexity feature amongst local investors given the numerous callable bonds issued over the years in the local market with some eventually being redeemed early in recent years as a result of the prevailing low interest rate scenario.

Subordination, in essence, means that the rights and claims of any holders of such bonds or notes in respect of the payment of capital and interest will, in the event of financial difficulties being faced by the issuer in question, rank after the claims of all senior and unsubordinated indebtedness and will not be repaid until all other senior and unsubordinated indebtedness outstanding at the time has been settled. Local investors might also be familiar with this term as in the past some bond issues were ranked as subordinated. Subordinated instruments are mainly issued by banking institutions.

Meanwhile, the concept of BRRD is probably the least known amongst local investors. The BRRD regime was introduced by the European Commission back in July 2014 with the aim of ensuring that in the future, governments will not use taxpayers’ money to ‘bailout’ any financial institution as happened in various jurisdictions, such as Greece and Cyprus, during the global financial crises. The concept is now on ‘bail-ins’ whereby the risk is placed on shareholders, bondholders and depositors rather than taxpayers. All European bank bonds are subject to the BRRD regime.

These complexities must also be considered within the context of BOV’s capital structure. Like all other banks, BOV’s capital base is split into Tier 1 and Tier 2 capital. Tier 1 capital is largely composed of shareholders’ equity and retained earnings, hence the primary source of funding for its operations as well as serving as the main source of loss absorption in case of financial difficulties. Tier 2 capital is also referred to as supplementary capital as it presents an additional support to the bank’s main capital base. The new €50 million bond from BOV will form part of BOV’s Tier 2 Capital and will replace the bond of an equivalent nominal amount that matured earlier this month.

In this respect, it is also noteworthy to highlight that BOV’s total capital ratio of 21.1% as at 31 December 2018, already exceeds the minimum regulatory capital requirements. However, BOV is further strengthening its capital base in view of the litigation cases it is currently facing, namely the Deiulemar case, as well as in anticipation of new capital requirements coming into force in the months and years ahead. In fact, in the coming months, BOV is also planning to issue €150 million in additional Tier 1 capital which, as its name implies, will be added to BOV’s Tier 1 capital given its loss absorbing capabilities although it will not be an equity issue. Details in this regard have been limited as the Bank is still assessing the appetite for such offering which will only be available to institutional investors.

It is also important to review the salient steps in the application process applicable in such circumstances in line with the Conduct of Business Rulebook published by the Malta Financial Services Authority (MFSA). Investors may apply for such complex instruments either on a non-advisory basis, where the investor makes the investment decisions without seeking investment advice, or under an advisory service where the investor seeks personal investment advice from a licenced investment advisor.

Under a non-advisory service mandate, an appropriateness test needs to be carried out by the licence holder to assess whether the investor possesses the necessary knowledge and experience to invest in the proposed instrument and to understand its complex features as well as related risks. In this case, applicants should be asked to provide certain information including their level of education, their knowledge of bond markets and the features of complex debt instruments as well as their experience in investing in similar complex instruments.

Meanwhile, when providing investment advice, apart from assessing the client’s knowledge and experience, an investment services licence holder must also assess whether the instrument is indeed suitable for that particular client. This assessment of suitability, which is a requirement on licence holders in terms of MFSA rules to enable the licence holder to act in the client’s best interests, entails understanding the person’s knowledge and experience in relation to the instrument being discussed as well as that instrument’s suitability in the context of the person’s financial standing, investment objectives, investment horizon and risk appetite. Irrespective of the advice given to the client, the licence holder must issue and handover a copy of the suitability report to the client who in turn is generally asked to countersign this document.

The main difference compared to the application procedure at the time of the last bond issue by BOV in late 2015 is that under rule R.4.4.61 of the MFSA’s Conduct of Business Rulebook (as last revised by the MFSA on 2 April 2019), before providing a service to a client with respect to a complex financial instrument, the financial intermediary must consider whether that complex financial instrument is to be provided to such client on an advisory or non-advisory basis. Therefore, the type of service under which complex financial instruments may be transacted is to be considered by the licence holder on the back of a number of considerations including (as indicated in the guidance note G.4.4.68 of the Conduct of Business Rulebook) the level of complexity of the financial instrument in question; the categorisation of the client as retail or professional; and the level of sophistication of retail investors as well as any aspects of vulnerability which they may have.

Investors should be aware of these lengthy procedures when transacting in any financial instrument classified as complex and must collaborate accordingly to ensure that the financial intermediary captures all the information required to act in their best interests while performing the duties expected of them by the regulators.

Furthermore, investors need to continuously absorb information about how the markets work, how to evaluate financial instruments, and keep abreast of all investment topics in order to broaden their skills and ensure that their portfolios are well-structured to meet their objectives without taking undue risks.

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