Subordinated loans – a financial instrument for financial institutions

Subordinated loans – a financial instrument for financial institutions

As a financial instrument, subordinated loans are quite common for financial institutions and are used to ensure adequate capital ratios. They can be an attractive alternative option for making investments by business companies and relatively inexpensive capital for financial institutions themselves. However, before making such investments, one should take note of the applicable legal requirements and restrictions.

Subordinated loans are gaining popularity on financial markets as a way for financial market players to build their Tier 2 capital.

Capital requirements for credit institutions and investment firms (and for certain other financial institutions) operating in Lithuania and in other countries of the European Union (EU) (the “financial institution(s)”) are set out in Regulation (EU) No 575/2013 (the “Regulation“), which ensures the uniform application of the so-called Basel III international standards across the EU.

The own capital of such financial institutions generally comprises Tier 1 and Tier 2 capital. Tier 1 capital consists of fully paid-up capital, share premiums and other instruments that are not anyhow financed by the financial institutions out of their own funds, and is non-repayable. On the other hand, Tier 2 capital may consist of a much wider range of instruments but cannot amount to more than one-third of the financial institutions’ Tier 1 capital in order to continue to be their own capital.

Tier 2 capital may only consist of the instruments that meet the strict criteria specified in the Regulation, one of such instruments being a subordinated debt that may be granted to the financial institution as a loan.

In this article, we will have a closer look at the possibilities for granting subordinated loans to financial institutions and at the legal risks involved.

Subordinated loans to financial institutions

The subordinated loan differs from the normal loan in that it might constitute the financial institution’s Tier 2 capital. The Regulation stipulates that in order for the subordinated loan granted to the financial institution to be regarded as Tier 2 capital, the subordinated loan agreement must comply with the criteria and requirements set out in the Regulation. These criteria imply that it would not be allowed to include in the agreement any clauses that might predetermine early repayment of the loan or prioritize it over other claims of that financial institution’s creditors.

First of all, as already noted, such loans would have a subordinate status vis-à-vis other loans of the financial institution’s creditors, except for its shareholders. If the financial institution goes bankrupt, the claim of the creditor having granted a loan under a subordinated loan agreement would rank, in fact, behind almost all other claims, save for those lodged by that financial institution’s shareholders. This means that the claims of all secured creditors, depositors, and employees would be paid first. Therefore, each creditor should consider the risk that in the event of bankruptcy, the probability of non-recovery of the loan could be fairly high because the financial institution’s assets may turn out to be insufficient to meet its obligations, while the Regulation prohibits to provide any collateral for such loans.

In addition, no early repayment possibilities may be included in the subordinated loan agreement, which must provide for at least a 5-year repayment term. No repayment of the loan before the agreed-upon due date would be possible otherwise than in exceptional cases and unless the supervisory authority’s consent has been received. To receive such consent, the financial institution would have to demonstrate that its equity capital remains sufficient after its obligations under the subordinated loan agreement are met.

Similarly to the above, no clauses that may implicitly encourage early repayment of the loan may be included in the subordinated loan agreement. It is typical that loan agreements make it possible for the creditor to demand early repayment of the loan in certain cases, for example, if the borrower breaches the agreement or if certain events or situations occur that might significantly impair the borrower’s ability to repay the loan. In the case of the subordinated loan, such possibility would be virtually ruled out as priority over other creditors might be gained in that way. Moreover, since the loan facility granted under the subordinated loan agreement constitutes the financial institution’s capital, the non-existence of such restriction might have serious consequences for the compliance with capital adequacy ratios. It is also recommended that the subordinated loan agreement should equally restrict the contracting parties from offsetting their mutual obligations under such agreements so that no priority over other creditors is gained. All the criteria discussed above, as well as other criteria specified in the Regulation should necessarily be addressed in the subordinated loan agreement between the creditor and the financial institution. Otherwise, there is a risk that the credit facility granted will not be regarded as Tier 2 capital, which may consequently cause a risk that the financial institution may not achieve its capital adequacy ratios.

Opportunities for businesses and financial institutions

Although the Regulation sets forth the criteria, which are strict, there still exists some flexibility that can be exercised by the parties to the subordinate loan agreement. For example, the Regulation does not restrict the financial institutions from committing themselves to use the loan facilities received under such agreements for some specific targets, e.g., for financing renewable energy projects. In any way, such commitments must always comply with the criteria discussed above and must never encourage early repayment of the loan.

Subordinated loans may be an attractive alternative option for financial institutions to obtain capital, while businesses often see such loans as a safe investment because in its capacity as a borrower, the financial institution is supervised by government authorities and is bound by strict capital adequacy requirements, which significantly reduces the risk of default.


Article by Marius Embrektas, Partner, and Tautvydas Užkuras, Senior Associate, at Law Firm Glimstedt

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