Since the financial crisis from 2007 to 2009, banks have had to follow stricter rules to make the financial system safer. When big banks fail, it can hurt not just their investors and lenders but also the whole economy and taxpayers. To prevent this, new laws were put in place so that losses are covered by the bank’s shareholders and knowledgeable creditors, rather than taxpayers (via government bailouts). One of the outcomes of these reforms was the creation of specialised financial instruments known as "First Loss After Capital Instruments" (FLAC). These instruments were developed as part of the broader effort to build more transparent and resilient financial structures in the wake of the crisis.

Enhanced regulatory framework for South African banks

As South African banks prepare to implement these instruments starting January 2026, market participants should familiarise themselves with the key features:

• Systemic importance as determined by the South African Reserve Bank: FLAC instruments can only be issued by systematically important banks. This requirement helps make sure that the biggest banks, whose failure will have a big impact on the financial system, are more protected.
• Seniority: FLAC instruments will be issued by the bank holding companies and not the underlying operating companies. Although these instruments are senior at holding company level, they are structurally subordinated to instruments issued by the operating company. This raises an interesting debate on whether these instruments should be classified as subordinated debt or not. We view these notes similar to current senior unsecured notes.
• Bail-in mechanism: Bail-in instruments are designed to help banks during severe stress events. If a bank faces a severe stress scenario such that they are unable to meet their obligations, these instruments may be converted into shares, effectively turning creditors into owners (and converting liabilities into equity). Another bail-in mechanism which may be used is write-off rather than conversion. With this mechanism the instruments are written off, essentially removing the liability from the banks’ balance sheet. Both these mechanisms help boost the bank's financial strength when it needs it the most.
• When will bail-in be applicable for FLAC: FLAC Instruments do not form part of Regulatory Capital (which comprises Equity, Additional Tier 1 and Tier 2 instruments).  Essentially, FLAC instruments will only be bailed in when a bank is in Resolution, this process is handled by the Resolution Authority, which will begin to bail-in instruments as per the proposed creditor hierarchy shown below.

• Maturity Requirements: FLAC instruments must have a remaining maturity of at least 24 months when first issued. This design provides banks with a steady source of protection and strengthens the banks’ balance sheets.

Risks of investing in FLAC

Understanding the risks associated with FLAC instruments requires investors to have a view on the current and future performance of a bank, the health of its loan book and how well-capitalised the bank is. FLAC instruments will only be at risk of losing capital when a bank is facing such severe stress that it is placed in resolution and the capital instruments ranking below it are not enough to return the bank to viability. This is an extreme scenario. We are of the view that the banks are performing well and have been managing a healthy loan book through the cycle. The banks have all comfortably met their minimum capital requirements and in many cases hold excess capital (over-capitalised).

Market opportunity

The rollout of FLAC instruments into the market is expected to be fully implemented over five years. As the market prepares for the initial release of FLAC, we anticipate that their yields will be somewhat higher at first. This expectation is based on the relatively low liquidity these notes will have as initial volumes of these notes in the market will be small and the number of investors participating in these initial issuances is likely to be less as investors get comfortable with these instruments and can get a handle on price discovery. A similar trend was seen with the initial issuances of both Additional Tier 1 and Tier 2 bonds. However, as more FLAC notes are issued and investors become more familiar with these instruments, the yields of these notes are expected to tighten and then stabilise at levels closer to senior unsecured debt instruments.

The road ahead

With the banking sector evolving and the introduction of these new instruments, we believe the FLAC framework bolsters financial stability. We see these instruments as a compelling opportunity for investors to adapt to this new environment. These instruments offer a unique combination of regulatory support, improved recovery potential, and a solid position within a stable financial framework, making these instruments an attractive choice for investors looking for security in uncertain times while targeting good returns.