On 6 March 2013, Moody's credit rating agency placed subordinated debt ratings of Gulf banks on review for possible downgrade. The agency cited that the implementation of Basel III would require Tier 2 instruments to have 'loss absorption' features. This is expected to result in the risk of loss-sharing among creditors of subordinated debt. Even though the subordinated debt of these Gulf banks is on review for possible downgrade, the counterparty credit rating of these banks would not be affected. This shows that the credit quality of most of these issuers would not have a significant impact from this development. The two key reasons for this are strong capital position of these banks and expectation of state government support to most of these banks through capital injection in future, if needed.

If Moody's downgrades subordinated debt of Gulf banks, yields on some of these papers could widen from current levels. However, we do not expect the impact to be significant. We believe that credit fundamentals of most of these issuers would continue to remain strong which would support bond prices going forward. We think if a possible downgrade results in the yield widening then it should be looked as an entry point in some of the higher yielding subordinated papers.

Even if rating agencies downgrade subordinated papers owing to addition of loss absorption feature, Financial advisors dont think that demand or supply of these papers in the GCC would get affected in future. This is mainly due to limited supply and attractive yields associated with these instruments. From issuers' perspective, these bonds continue to remain part of tier 2 capital. In addition, longer maturity of these bonds supports asset – liability profile as at present short term deposits are supporting long term assets including infrastructure.

We believe that local governments as well central banks to remain supportive of capital requirements of systematically important banks. Post 2008 real estate crisis in the UAE, Ministry of Finance had extended deposits to some of the key banks. These deposits were later classified as part of tier 2 capital. The regulators are expected to support the local banks either through subordinated tier 2 loans or direct capital infusion (tier 1 capital) in future to ensure strong local baking system.

Tier 2 notes would continue to remain part of total capital going forward as well. Only the repayment of subordinated loans through internal cash would reduce the overall capital base. However, we expect banks to refinance or continue to issue fresh subordinated notes in the future based on interest rates in the market.

However, fundamentally weak banks would suffer from this event. It would be difficult for them to raise tier 2 debt in the capital market. In addition, most of these banks lack government support or have a weaker parent. This also means lower possibility of getting capital injection from the parent. Therefore, portfolio managers are likely to stay away from smaller banks based out of Dubai and Bahrain, which have relatively weak banking sector fundamentals relative to other players in the industry.