After such a long time waiting for the missing pieces of the regulatory capital puzzle, the questions on everyone’s lips are obvious: how much issuance might we see, and where will it come from?
According to their most recently reported numbers, the largest 30 banks in central Europe have a combined additional tier one capital deficit of €31.6bn, and a tier two deficit of €19.3bn.
Some bankers have taken a more rudimentary approach to calculating the possible quantum of supply, looking at the RWAs of the top 40 European banks. According to that calculation, for every bank to fill the 1.5% AT1 buffer would require €250bn of issuance, they say.
Tax is still an issue, but is expected to be resolved soon. Now that the market has seen the near-final draft of the EBA’s technical standards, issuers can make their move, and most expect Nordic banks to be some of the first to bring new deals.
“The Nordic banks are obvious candidates for additional tier one issuance,” says Jochen Mehltretter, head of Benelux and Nordic DCM FIG coverage at Morgan Stanley. “It depends on things like the leverage ratio and their ambitions on S&P risk adjusted capital (RAC) credit, but we expect them to take a close look at the market in the second half of this year and next year.
“In the Netherlands and in the Nordic area, most banks are now comfortable on core tier one capital, and they are moving towards building up and maintaining their strong total capital levels.”
Meanwhile, banks in the UK are expected to focus on Cocos. But they will structure them with additional tier one host paper, says Cecile Houlot, head of UK and Ireland FIG DCM at Morgan Stanley.
“There will probably be two different structures — additional tier on paper with a 5.125% trigger, complying with CRD IV, and AT1 with a 7% trigger, similarly to what we have seen recently in a tier two context, and in order to fill the UK regulator’s pillar two capital requirements.”
Banks in the UK are also working towards a 17% primary loss absorbing capital (PLAC) buffer. In all likelihood, that will be filled up with tier two debt, to insulate senior unsecured holders from bail-in, says Houlot.
Euros on the horizon
Until now, all contingent capital and additional tier one deals have been denominated in US dollars. But that may be about to change, according to Claus Vinge Skrumsager, co-head of global capital markets EMEA at Morgan Stanley.
“From the first deals being anchored in Asia, with high net worth demand, we have seen the US become a bedrock of liquidity for this market. However, Europe is coming online. All of these deals so far have been in dollars, because that was the deepest investor base.
“But look at the KBC transaction — around 60% of that was sold to accounts based in Europe. Large institutional investors now have funds dedicated to buying these products. Some of them specifically mention Cocos as their favourite trading idea. And what that tells you is that it won’t be long before we see a euro-denominated Coco.”
Yields have been plummeting in the fixed income market since Mario Draghi’s now infamous “whatever it takes” statement in the summer of 2012 triggered a bull run on credit. That has greatly helped issuers get new-style capital instruments away at far tighter levels than they might otherwise have anticipated.
BBVA’s AT1 deal, for example, was printed with a 9% coupon. Given that some market participants felt that the 9.5% initial pricing talk was tight — and that one of the leads told EuroWeek that fair value for the trade was more like 10% — it is easy to see how investors’ desperation for yield can drive demand even for complex and risky structures.
However, the sell-off in US Treasuries that Federal Reserve chairman Ben Bernanke triggered in May, when he suggested the US could start to taper its quantitative easing programme, showed just how quickly the market can move against issuers.
Even if few market participants expect baseline rates to widen sharply any time soon, there is a worry that if they do, new-style capital instruments could become too expensive for issuers.
But the spreads banks offer for these deals will begin to tighten as the market becomes more comfortable with the product, says Philipp Lingnau, head of European bank debt capital markets at Morgan Stanley.
“In a normal and developing market, the more familiar and homogeneous the product becomes, the more spreads come in — possibly compensating for a possible increase in baseline rates,” he says.
Old-style capital issues will be grandfathered under the CRD package, progressively losing capital treatment as the new rules are phased in. But issuers will need to replace it eventually, and they may look to the liability management market to do so.
Over the past two years, in order to generate core capital, banks took advantage of depressed prices in their own hybrid and subordinated debt, buying them back at a discount to par so they could book a capital gain.
This led to some investors complaining of being treated roughly by issuers. Now, the motivation of liability management has changed — and banks’ approach towards investors must change with it.
“The dynamic is fundamentally different,” says Peter Jurdjevic, head of balance sheet solutions at Barclays. “When banks engage in liability management in isolation, to improve the quality of their capital, it’s a more aggressive proposition because you’re buying back securities for less than par.
“The liability management that is going on now is motivated by different objectives. It’s not for the sake of capital generation — it’s to lay the ground for placement of these new securities into the same investor base. If you are not doing that in a way that makes investors happy, you’re working at cross-purposes. You can’t prime the market by upsetting investors — you need to seem thoughtful and careful, taking their interests into account.”
After concerns about the complex trigger structure of BBVA’s debut AT1 trade, market participants hope that products will become less idiosyncratic and more homogeneous as supply increases.
Creating a more comparable and easily understandable market is not just down to the issuers and banks structuring these deals — it’s also down to national regulators. CRR may be a pan-European regulation, but CRD IV is for national implementation, so national supervisors have some wiggle room.
Another issue is that the more complex deals take longer to prepare. And borrowers looking further afield than their domestic markets have some complex legal work to do, says David Howe, partner at Sidley Austin.
“If you’re talking about a European bank doing a Reg S tier two deal, the chances are they’ll be able to pull the trigger fairly quickly,” he says.
“They’ll update their EMTN programmes to include basic CRD IV compliant provisions. But if they need to go outside the Reg S market to tap the US investor base, like an SEC-registered or 144A deal, you’re looking at more issues to do with governing law, and that necessitates a longer timeframe.”
On top of that, national regulators have their own demands for bank capital, and as a consequence have a great deal of influence over how these deals are structured. That makes harmonisation difficult, says Morgan Stanley’s Skrumsager.
“We want liquidity,” he says. “We have no interest in creating illiquid instruments, because illiquid instruments don’t create markets that grow in size and encourage further demand. But the reality is that regulators throughout Europe have different views on what this instrument should cater for.”
“Then there are different tax treatments, different rules around issuing equity, from country to country. The challenge is getting regulators in each country aligned to a common set of standards — that will lead to more homogeneity.”
But even if individual instruments adhere to a harmonised set of terms, they might still not be comparable across different jurisdictions and issuers. This is partly because triggers for additional tier one and contingent capital are based on RWAs, which can be calculated differently at different institutions, according to complex internal models.
This March, a study by the EBA found that half of the variation between banks’ RWAs could not be explained by differing balance sheet structures and regulation, but were instead down to banks’ own methods for calculating the figure.
That is worrying for investors in new style capital, says Lingnau.
“If you want instruments to be truly comparable you also have to make sure that investors can easily compare the asset side of the respective issuers,” he says. “Otherwise you might have homogeneous instruments that in reality act differently because the RWAs of the different issuers are calculated based on different models.”
Andrea Enria, chairman of the EBA, has said better disclosure could go some way to appeasing investors’ concerns. But this is not enough, and the EBA has committed to deepening its analysis of RWAs to make sure they can be a reliable figure.
Predictably, many banks are resisting this push. A turf war is underway, says Skrumsager.
“RWAs are black boxes in many respects, and there is a big drive from regulators to reverse the direction of travel,” he explains. “We moved from a standardised approach to an internal modelling approach. And now we are going back, because investors are saying ‘just tell me what is there and I will decide what it is worth’.
“It is a turf war, over whether we can keep this internal model approach without moving to a fully standardised approach which would maybe produce misleading RWA numbers, but is easier to understand because it is the same across any bank in any region.”
The risks of reform
The move to force losses on investors who consciously decide to lend to banks is mostly based on common sense. It is difficult to argue that taxpayers should foot the bill for banks that lend recklessly or fail to properly manage risk.
As global economies recover from the financial crisis, banks are deleveraging — and, of course, increasing capital. But the rapid pace of change is hurting the economy, says Skrumsager.
“Regulators have to realise that this process takes time, and if you are very aggressive on asking banks to get to a lower leverage level, that has growth consequences,” he says.
“The big problem right now is the SME space. There is not enough capital. We need a SME securitization market — we need it to take up some of the demand that came from the banks pre-crisis. The banks are not providing the SME sector with as much capital as they were in the past, so the SME sector is suffering and that is not good for growth.
“What we learned during the crisis is that banks were operating at too high leverage with too little capital. That is what we are trying to change. What some people will ask is have we gone too far too fast, leading part of the transmission mechanism, like for example the SME space, to suffer.”
But confidence is critical for the existence of the system as well. With less government support, an under-capitalised bank can lose its deposits quickly and cease to exist, which will also hurt SMEs and growth.
Boosting capital is about creating that confidence. But confidence must also come from a fundamental truth of the financial system: that there will always be banks that fail.
The financial crisis has of course become political, and there is no shortage of talking heads willing to endorse reforms that make the banking industry safer. But there will always be accidents — reform is about convincing people that they can be cleaned up quickly, says Lingnau.
"All the things which are going to be put in place will try to avoid something like Lehman happening again," he says. "This will make bank failures more transparent, easier to digest, and will make it easier to predict the consequences — but we cannot eliminate the risk of bank failures altogether."