The starting gun has been fired in the race for bank capital, even as the final details of the new regime are being hammered into place. Equity is king in this new world. Subordinated debt and hybrids still have a role, but above all, regulators are calling for equity. And lots of it.
"Core equity tier one is where its at," says Nigel Myer, bank credit strategist at Lloyds Bank Corporate Markets. "Its what everybody is disclosing: nobody cares about total capital. The rest is just managing to a regulatory constraint. The market is absolutely running not only on a Basel III type view, but it doesnt care about total capital, it cares about core equity tier one, so banks are being forced down that route."
Total capital requirements are close to doubling from the 8% pre-crisis requirement. And, while banks have until 2019 to fully implement the new ratios, market discipline will encourage them to comply with the rules much sooner.
"Market pressures are likely to push banks to move to a Basel III environment earlier than the phased transition allows," says Jonathan Winstanley, managing director in Lloyds Bank Corporate Markets strategic transactions group. "Analysts are already looking at banks under the Basel III rules, separating the stronger institutions and driving early implementation."
When it comes to hybrid capital, several details on how it can be structured remain up in the air at the European level. Without certainty on whether some structures will count as tier one capital, some banks prefer to wait before looking at filling their hybrid requirements. In the meantime, they are examining a range of other ways to address their capital profile.
The shift to common equity for bank capital is dramatic. Before the crisis, institutions were required to hold equity equivalent to some 2% of risk weighted assets. Once Basel III is fully implemented in 2019, the common equity requirement rises to as much as 12% for the largest institutions. That comprises a 4.5% basic equity requirement, a 2.5% capital conservation buffer, another 2.5% in a counter-cyclical buffer, and up to 2.5% on top of that for the most systemically important banks internationally in the G-SIB buffer.
The obvious big step to preparing for the new rules is to issue equity something many, like Bankia, Aareal Bank and UBI Banca, have done this year. At the same time, banks are looking at whether they can issue hybrid capital that complies with the new rules and how they can optimise the composition of their assets to minimise the capital they need to hold.
Institutions are combing through their holdings, weighing up the advantages of maintaining the exposure versus moving them off balance sheet, or getting rid of them altogether.
"Given all the lack of clarity on the capital side, and the opacity around capital measures being taken, there is a lot of work being done on balance sheet reduction," said Paul Adams, vice president of FIG DCM at ING. "That includes divestments, earnings retention, and otherwise strengthening the common equity bucket. These are exercises that banks can do without knowing the regulations on hybrid capital instruments."
Securitisation will be a useful tool here. In August, Standard Chartered used Sealane II, a synthetic securitisation, to cut its capital requirements on a $3bn pool of emerging market trade receivables.
Trades like this could become more popular for banks managing their capital under the new regulatory system.
Christoffer Mollenbach, managing director and head of FI debt capital markets at Lloyds Bank Corporate Markets, says trades to move risk off balance sheet may become more attractive, given the higher cost of capital. "There are a number of specialist investors out there to take equity-type risk on bank balance sheet," he says. "Securitisations become a lot more interesting when a bank has to raise capital through pure equity rather than a mix of hybrids and equity."
But securitisation is unlikely to be a catch-all solution to banks looking to trim their assets. Regulators are tightening their criteria about how these trades can be structured, says Gerald Podobnik, co-head of capital solutions for Europe and CEEMEA at Deutsche Bank.
"Before the crisis it was about risk management exercises RWA trades but regulators have become ever more strict about the requirements these trades need to fulfil. Now banks are looking at reducing risks by adjusting their business models, cutting back RWA intensive businesses and simply selling assets."
Similarly, the way banks risk weight their assets is coming under increasing scrutiny from investors. Introduction of a leverage ratio, whereby banks must hold 3% capital against their total exposures, has been pushed back. That makes capital held against risk weighted assets the main measure of bank strength and makes calculation of those risk weights crucial.
Banks should engage more with investors over their RWA calculations, Barclays Capital analysts said in a research note in July. "RWA definitions are becoming perhaps the most important issue for investors, rating agencies, regulators and analysts to regain confidence in. If confidence isnt restored, the implications for the European bank sector are profound, and potentially ugly."
(see page 159 for more details)
A lack of certainty on the European rules for new-style tier one instruments, which will fill banks 1.5% Additional Tier One buckets, closed the market for hybrids for most of 2011. Since the European Commission announced how it would introduce Basel III rules in July, much of the fog has lifted.
Introduced largely as a regulation, rather than as through a directive as in the past, the new rules should standardise tier ones across Europe.
"In the past, a lot of banks issued subordinated bonds or hybrids regularly, and they frequently changed structures," says Deutsches Podobnik. "Some structures tend to behave in times of stress in a way thats not envisaged at the time they are issued. The fact that CRD IV is in the form of a regulation will really harmonise these instruments all over Europe and within institutions. There will always be tweaks, but there should be a focus on keeping the main elements as standardised as possible in one bank and in one jurisdiction. With different corporate and tax laws there will always be slight variations between countries. But within institutions the instruments should stay more consistent."
Hybrid tier one will now have to convert to equity or take a permanent writedown if a bank breaches a 5.125% common equity tier one ratio or a regulator deems it non-viable. But many banks are still hesitant to proceed, wanting more clarity from the European Banking Authority on writedowns, and from the European Commission on non-viability.
"Recently all capital transactions weve seen have been rights issues, some combined with liability management exercises where banks bought back hybrid capital and exchanged it into equity," says Isaac Alonso, head of FI capital origination at UniCredit. "We would not advise clients to bring any hybrid capital (tier one) at the moment, not knowing what the exact EBA features are going to be."
Not all are so cautious, however. Some investment banks say it would be possible to go ahead with a hybrid security now, market conditions permitting of course. Most issuers have been preparing for new instruments over the past 18 months says Karim Mezani, head of FIG syndicate at Natixis. "Theyve been monitoring the market, and monitoring what could be the regulatory rules in their own jurisdictions. In the vast majority of continental Europe there have been advanced conversations between issuers and the regulatory authority. I dont think it will surprise anyone to see new issuance in the future, depending on the market backdrop."
To banks evaluating their options to comply with the incoming capital requirements, the swathe of extra equity they must hold may seem onerous. The future of bank capital has been designed by regulators who have one eye on financial stability and the other on saving taxpayer funds from future bail-outs of financial institutions. But the requirements should have positive repercussions for the banks themselves.
Debt investors will be much more comfortable lending to the better capitalised institutions. That will bring comfort to Europes banks, which have seen senior unsecured term funding markets shutting down completely for weeks at a time."This is what we expect to play out over the next few years," says Matthew Pass, head of FIG origination for Europe at RBC Capital Markets in London. "If youre very well capitalised and you prioritise common equity, do you get that back with lower funding costs? Over the past decade many banks have attempted to make decent returns for shareholders by adding leverage into the equation. It may well be theyre better off being more transparent and extremely virtuous going forward."