The CIS, Middle East and Turkey all appear more promising prospects for subordinated and hybrid issuance than the former EU accession states proved to be. But the size, ownership structure and ratings of banks should be carefully considered before precise forecasts can be made.
One of the key themes in the international capital markets in the past decade has been the convergence of former emerging market countries in central and eastern Europe with the European Union, a process that culminated for many in the accession of these countries to the EU on May 1, 2004. After the Emu convergence trade involving the established EU members, it was — over the long run — a sure-fire bet.
Investors poured money into sovereign credits, hastening their convergence with western Europe, and then moved gradually down the credit curve into banks and corporate credits as issuers from the region became more sophisticated and keen to take advantage of the opportunities available.
But almost entirely absent in the steps taken as these countries evolved from centrally planned to market economies was the development of a market in bank capital instruments.
Banks such as Slovenska Sporitelna and Vseobecna Uverova Banka from the Slovak Republic opened a subordinated debt market for central and eastern European credits as long ago as 1996, but while the occasional issuer such as the Czech Republic's Komercní Banka joined them, few others raised subordinated debt, let alone issued hybrid tier one securities.
Market participants say that there are two main reasons for this. "Regarding the accession states that are now in the EU, regulators in the region were historically more prudent, and rarely allowed anything other than equity to be accounted for as regulatory capital," says Tom Keatinge, vice president of financial institution group, capital markets at JP Morgan in London. "I remember working on the first subordinated debt deal from CEE back in 1998 and it took a very long time to get the regulators to acknowledge that such capital could supplement equity capital.
"Meanwhile in countries like Poland, capital really meant equity only, until they acceded to the EU. So in general, the regulators were very prudent and conservative about what they would allow to count as regulatory capital."
The second reason for the absence of bank capital supply in the bond markets from central and eastern Europe, say observers, is that banks from the region have been able to source capital more cheaply elsewhere.
"A large percentage of the banking sectors in many central European countries are now owned by highly rated European banks," says Richard Luddington, head of CEMEA debt capital markets at UBS in London, "so there has been little or no need for banks in countries such as the Czech Republic, Hungary and Poland to raise subordinated debt in their own name. They have effectively been grandfathered in terms of capital requirements."
The importance of foreign ownership of the banking industry in central and eastern Europe was highlighted by RZB analysts in a review of banking trends in the region in October.
"With most of the banking sectors in Central Europe [Poland, Hungary, Czech Republic, Slovak Republic, Slovenia] already in the hands of international banks, there are only a very few state banks still left to be privatised," said RZB's analysts. They noted that further progress in privatisation in Poland had left Slovenia with the highest market share of state-owned banks in central Europe, at 19%, while in the other three countries' the share was less than 5% or zero.
When RZB's analysts looked at southeast Europe — Romania, Bulgaria, Croatia, Serbia, Bosnia-Herzegovina and Albania — they found a similar situation. Romania and Albania had through privatisations cut the market share of state-owned banks to below 10% — in line with Bulgaria, Croatia and Bosnia-Herzegovina. Serbia was also making progress, having completed the privatisation of four smaller banks.
As in the new EU members, much of the privatisation process in southeast Europe has seen banks sold to foreign buyers. At the close of 2005, for example, Austria's Erste Bank won the bidding for a majority stake in leading Romanian bank Banca Comerciale Romana, for Eu3.75bn.
This has left DCM bankers seeking business in the region kicking their heels. "We spend a lot of time trying to square the circle between their internal cost of capital and what the market can offer," says one, "and frankly the ratings on these institutions just mean that it is cheaper for them to get capital internally."
And when bankers do manage to find a candidate that has yet to be sold to a foreign buyer it is unlikely to be an exciting prospect. "The other thing to bear in mind when you come to somewhere like Romania or Bulgaria is that a lot of these banks are just very small," says one. "They have an equity base of Eu50m-Eu100m, which only gives you capacity for a lower tier two deal of Eu25m-Eu50m, so they are not particularly interesting opportunities."
OTP, NLB the exceptions
A notable exception to these rules is OTP Bank of Hungary. In early March the bank issued a Eu125m lower tier two debt issue, the first public subordinated bond from the country. Led by JP Morgan, the transaction was structured as a 10 year floating rate note paying a coupon of three month Euribor plus 55bp.
"We launched our subordinated bond issue because at that time we were involved in a lot of acquisitions and to finance and support these we needed more capital," says Dóra Losteiner, head of the corporate finance department at OTP Bank in Budapest, "and in the next year we may tap the market with more subordinated bond issues if further transactions require it."
OTP has been a busy acquirer in the region, since 2002 buying subsidiaries in Slovakia (OTP Banka Slovensko), Bulgaria (DSK), Romania (OTP Bank Romania/RoBank), and Croatia (OTP banka Hrvatska/Nova banka). The bank is also pursuing opportunities in Serbia and Montenegro, and Ukraine.
Unlike most of its peers, OTP is not part of a larger international banking group. "The other Hungarian banks have international strategic owners and do not therefore need to sell subordinated bonds as they can be supported by their parent banks and they are also not involved directly in acquisitions," says Losteiner. "But OTP Bank has to support all its international acquisitions directly and that is why we are active in selling subordinated bonds."
Part of the proceeds from the lower tier two issue were also used to replace subordinated debt that had been provided by the European Bank for Reconstruction & Development that was amortising.
Losteiner says that the bank was pleased with the results achieved in the subordinated issue. "It was a relatively quick transaction and more like a private placement," she says, "but it was sold to nearly 20 investors and we were very satisfied with it because the 55bp spread at that time was very good for us."
In Slovenia, Nova Ljubljanska banka (NLB) finds itself in a similar position to OTP. Belgium-based KBC Bank owns a 34% stake in NLB, but the state for the time being remains its biggest shareholder, with more than 35% of the shares. The bank therefore optimises its capital structure without recourse to its large international shareholder.
NLB has not only launched a lower tier two equivalent transaction, a Eu50m deal in May 2004, and an upper tier two equivalent transaction, a Eu100m deal in December 2004 — both led by Merrill Lynch — but also a hybrid tier one issue, a Eu130m transaction led by KBC in July 2005, says Gregor Kaiser, general manager of the financial institutions and international department at NLB in Ljubljana. However, all three deals were sold as private placements.
Advantages for Turkish banks...
Further east, in Turkey, some market participants see more promise for the expansion of the bank capital market. Not only are its banks of a size to produce chunky bond issues but the prevalent ownership structures could make sub debt attractive.
"Turkey is an interesting market for subordinated debt because many of the banks are owned by private holding companies that want more return out of the banks," says JP Morgan's Keatinge. "In some cases they are selling off stakes to raise additional equity, but in some cases it might make more sense to raise some subordinated debt if they need more capital across the group."
In Moody's 2005 Banking System Outlook for Turkey, published in January 2005, the rating agency highlighted the way in which greater stability of the country's banking sector was tempting foreign banks to invest in Turkish banks. However, it pointed out that so far acquisition of 50% stakes had been the norm.
"It appears that where the bank's original owner is a Turkish business group, the foreign bank has been able to buy only a 50% stake," said the rating agency. "The improved banking sector prospects have made current owners reluctant to leave the business but have also made them realise that a strong foreign partner can help develop the bank's retail banking franchise."
Should this soft limit remain, it should support the use of subordinated debt as a way of raising additional capital. So, too, could the trend of larger banks seeking to increase their networks through capital expenditure or acquiring smaller, weaker banks.
"In the context of what is generally viewed as being increased consolidation in Turkey, I believe that there will be more opportunities for people to issue sub debt because it is going to be a case of strong banks buying weaker banks and as a net effect you want the capital to remain stable," says one banker.
Last year's acquisition of Yapi Kredi by Koçbank is seen as an example of this trend. Although Koçbank was given a capital injection from its shareholders, which include indirectly UniCredito Italiano, market participants suggest that subordinated debt might be an appropriate option for the bank.
...but little so far
George Chrysaphinis, an analyst at Moody's in Limassol and one of the authors of the rating agency's Turkish Banking System Outlook, agrees with this view. However, he says that in general subordinated debt issuance is not high on the agenda for the country's banks.
"Banks are generally well capitalised in Turkey," he says. "Capital to total assets is close to 10% for a large number of banks and for some of them it is even higher. The capital adequacy ratio, according to Turkish standards, is typically in the mid to high teens or even higher.
"Furthermore banks have been very profitable over the last three years, so they are retaining a lot of capital. For most of them, their capital needs are currently met through internal capital generation. Retained earnings have been boosting capital levels by 10%-30% every year."
Whatever the prospects for issuance, only one public deal has so far emerged. In October 2004 Finansbank launched a $200m lower tier two transaction via Merrill Lynch that carried political risk insurance. The 10 year non-call five issue steps up from 9% to 11.79% if not called.
Like many of its peers, Finansbank had, since the Turkish banking crisis of late 2000/early 2001, changed its business model.
"The main driving force for the deal was Finansbank's change in strategy from holding government securities and lending to the government to running down its T-bill portfolio," said Alex von Sponeck, director, EEMEA securitisation and structured finance at Merrill Lynch in London, at the time of the transaction.
"There has been a big increase in consumer lending, lending to SMEs, credit cards, and retail lending like mortgages and so on. This growth strategy meant that a potential capital constraint would have been reached soon, and to keep up the pace of growth, and capture further market share, they needed a capital increase."
Ozlem Cinemre, executive vice president at Finansbank in Istanbul, says that in light of these needs and the bank's ownership structure, lower tier two capital proved an interesting option.
"We are owned by a private shareholder that can of course inject capital into the bank, but we felt that raising capital from international resources to support the growth of the bank would be a good alternative," she says. "At the time, we felt that it would be too early to issue tier one or enter into negotiations for a strategic partnership with a local or foreign investor.
"Management felt that if the bank could borrow at a more reasonable rate than the cost of equity capital then subordinated debt would be the best alternative."
Russian market gains momentum
Where subordinated debt has been wholeheartedly embraced by the banking industry in the past 12 months is the Russian Federation. A half dozen issuers from state-owned Sberbank and Vneshtorgbank to privately owned Alfa Bank and Russian Standard Bank launched lower tier two transactions in 2005, creating a market for subordinated bond issues that had not previously existed, either domestically or internationally.
The reason for the surge in issuance, along with regulatory progress, has been Russian banks' strong appetite to feed the growth in their assets, highlighted by Fitch in a report published in November 2005, Russian Bank Capitalisation — Towards Greater Flexibility.
"To date, most Russian banks have increased their capital from two sources: internal capital generation and, to a lesser extent, equity injections," said the report. "However, average return on equity and the rate of equity contributions were both significantly less than the pace of asset growth in 2004 and H105 for a group of leading banks studied in this report."
This, said the report, has resulted in Russian banks looking at alternative sources of capital.
"Russian banks have begun to consider additional ways to strengthen their capital bases, such as subordinated debt and (more recently) tier one capital instruments," said the report. "Such issues have the advantage of not requiring cash outlay from existing shareholders, reducing the weighted average cost of capital of the bank and being more quickly registered than share issues."
Igor Hordiyevych, director, CEMEA debt capital markets at UBS in London, says that banks in Russia are increasingly understanding and are seeking to take advantage of these benefits.
"Subordinated debt instruments are a good tool because they are first of all cheaper than equity but also tax-deductible," he says. "Secondly, you don't need to hold a shareholder meeting and to go through the lengthy legal processes involved in issuing new shares, which is particularly difficult for those banks in state ownership.
"And clearly in terms of improving shareholder returns these instruments allow you to leverage the bank better and improve your return on equity."
But Hordiyevych adds that, like all good things, subordinated debt is best consumed in moderation. "At the same time one needs to be conscious of the fact that the quality of capital still needs to be there," he says. "People will still look for banks to have a good amount of equity and, of course, under the Basel model innovative hybrid capital is, in most cases, limited to 15%-25% of tier one and lower tier two to 50% of total tier one capital."
The size of Russian banks offers further explanation as to why the country has provided such a feast of subordinated debt issuance in the past year.
"Bearing in mind that you can issue lower tier two up to 50% of your tier one capital and upper tier two up to 100% of your tier one, there is a lot of potential from Russian banks because of their big equity bases," says Jan Mutsaers, head of EMEA debt origination at ING in London. "Banks like Vneshtorgbank and Sberbank have yet to exhaust their 50% lower tier two limit, but even if they were to do so they could still do a nice liquid upper tier two issue because they can add a similar amount as they have done in lower tier two and use it for capital calculation purposes.
"So the fact that the Russian banks are bigger gives them more manoeuvrability to use these bank capital products — as long as the central bank allows them to move beyond lower tier two to upper tier two and tier one."
Issuers embrace new instruments
The Russian central bank's constructive approach to the concept of lower tier two issuance unlocked last year's subordinated debt issuance, the first of which was a $750m 10 year non-call five issue for Vneshtorgbank (VTB), led by Barclays Capital, Deutsche Bank, HSBC and JP Morgan at the start of February.
Like its peers, VTB had seen its capital adequacy ratio falling as a result of the tremendous growth of its lending. "We had previously been an overcapitalised bank," says Nataly Loginova, head of financial institutions at VTB, "but since our growth has been spectacular over the last four years — we grew by some 40%-50% — our capital adequacy of course declined. Since the capital generating capacity of our profits was not growing as fast as the total assets were growing we looked at what we could do to raise capital."
And rather than look to its owner — the state — VTB explored new options. "We looked at international practices and in particular lower tier two and the possibility of raising capital in the Eurobond market," says Loginova. "There are Russian banks that raise subordinated loans, but from their shareholders, but for us that is not something we would like to consider.
"Lower tier two capital is non-dilutive and cheaper than equity, so we decided to go ahead with our transaction."
Towards the end of 2005 Alfa Bank turned to the new market to help it grow, with a $225m 10 year non-call five issue via Barclays and UBS.
"We have a commercial portfolio that is growing extremely fast and launched our lower tier two issue firstly to fund this growth and secondly to diversify our capital base," says Marco Salvi, head of the investment bank at Alfa Bank in Moscow. "Alfa Bank has traditionally pursued an aggressive capital structure, focussing on maximising returns for shareholders, especially in terms of regulatory capital, and this transaction also put us more in line with our peers in terms of total capital ratios."
Alfa Bank has over the past five years maintained a capital ratio of around 10%, but through the subordinated bond issue as well as retained earnings and capital injections it wants to reach a ratio of 12% in the first quarter of 2006.
Although the variety and volume of Russian subordinated bond issues in 2005 exceeded expectations, market participants are not getting carried away with the outlook for supply.
"In this type of market you always start with the bigger, better rated banks and then develop it further down the credit curve," says Hordiyevych at UBS. "But at the end of the day there is a natural limit to the market for these instruments and that, first of all, is the size of banks' capital.
"For public deals we would always like to see ideally a minimum of $100m, so that means that a bank needs to have a minimum of at least $200m of tier one capital."
The second limit is on the ratings front. "The rating agencies notch lower tier two between one and two notches below the senior unsecured rating so you need to have a high single-B or even low double-B rating for this to be rated at least in the single-B territory," says Hordiyevych. "Selling this as triple-C paper is a very different ask.
"But clearly there are enough banks in Russia that are big enough and have a good enough rating to be able to access this market to keep it busy in 2006."
Kazakh banks lead the way
The CIS market for subordinated bond issuance was opened up to international accounts by Kazkommertsbank (KKB) in April 2004, with a $100m 10 year non-call five lower tier two deal via Citigroup and ING.
"Kazkommertsbank is the number one bank in Kazakhstan, which has the best regulated banking sector in the region," said a syndicate banker at ING in London at the time. "KKB's asset growth has been significant and this deal gives the bank a good platform to expand further."
Kazakh banks had already been in the position to sell subordinated debt locally because of the country's developed pension industry, something lacking elsewhere in the CIS. Suffering a lack of supply of securities to invest in, local pension funds have proven a competitive source of capital for Kazakh banks, which typically sell plain vanilla bonds of maturities up to 10 years to the domestic accounts, although the paper is inflation-linked.
However, in spite of the attractive funding available domestically, KKB was keen to explore greater opportunities. "The local market is relatively small," says Andrei Timchenko, managing director and head of the bank's international division, "so we can raise around $20m-$40m. With our international lower tier two issue we were able to issue $100m."
The next logical step for the country's banks was then to look at more deeply subordinated layers of capital. "The Kazakh banks have raised more or less all their lower tier two capacity in either the domestic market or in KKB's case the international market as well," says one CEEMEA banker. "So the next step would be either hybrid tier one or upper tier two.
Following this logic, KKB in October launched a $100m perpetual non-call 10 year tier one issue, the first hybrid tier one issue from the CIS. Leads ING, JP Morgan and UBS launched the deal in parallel with a $500m 10 year senior transaction (see case study on page 42 for full details).
Market participants expect Bank TuranAlem (BTA) to follow KKB's lead with a hybrid transaction. In its Industry Report Card: Major banks in Kazakhstan, Russia, and Ukraine, published at the end of October, Standard & Poor's said of BTA's BB- rating with positive outlook: "The positive outlook reflects S&P's expectation that BTA will address its very tight core capitalisation in the near term to provide greater support for its projected high growth. Failure to address the above-mentioned issue could result in the outlook being revised to stable."
Rating Ukraine's prospects
The only subordinated bond issue yet to emerge from the Ukraine was a $40m lower tier two issue for Ukreximbank, led by Dresdner Kleinwort Wasserstein and UBS in February.
The state-owned bank had previously relied on capital injections when in need of additional capital or retained earnings, but wanted to take advantage of a further source.
"We are state-owned so if we grow organically then we need to look seriously at the best way in which we can increase our capital in order to be in compliance with the necessary capital adequacy ratios," says Nikolay Udovichenko, deputy chairman of Ukreximbank in Kiev. "Having tier two capital available increases the flexibility of our capital structure."
Although Privatbank, the largest Ukrainian bank by assets and market capitalisation, is thought to be considering a lower tier two transaction, the prospects for subordinated supply from the country appear mixed.
"Two of the leading banks are owned or set to be owned by foreign banks," says James Watson, an analyst at Fitch in Moscow, "and that may be the case for other banks in the near future as well. That obviously introduces an additional and very important option into the capital equation as those owners are going to be capable of injecting equity into these banks rather than have them raise sub debt on the market themselves."
A further impediment could be the ratings of banks in the country. "You are starting off with a rating that is substantially lower than those of the top banks in Kazakhstan or Russia," says one banker, "and when you take a notch or two off for subordination there are very few banks in Ukraine that would not then end up in triple-C territory."
The political turmoil of the past 18 months also clouds the outlook. "It is very difficult to make any estimations for Ukrainian banks because recent performance has been and is still somewhat distorted by the political uncertainty there has been," says Ekaterina Trofimova, an analyst at S&P in Paris, "and this has also constrained growth. Banks may therefore be somewhat hesitant in going to the market with what are somewhat revolutionary debt instruments."
Middle East opens for business
Questions of credit quality are unlikely to hinder the growth of the subordinated bond market in the Middle East, where Gulf International Bank (GIB) opened the market in September. The $400m 10 year non-call five lower tier two issue, led by Barclays Capital and Citigroup, was rated Baa1/BBB+/BBB.
The pace of economic activity in the Gulf states has been hard to ignore and GIB's transaction was launched to support its growth.
"In 2001 GIB adopted a new Gulf Cooperation Council [GCC] focused merchant banking strategy," a spokesperson for the bank told EuroWeek at the time of the issue. "Subsequently, we have been building up our balance sheet, particularly our GCC loan portfolio. As a result, we wanted to further enhance our capital adequacy ratio so we decided to enter the debt capital markets."
A $100m lower tier two issue for Ahli United Bank that followed in November was prompted by M&A activity. "The bank is looking to strengthen its capital ratios after it completed the majority share acquisition of Bank of Kuwait & Middle East in August," says Gilles Franck, head of EMEA origination at BNP Paribas in London, who was bookrunner for the issue.
Other banks from the region are meanwhile making their first steps into the bond markets with senior issues, such as the National Bank of Abu Dhabi, which launched its debut issue, an $850m five year floating rate note in early December. Market participants are therefore optimistic that subordinated issuance will continue to flow from the region.
"There has been a very interesting development whereby Middle Eastern banks have started to move away a little from syndicated loans," says Jonathan Brown, managing director and head of CEMEA syndicate at UBS in London, "to broaden their investor bases and get good penetration outside the Gulf region for their bonds.
"These have so far been mostly senior issues, but there will come a time when the subordinated debt product really comes into play and hopefully that will be this year.