China’s largest banks have begun planning to issue Lower Tier II bonds that comply with Basel III capital adequacy rules but any issuance is likely to be delayed until regulators sort out legal and infrastructure hurdles in the interbank bond market.
“Regulators are nowhere prepared for Basel III bonds because they have not been issued before,” said Wilson Li, a China bank analyst at Guotai Junan Securities. “It’s a natural process to be considering these bonds right now...but it will take a while before China banks will issue Basel III bonds because there are a lot of developments that need to take place.”
Bank of China (BoC) became the second major bank to release plans to sell Basel III-compliant debt onshore. According to its submission to the Hong Kong Stock Exchange on April 25, BoC will look to sell up to Rmb60 billion (US$9.73 billion) of bonds with maturities of longer than five years by December 31, 2015. The proceeds will be used to replenish Tier II debt, and it will include a write-down clause to absorb losses if its Tier I capital ratio falls below 5.125%.
BoC’s announcement follows a similar release by China Construction Bank (CCB) on March 24, which also aired plans to issue up to Rmb60 billion of Tier II debt by the end of 2015.
These are the first major announcements from Chinese banks on issuing Basel III bonds onshore. But despite their intentions, bank analysts don’t expect any these institutions to raise capital any time soon because the market simply cannot handle it.
“In terms of the market’s environment, it’s unclear that China’s domestic market can support these bonds or not. There are a lot of issues to overcome,” said Qiang Liao, senior director of financial institutions ratings at Standard & Poor's.
Among the main issues is the uncertainty associated with Basel III bonds as well as the investor base in the interbank bond market, where financial institutions are approved to sell bonds.
Basel III-structured bonds are inherently riskier than vanilla bonds as they are saddled with write-down to zero features or turn into equity if banks’ capital adequacy ratios fall below a predetermined threshold. This also means that issuers must therefore pay more to sell this debt.
But banks themselves are the main investors of the interbank bond market, holding more than 80% of policy bank bonds and 60% of government bank bonds, according to ANZ. This means that banks will likely be the main investors of each other’s Basel III bonds, posing far more systemic risk to the banking system than if non-bank investors held the majority of these bonds.
“If the investors themselves are the banks buying into one another’s bonds, from a system perspective, there’s no additional buffer for loss taking,” said Liao.
Regulators recognise this circular investment structure and have long considered methods of diversifying the market, including allowing more foreign participation. But while these measures have helped dilute banks’ hold on the market, getting non-banks to buy Basel III bonds is another matter.
“It could be very difficult to distribute this paper,” said Li. “And it’s a question of how much they would have to pay to get other investors interested.”
In addition to finding non-bank investors for these bonds, China is considering the legality of Basel III-compliant bond structures. According to analysts, China does not have a system to cope with bonds’ write-down features to zero, and lawyers are exploring the legalities of such features.
The concept is especially fickle as China has never seen a domestic bond default. Introducing measures in which investors can lose their money is contentious.
“It’s not clear that this kind of instrument could be accepted by regulators and shareholders,” said Li. “Turning to the debt markets to raise this money is something that banks would like to consider rather than going the equity market, but the write-down feature is difficult.”
Chinese investors are more accustomed to a structure by which their bonds would dissolve into equity if a bank’s core capital falls below its threshold, as many state-owned enterprises did this in the late 1990s when their debts mounted. Yet this method is also politically sensitive.
“This could be more feasible but the question is whether the securities market watch dog is in the position to allow this kind of debt-to-equity swap to occur,” said Liao. “On a significant scale, the CSRC [China Securities Regulatory Commission] tends to become really be concerned by any implication to the stock market’s performance, so that’s another issue.”
However, there is little immediate need to raise Tier II capital for most Chinese banks. First, their core capital ratios are strong relative to most global banks, with BoC reporting a core capital adequacy ratio of 10.33% and CCB core capital of 11.32%.
And secondly, most commercial banks rushed to sell Basel II-compliant bonds at the end of 2012 before the new regulations became enforced on January 1. This gives them time before they need to raise more capital.
“I wouldn’t expect to see major banks selling Basel III bond issues this year, but maybe they would start next year,” said Liao. “For the large banks, if they need capital then they also have the possibility to do this offshore, which is what ICBC had done. It still counts towards their core capital from a consolidated balance sheet point of view – if these banks have a real need to raise capital, all of them have the opportunity to do this from their offshore branches.”
ICBC issued Asia’s first Basel III bond in November 2011. It remains the only Basel III bond in the offshore renminbi market.