In the months leading up to the landmark agreement on Basel IV, William Coen, secretary general of the Basel Committee on Banking Supervision, became fond of likening the process of finalising the international set of banking rules to running a marathon.
“Even if one is not thrilled with the final result, there is satisfaction knowing that the race has ended,” he said in a speech in Washington DC last year.
This was exactly the same reaction from European banks at the very end of 2017, on hearing that an agreement had been reached on Basel IV.
Many had been dreading arriving at the finish line, because the proposed changes to the way in which banks should model for risk had been seen as a covert way of pushing up their capital requirements. But there was a profound sense of relief in learning that a long run was over.
Now a new kind of marathon is beginning. Banks are setting off on a journey towards building the most efficient capital structures possible in the post-crisis era of financial regulation.
“Clarity on Basel IV gave banks what they needed to be able to plan ahead,” says Charles-Antoine Dozin, head of capital structuring at Morgan Stanley in London.
“It was the last piece of the puzzle for them to get a much better sense of where their capital bases and requirements are likely to land in the next five to 10 years.”
Dozin says that the removal of some of the fog of uncertainty around Basel IV may even allow banks with excess capital to start thinking about returning some of that money to their shareholders.
This newfound freedom is already starting to bear fruit. One by one over the last six months, European banks have been nailing down clear targets for the amount of common equity tier one capital they want to form the base of their capital stacks.
Financial institutions have been able to get on with setting these goals even without precise details about how Europe will eventually implement the latest Basel reforms into law.
ING’s first earnings presentation in 2018 was a clear demonstration of this flexibility. The Dutch bank gave a rough estimate for the potential impact of Basel IV on its prevailing CET1 level of 14.3% of risk-weighted assets. It was then also able to confirm that it would be targeting a 13.5% CET1 ratio going forwards, including a management buffer of 170bp over its minimum requirements.
But there is still a lot of work to be done before banks are out of the woods, and before they can feel comfortable about the capital structures they have in place.
The most obvious impact of the changes to the way in which banks account for risk under Basel IV will be a significant boost to the volumes of their risk-weighted assets.
“This will have a knock-on effect for the optimal size of the additional tier one and tier two buckets and, more importantly, for MREL,” says Dozin.
MREL, or the minimum requirement for own funds and eligible liabilities, is the EU’s effort at ending “too-big-to-fail”, by telling banks to have a certain level of resources that can easily be bailed-in during a resolution to save the taxpayer footing the bill.
“Banks could have come to a conclusion last year about what MREL they needed,” says Dozin. “But they won’t have the full picture without knowing what their RWAs will look like after Basel IV is implemented.”
Still buffering?
MREL is the last area of heavy lifting in terms of building out the capital structure for some banks in mainland Europe.
Notwithstanding the impact of RWA inflation from Basel IV, issuers still have some way to go before meeting their requirements, which the Single Resolution Board has been handing out in binding format this year to the region’s largest institutions.
The majority of the work will be in selling non-preferred senior bonds, a relatively new asset class designed to meet MREL eligibility criteria.
The eagerness to get on with the job of issuing these instruments has been clear. Rather than waiting for EU member states to legislate for non-preferred senior issuance, a handful of institutions have opted to replicate the product using contractual language that would then allow the bonds to be aligned with relevant domestic law once implemented.
“It is difficult to understand why at this juncture we are still lacking all details related to minimum MREL requirements as well as why certain countries have still not passed the appropriate legislation to allow for issuance of MREL-eligible instruments,” says Matthieu Loriferne, executive vice president and credit analyst at Pimco in London.
The good news for all European banks is that the process of building up a stock of non-preferred senior debt is largely going to be a case of rolling old-style, preferred senior bonds into the new asset classes on maturity.
Alex Menounos, head of EMEA IG debt syndicate and co-head of EMEA FIG FICM at Morgan Stanley in London, says that this process of refinancing senior debt with non-preferred senior has been working very smoothly.
“The market has shown impressive capacity to absorb non-preferred senior and holdco debt so far and I see no reason for this dynamic to change,” he says.
Identity crisis
Banks have been particularly keen to shift into using non-preferred senior because the product offers a way of optimising the cost at which they can meet their MREL requirements.
Indeed, the creation of a market for non-preferred senior bonds is likely to have big implications for how banks shape the rest of their capital structure.
A number of European banks have previously placed a lot of importance on building up healthy buffers of tier two in order to boost their total capital ratios — a measure of financial strength that also signals the extent to which more senior creditors will be protected from losses if the firm fails.
However, there are signs that this metric is starting to fade in importance.
Société Générale’s implied targets for a total capital ratio have come down this year from about 18% of risk-weighted assets to 17%, for example, with non-preferred senior beginning to represent a greater proportion of the institution’s debt liabilities compared with the more expensive tier two format.
“Banks are moving away from targeting total capital and towards targeting core capital and total bail-in capital,” explains Menounos.
There are still some compelling reasons why banks might want go above this level and tend to bigger stocks of tier two.
For one thing, rating agencies can give credit to banks sporting thicker layers of capital. This is particularly true with respect to Moody’s, which has based its ratings framework on an assessment of the extent to which creditors may face losses if a bank defaults.
“For S&P and Fitch, the focus is more on likelihood of default, and instrument subordination,” explains Austen Koles-Boudreaux, head of EMEA ratings advisory at Morgan Stanley in London.
“Institutions are increasingly synchronising their regulatory build-up and issuance with their ratings strategies, identifying the most cost-efficient way to both meet regulatory requirements and drive ratings improvement,” he says.
But there is little evidence to suggest that running with a large surplus to the total capital requirement has a significant impact on financing costs in other parts of the capital structure.
“You could imagine that a bigger capital buffer is better from the point of view of a non-preferred senior investor and hence should have a cost benefit,” says Michael Tromp, a senior capital issuance and structuring specialist at ABN Amro in Amsterdam. “But when investors ask about non-preferred senior issuance you hardly ever hear questions regarding the layer of capital protecting them.”
Issuance volumes have already been falling for tier two, which has begun to take a backseat as banks begin to build up MREL layers.
Dozin describes the product as a kind of transitional instrument that will remain important to issuers as a means of smoothing the introduction of non-preferred senior into the capital stack, but will lose its importance once that buffer has been constructed.
“You are unlikely to get any kudos for running capital buckets that exceed the minimum requirements,” he says. “But in the interim, larger tier two buckets will still play a valuable buffering role in the implementation strategy of your MREL plan.
“People may start to think about tier two in the way in which they think about additional tier one — as a means of optimising the capital structure and in particular your maximum distributable amount buffer.
Equity on demand
Under the terms of the EU’s Capital Requirements Regulation, banks are allowed to use up to 2% of their risk-weighted assets as tier two to offset the amount of CET1 that would otherwise be needed to meet Pillar 1 capital requirements. The corresponding level for AT1 is 1.5%.
Market participants expect that banks will make full use of this 3.5% allowance, because it enables them to optimise the cost of their capital stacks by using less equity to meet their minimum capital requirements.
But this is just a thin slither compared with the overall levels of capital that banks must maintain following the introduction of reams of financial regulation after the crisis.
Dozin says that there may therefore be space in the modern capital structure for a new type of debt instrument, allowing banks to optimise and reduce the overall level of CET1 they have on their balance sheets.
“This is particularly important in the wake of the Basel IV agreement, which is expected to ultimately have a negative impact for return on equity at European banks,” he says.
“It could make a lot of sense to explore whether there is a market for facilities or convertible instruments that can provide equity on demand, which could substitute management buffers and reduce the sheer amount of equity that institutions are going to have to hold.”
Potential
The potential designs are still very much in the planning stage, but one of the suggestions is that issuers could sell instruments with structures based on tier two or senior bonds, which could then be converted into equity at the issuer’s discretion via an embedded option. Another option would be to include a much high CET1 trigger levels of 9% or higher.
The idea is that these instruments would act like fully-subscribed capital increases, restoring the equity position to a healthy level while the bank is still open for business.
In essence this would be a step into the shoes of AT1 — a product that few believe could function on a going concern basis following Banco Popular’s collapse because the in-built solvency triggers of 5.125% or 7% are expected to be well below the point at which an institution is likely to fail.
“If there are new instruments that can reliably work as early stage recovery measures, they would sit naturally in the context of stress testing and could mitigate adverse scenario adjustments,” says Dozin.
Fixing a price on a new type of capital could prove challenging for investors, but Menounos says that the buyer base is definitely there.
“As the AT1 structure becomes commoditised, the global buyer base matures, and these dynamics are both reflected in relative pricing, more and more investors are starting to consider the next development in the evolution of bank capital structuring,” he says.
The real challenge for issuers is knowing what the regulator would make of these new instruments.
There is a long history of experimentation in the market for bank capital, from Rabobank’s senior contingent notes in 2010 to the enhanced capital notes sold by Lloyds in 2009.
But as bank management has doubled down its focus on boosting profitability and preserving net interest margins, appetite for creative endeavours in the capital markets has waned.
BBVA says that even seeing another bank test a new type of capital for the first time would not quite be enough to persuade them to follow suit.
“We would rather see a statement coming from the regulator,” says a source at the bank. “An issuer cannot say it is using an instrument to reduce its Pillar 2 guidance, for example, because that information is not public.”
The race is on
The arrival of conversations about the potential for a new generation of capital instruments gives an indication as to how far European banks have come in raising the vast amounts of capital required by post-crisis financial regulation.
The European Banking Authority’s latest risk dashboard shows that about 40% of European banks had a CET1 ratio below 11% at the end of 2014. Now the same proportion of banks has a ratio of over 14%.
There is still plenty of work left to be done — particularly in terms of creating a layer of MREL — but financial institutions are already beginning to think less about capital build-up and more about capital optimisation.
When the Basel Committee’s William Cohen compared the process of finalising the Basel IV reforms to a marathon, he said that it was “important to pace yourself and keep sight of the big picture”.
This is likely to be true for those banks that are refining the composition of their liability structures. But there also are clear benefits to moving quickly towards end-state capital positions.
Market participants have been waiting a long time for the finalisation of Basel IV and MREL, which has stunted banks’ ability to deliver what investors have been calling for.
Fixed income investors are keen to see the banks build up large buffers to protect them from losses in the event of a failure, while shareholders are eager on the other hand for financial institutions to give them a better return on their investments.
Having been given a greater sense of clarity on the future for capital regulation, banks finally have an important opportunity to pick up the pace in working towards some of these goals.
As Pimco’s Loriferne notes: “The speed of transition to the final destination in terms of a capital structure is of paramount importance.”