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Investors confront shifting sands of bank capital risks

As regulators have looked to make banks bankruptcy-proof in the years since the financial crisis, bank capital investors have been forced to adapt quickly to new layers of protection. For seasoned buyers, the disruptive force of the Financial Stability Board’s rules on total loss-absorbing capacity (TLAC) is simply the next challenge.

A couple of years ago many found the risks attached to additional tier one capital uncomfortable, but now, there is a broadening acceptance that nothing is risk-free, and buyers are forced to make judgments on a case-by-case basis.

GlobalCapital gathered six leading investors, two top issuers and two investment bankers to tussle with the knots of complexity in a market where the final shape is still to be decided.

Alex Menounos, head of EMEA syndicate and co-head of EMEA FIG FICM, Morgan Stanley

Khalid Krim, head of capital solutions, EMEA, Morgan Stanley

Georgina Aspden, European banks senior analyst, Goldman Sachs Asset Management

Toby Dodson, Achievement Asset Management

Bruno Duarte, financials analyst, Claren Road Asset Management

Dan Lustig, senior credit analyst, Legal & General Investment Management

Rogier Everwijn, head of capital and secured products, Rabobank

Erik Schotkamp, head of capital management and long term funding, BBVA

David Butler, head of financials credit research, Rogge Global Partners

Leopold Bian, bank analyst, BlackRock

Tom Porter, moderator, GlobalCapital

GlobalCapital: Let’s start with the tier one capital market. We had over €40bn of additional tier one issuance last year. We’ve had over €20bn-equivalent issued so far this year and expectations are for a total €50bn in 2015. A Morgan Stanley survey of 192 investors in April suggested asset managers hold 72% of the AT1 market, and 93% of those polled said they could buy AT1. How much more development does this asset class have left to do?

Toby Dodson, Achievement Asset Management: From our perspective, having been involved in the asset class going back all the way to BBVA’s first deal, we’ve definitely seen a change in behaviour in the last 12 months. If you look at how deals have performed in secondary during recent periods of market stress, there have definitely been days this year where if the asset class had been in the same place it was 12 to 18 months ago, we would have seen two to three point gap moves in AT1, and we’re not seeing that. 

The asset class has definitely matured, it’s behaving a lot better on the secondary side and that probably speaks to a deeper and more diverse investor base, and maybe an investor base that is educated about the product and understands the nuances of what they own better, rather than someone who is jumping into it for a short term trade. I struggle to believe that 93% of investors can buy AT1, but we’ve been pleasantly surprised about the way the securities have traded in terms of prices. 

On the flip side, I would say liquidity is just as challenging today in some regards as it was 12 to 18 months ago. The ability to transact in any meaningful size on the secondary side has in some ways diminished, so you have to be very comfortable with what is in your portfolio. I think we all expect the day will come when the asset class faces its first real fundamental rather than market test, and how the asset class trades on that day will be most telling.

Georgina Aspden, Goldman Sachs Asset Management: The market is still evolving. We’re not there yet. When you look at supply estimates there’s a lot more still to come, and even policies aren’t completely finalised on how regulators want banks to change the composition of their capital structures. So there is still room for more variation. We see with every new deal that comes out there’s always a slight change or nuance from one to the other. You could only say something is fully evolved when it becomes fully standardised, when there’s no variation.

Lustig, Dan
Dan Lustig, Legal & General Investment Management: I tend to agree. The market is well developed, with around €70bn of issuance so far, but it’s not yet fully developed. What you actually need for a market to become fully developed is a clearer and more certain regulatory environment. 

Investors need more clarity on evolving regulations that have risks and pricing implications. For example, what are the Total Loss-Absorbing Capacity [TLAC] requirements? What are the Pillar 2 requirements? Are they going to be included in the minimum capital requirements for AT1 coupon payment?

Liquidity is also a very important requirement. We need better liquidity and a more permanent investor base, and I think that this market has benefited from the European Central Bank’s quantitative easing programme as well, which has driven a search for yield. 

The first test will be once interest rates start to rise, or perhaps when the first issuer needs to refinance an AT1 deal. That would be a milestone. Once we’re there, the market will mature and will be fully developed.

Alex Menounos, Morgan Stanley: This highlights a very good point. Two years ago, if we had polled a similar audience on ranking the three risks that differentiate Additional Tier 1 from senior debt, namely principal risk, coupon risk and extension risk, number one on the list would have been the risk to principal. About a year to 18 months ago, this started to shift gradually towards coupon risk.

The focus today is probably still on coupon risk, although maybe for different reasons. Initially it was minimum distributable amount [MDA], then it became available distributable items [ADI] risk, and now investors are focused on Pillar 2 and potential impact on combined buffers. Extension risk still seems to be lower down the list. Have views changed, or do investors still think that’s the right order?

David Butler, Rogge Global Partners: The market is definitely focused at this point on coupon deferral risk. You’re right, when this first started we were more focused on the triggers and then people started to become more comfortable with that. Also, the trigger levels in absolute terms have improved versus where capital levels have been moving.

Coupon risk is still going to be the key issue for the foreseeable future, because the actual buffer rules around that are still evolving. To a certain extent investors are still buying a little bit on trust in terms of where that coupon deferral point could actually be, and obviously disclosure varies as well. 

Sometimes it’s the bank’s disclosure, sometimes the information just isn’t there at this point. My sense is that extension risk is probably out there somewhere, but it’s not what people are focusing on in their analysis.

Bruno Duarte, Claren Road Asset Management: Especially when you consider the first deal that came, 810bp over, that was your spread, right Erik? I would like to think you would not be extending that and you can refinance that much cheaper.

We have to bear in mind that the early deals did have a much higher reset rate, but rates have subsequently come in, as Dan alluded to. We were surprised recently because we communicated with some real money accounts on the continent and in countries where we thought they could not buy AT1. They’re talking about having substantial inflows into funds for AT1 and supporting bank capital products.

So, whether it’s because the “risk-free” Bunds are getting too low [in yield], whether it’s the effect of QE, the asset class has clearly stabilised. To Toby’s point, the AT1 market today has evolved versus what it was one and a half to two years ago. Georgina’s right, it still has to go a little bit further, but we have been pleasantly amazed at how well behaved it has been throughout this whole Greece episode and other unknown factors.

You’re definitely seeing a much different market reaction to spread products, like senior secured and tier two, compared to AT1. Historically you would have thought it’s got to have a multiple effect in terms of the movement, but it’s just not there. 

That, we think, is a good sign for the asset class. It also shows you that the actual investor base is becoming much more knowledgeable about what they have in their portfolios. That’s partly also down to the banks getting stronger, the education process getting better and we just have to wait for the first new deal to refinance. We need to see they can be refinanced without regulatory objections, so that it’s not something we have to worry about.

Bian, Leopold
Leopold Bian, BlackRock: Given that the first call date for an AT1 security is 2018, I think markets focus on things at the time. The 2018 step-ups are relatively expensive, given today’s markets. Coupon risk obviously is still in people’s minds, but beyond MDA risk and ADI and so on, there’s also another big factor, which is regulatory discretion. 

That’s a huge power that hasn’t been tested. You make a huge loss, you’re still above your buffers, but who knows, maybe the regulator thinks it’s prudent to switch off coupons. The more uncertainty you have, the more you’re preoccupied with these issues. 

On the point of liquidity, it’s got much, much better. It’s very helpful to have funds dedicated to these products because then it’s actually the benchmark. You used to see behaviour from a lot of asset managers that had their benchmarks and then had a little buffer to invest in non-benchmark instruments, and AT1 was very appealing. 

It’s good when it’s going up because it’s additional alpha you generate versus your benchmark, but then when things go down it’s the other way round and it’s the first thing they want to sell. So, the less you have of these types of mandates and the more you have dedicated funds aligned with the product, the better the market will be.

Rogier Everwijn, Rabobank: In terms of valuation, do you refer to spreads? Is this now already getting to be a market where the various transactions are compared on a spread basis or is it still on a coupon or yield basis? 

Our experience in the 2010 and 2011 transactions was still on a coupon basis. I know you can’t compare the investor bases, especially for our 2011 transactions, which were predominantly sold into private wealth in Asia, which is really coupon-focused. But is this now an instrument that is getting mature enough to compare it on a spread basis, even if the coupon is still relatively important?

Butler, Rogge: That’s another way in which the market has maybe moved on. Certainly, it was obvious that a lot of the buying with fairly early vintage AT1s was outright yield-driven. You can see that in the fact that curves were not only flat but often inverted on that basis, and it hasn’t actually adjusted quite as much as it should do.

That’s still going to play out over time. People will start thinking about spreads and that would be consistent with the idea that I think is implied here, which is that we’re moving from an outright yield, private bank, private wealth buyer base to an institutional investor base that is thinking about relative value in that kind of way.

GlobalCapital: Is the job of a financials credit analyst easier or harder now than it was pre-crisis? I know one head of capital solutions, not you Khalid, who takes the view that it has become easier for investors because the regulators are doing a lot of the work for you. Would you agree?

Bian, BlackRock: It’s pretty hard from the uncertainty you have with the regulator. The regulator has an immense amount of power today, which is very much behind closed doors. All these processes, we were discussing about Pillar 2, these things are completely unknown to the market. The processes, the conversations the regulator has with the banks, it’s very hard to estimate that, it’s very hard to calculate that. The job of financials analysts is to assess the riskiness of the credit. With the regulatory discretion it’s tough, because it adds a huge amount of uncertainty that can’t actually be measured, and to some extent the banks can’t talk about. And obviously we don’t have access to the Single Supervisory Mechanism [SSM].

Dodson, Achievement: I would say that the regulator has been good enough to keep financial analysts in a job, because though they’ve undoubtedly lowered the probability of default for banks, certainly the actions they’ve taken and the rules they’ve put in place have probably been some of the most market-moving events, specific to the financial sector rather than macro, over the last couple of years.

So I would definitely disagree with whichever head of capital solutions said that to you. I’m very grateful to the regulators for keeping me busy.

Menounos, Morgan Stanley: But does that make the investor community focus more on jurisdiction, or perhaps create a bias for national champions?

Dodson, Achievement: It means you have to have, despite Europe’s best efforts to harmonise, an understanding of the laws and regulations of each individual jurisdiction. That has in many ways multiplied the amount of work you have to do, because whatever you’re doing for each individual nation or nationality, you have to do yet again if you’re looking at a French bank or a German bank or a Spanish bank. Only a few weeks ago the Germans proposed a piece of legislation that totally changes the hierarchy of creditor claims in their country, which is yet to be applicable anywhere else in Europe.

GlobalCapital: Erik, you were an early mover in the market, you’ve done a few trades and a number of roadshows. Can you tell us a little bit about your experience in terms of the investor base? Are the questions you get from investors changing?

Schotkamp, Erik
Erik Schotkamp, BBVA: This came about through CRD IV, which identified the possibility of issuing an instrument that hadn’t been tested and had a lot of bells and whistles, of which everyone was very sceptical. That was definitely a very interesting experience, because we talked to the 10 leading investment firms in London before deciding to go out, and that’s where you learn and understand. 

There was a focus on trigger. Nobody thought about MDAs. But we see the same people coming back. I still see it as a pocket in the market, which, without the fundamental support of those people that we met back then, is not going to function. That leadership is necessary. Whether it’s from the big platforms or the leveraged money or the dedicated specialist funds, it’s still for me the same go-to people if I want to do a bit of brain-picking to see how they feel about the market.

But it definitely has become broader, you can tell by the tickets. The last breakfast we did in France we had 30 accounts. The first two trades we didn’t. So it’s broadening out, yes, but I don’t think it is ready to stand on its own legs yet. 

You can tell by the number of names. If you do a subordinated trade, which is the closest thing to an AT1, you get a book of 400 names and you can do without many of them. In AT1 you can’t do without them. It remains a club of specialised investors, and if they’re not there, then I don’t know.

GlobalCapital: How about the regulatory process? Has that become more streamlined with familiarity?

Schotkamp, BBVA: Our first AT1 prospectus took us three and a half months to get approved, because of the amount of reviews with the regulator. The second one, because it was copy-based, they were more comfortable and we got a bit of recognition. The last one we did approval with the ECB. We showed them an edited version and indicated where we had changed it versus the last prospectus. That’s what they reviewed and they said 'go ahead and execute’. 

They want to move to rapid approval processes, which means you are going to have your call for standardisation. The regulator has moved from being sceptical on whether this product would work to being pretty comfortable and actually seeing it as market development. They see it as a true pocket of loss-absorbing capital.

Which means that as long as your combined buffer requirements are subject to phase-in, the MDA is subject to phase-in, the hard debate about switching off coupons will be applicable to banks that are in really bad shape, probably without frivolous, rule-based switch-offs. 

I’m thinking there is an intermediate stage, which is a recovery plan, and the materiality of switching off a coupon for capital recovery is probably not big enough, vis-a-vis the loss of access to markets to what is a true loss-absorbing instrument.

Krim, Morgan Stanley: I would echo that. If you look at the reports the EBA have done on tier one, looking at the structure across Europe, there is an effort to harmonise. Investors understand the differences across jurisdictions, the reasons behind issuers’ choices of high trigger, low trigger, permanent or temporary write-down, conversion and so on.

To increase harmonisation further, the EBA said recently in a public hearing that they would be working on standardised term sheets they can give to all issuers, which can be used by banks that haven’t issued already as a basis for AT1 and other instruments.

But we do have a new supervisor that will be looking at the value of AT1. It’s there and it can absorb shocks, but I think the way supervisors are looking at it is, increased supervision and more focus on the SREP [Supervisory Review and Evaluation Process], the Pillar 2, and ex-ante actions and supervision of the banks, to make sure that there is no accident, as opposed to waiting for the accident to happen and then acting post-trigger of AT1 or other securities.

The next stress test is happening early next year. This will be key to understanding how the ECB is working with all the banks. I view the move in Europe to an annual stress testing of banks, like the US and UK, as a healthy and positive development, and it should be welcomed by investors.

Aspden, GSAM: The other thing still in evolution is disclosure. There is a lot of focus on coupon deferral and not all banks disclose enough information to be able to accurately assess that risk. 

And on top of that, the ECB, as you say, is now more focused on its own capital adequacy requirements and some countries have disclosed those, other countries haven’t. That doesn’t create a very even playing field. It keeps us in a job, because then we have to make our estimates around it, but that would obviously be another point for evolution that still hasn’t come. 

Schotkamp, BBVA: In that sense your demands are completely legitimate, but you cannot underestimate that the list of priorities these regulators are looking at, it just comes at the bottom half. I’m not saying that’s good news, but we have had debates with the joint supervisory team and we come up with questions and they look at you as if to say, 'that is a good question, we need to think about it’.

Two weeks later, you have a follow-up call and they say, 'we talked about it and we think it’s relevant, but we have never before thought about it’. I’m not sure if that’s human nature, if it’s under-staffing, it’s priorities, it’s a lack of technical skills, but there’s a lot of that stuff about MDAs. I’m not aware there’s any European regulator that really has a great feel about the MDAs of its leading national banks.

Available distributable items — it’s almost like, can you distribute share reserves? Maybe theoretically you can. Are we going to do it? I’m not sure. So, a reality check on what you can count on once you get there, versus what the book says, is definitely needed.

Are capital ratios of banks being audited? They’re not. That’s interesting, given that we’ve got triggers, we publicise numbers, but the composition of your capital and the core capital ratio are not audited.

Menounos, Morgan Stanley: Yet you have economic risk driven off those numbers. Looks like financials analysts will be busy for a while.

Schotkamp, BBVA: That’s right, market inefficiency keeps us alive.

Menounos, Morgan Stanley: And the gist of what you were saying before is that in your view regulators are getting more comfortable with additional tier one as an asset class, the market capacity for the product etc…

Schotkamp, BBVA: Yes, the validity of it, the true loss-absorbing nature, yes.

Menounos, Morgan Stanley: But they don’t want to necessarily test it.

Schotkamp, BBVA: Where I was going is that since it is evolving from something that nobody believed really would ever work, it seems to be working and I kind of like it, and there’s an interest that you fill up the bucket, isn’t there? Don’t kill the animal.

Menounos, Morgan Stanley: And access to market to some extent is correlated with how the product performs.

Schotkamp, BBVA: From the conversations I’ve had with the people in our joint supervisory team, which I’m not sure is a representative view, I sense there’s an appreciation that this mechanical way of thinking about things, you want to rethink. 

You want to rethink when you actually switch off the coupon, which is from breaching minimum capital requirements to recovery to everything that’s wrong, but once in the recovery zone, probably the regulator would want to see your recovery plan before they tell you to switch off.

Krim, Khalid
Krim, Morgan Stanley: We did spend some time thinking about how to implement CRR and CRD IV, in an AT1 context trying to get some comfort from regulators on the seniority of claim. In other words, remember we discussed it before with no stoppers, not pushers in AT1. As an AT1 buyer you’re exposed to full discretion and you cannot give the option to the issuer to pay a dividend and then not pay an AT1 coupon. 

We did see an evolution in terms of the way our regulators gave the issuers the ability to go on the road and explain to the AT1 buyers that they could signal or communicate that seniority would be respected in terms of cancellation of coupon. So telling investors that we can choose to first cancel the bonuses, then the dividends and then the AT1 afterwards, wasn’t in the regulation or in the technical standards from the EBA, but regulators around Europe were pragmatic and comfortable with this kind of messaging.

Menounos, Morgan Stanley: How do investors feel? Bruno, what do you think?

Duarte, Claren Road: What we do, and it’s served us very well over time, is to focus on the country. What is the relationship between the national and the European regulators, as well as the issuer and the national regulator? Some countries are still a bit more lenient, and then it’s down to the bank’s fundamentals.

Whenever you look at this issue, what we take comfort from is, well, how much buffer do you have if you’re an investment bank? How much is your deferred comp? How much is variable pay? 

And then when you get actually down to the size of the AT1 coupon, you think, if AT1s are making up just 1.5% of the total capital base, but their coupons are only 5%-10% of pre-tax profit, the bank probably doesn’t want to impinge on that coupon. 

When we potentially might have an issue is when a bank somewhere takes a significant fourth quarter hit and needs its board to approve the accounts. All of a sudden, paying that coupon as a percent of what is left could be quite chunky. 

That’s when the nature and structure of the coupon is important. Is it a quarterly coupon, is it a full year coupon, is there flexibility, what’s the volatility of the P&L? If you bear all these factors in mind when making that investment decision, we think we should end up with those securities we’re very comfortable holding and probably have less of those that are more volatile. 

Somewhere down the line, we don’t know when, a weaker bank will not be able to pay an AT1 coupon and that’s a watershed moment for how developed this asset class is. Will it be treated as an isolated event or not? 

We’ve heard the view out there is that on this event, the whole asset class is down 15 to 20 points. We don’t want to believe that, but clearly it is something we’ll only know when we get there. 

GlobalCapital: Khalid, you started to mention bail-in. How has that changed investors’ lives? Do you feel you have enough information to know what your risk is at each level of the capital structure, particularly now in tier two?

Lustig, L&G: No, we don’t have enough information. A very good example is TLAC. When the first rules came out, tier two underperformed. Then when investors understood that it probably didn’t mean massive issuance of tier two, it outperformed.

From our perspective, if I think about bail-in I pretty much think about the hierarchy of capital and where I sit within the claim waterfall and the level of subordination below me. 

With regard to TLAC, from a creditor perspective we want it to follow several key principles. Firstly, the solution doesn’t violate our property rights. Secondly, it makes a clear distinction between existing senior debt and bail-inable debt, or TLAC-eligible debt. And lastly, it does not subordinate our existing senior debt.

We are quite comfortable with tier two now, but as regulation is evolving and changing the claim waterfall, then there is less certainty about what is bail-inable and the level of subordination below us.

GlobalCapital: Is it frustrating to operate in this environment, when you look at, say, the US capital regulation and see how much simpler it is?

Lustig, L&G: Yes, it’s certainly frustrating. Just in Europe we have the UK and Switzerland that adopted the holdco solution for TLAC. This solution is clear as it is pure structural subordination. 

Then we have the Germans going on a statutory law change solution, something that we don’t really like, as it violates property rights because it would apply retroactively to outstanding securities. And Spain, for example, changed the Spanish insolvency law to permit tier three debt. 

But, for most European countries, it’s not clear exactly what would be the eventual TLAC solution. If you need to invest today and you don’t know where you are in the ranking of claims, whether your property rights will be violated, it’s quite hard to price risk correctly and to invest in senior debt and maybe even in tier two debt.

Menounos, Morgan Stanley: Rogier, perhaps in your case you have a simpler view, how do you see it?

Everwijn, Rogier
Everwijn, Rabobank: We try to make it simple. To Dan’s point, the regulation is actually reasonably clear but I think in the end it’s the resolution authority who will decide how you will fill up your buffers. So you can, as per the German proposal, amend the law such that some chunks of the senior unsecured are MREL or TLAC-eligible, but the regulator can’t force you to issue capital instruments. 

In our situation, it’s pretty clear that we simply want to fill up all the buffers with capital, simply to avoid senior unsecured being bailed in. One of the reasons is the price, but also I think more importantly the availability of senior funding going forward.

GlobalCapital: Do investors feel that the German proposal can pose a threat to the availability of senior unsecured, as Rogier put it, maybe not in normal course of business but under stress? Does that change the ball game?

Butler, Rogge: It could do, but it really depends on the nature of the issuer. This is the problem with the assessment of senior debt and the potential changes — banks’ business models are different. For some, wholesale funding is part of their core funding if you like, and that’s a very different discussion to a bank that really doesn’t need it. So the outcomes for the two are potentially drastically different in terms of the way they run their businesses.

Dodson, Acheivement: I’d agree with that.

Menounos, Morgan Stanley: And is there room for tier three? From an investor perspective, imagine a new asset class which sits between senior and tier two, has different characteristics in terms of the duration, perhaps a shorter-dated instrument whose only purpose is to absorb in a bail-in scenario. Is that an investable product?

Duarte, Claren Road: There’s a bit of a paradox, because to Erik’s point, if the whole aim of Europe is to standardise and to make things simple, then creating a new asset class, even if it does have its advantages for certain jurisdictions for reasons we all understand, we’re sceptical whether the issuer will get the benefit. 

In the UK two years ago a UK bank issued CoCos that a couple of months later no longer completely served the purpose they had been issued for.

So we believe issuers need to be slightly cautious of the fact that you might bring a new product, which all of a sudden might not get the full intended benefit, or it doesn’t price or trade the way it was envisaged to. In the meantime, the bank’s capital structure has been complicated by adding a new layer. 

Look at how simple the US banks’ capital structure is. There are three very clear, defined buckets. If Europe is going down this route of, let’s simplify and standardise regulations, we’re not convinced that tier three — even though there are some merits to it — might be the solution some are thinking it might be.

Bian, BlackRock: If you create a new asset class, a subordinated asset class, and I say, OK, that’s your new way of TLAC funding going forward, how does the investor base actually change? 

So, if you were thinking before that you had to do €500bn of tier two capital, now you have to do €500bn of tier three capital. Do you have a hybrid sort of asset management community that would say, OK, no way tier two, but, yes, tier three’s great? And especially at the beginning where tier three would be very much like tier two, until you build a huge buffer, it should in terms of loss given default be pretty much the same thing. So, do you actually solve that issuance problem by creating this new asset class?

Lustig, L&G: So what is the difference then between a UK bank that moves all its senior debt from the opco to the holdco and a European bank that moves it from senior to tier three? From my perspective, it is the same thing. One is structurally subordinated, the other one is contractually subordinated. I don’t have a problem with that. Then it is for us to price this risk, and I believe the issuer will get some benefits from T3 and we will probably have some benefits, such as a clear distinction between senior term funding and bail-inable debt.

Menounos, Morgan Stanley: And the German proposal, does that price at the same level too?

Lustig, L&G: In terms of pricing, theoretically it should. But I don’t think that investors will be fully compensated for a scenario where a statutory solution is adopted. In my view, the pricing for senior unsecured debt should be determined by the level of subordination below the asset class and the thickness of the senior asset class. We’ve seen the German banks repricing with the German proposals and they would have to fund at more expensive spreads.

Dodson, Toby
Dodson, Achievement: One observation I’d make is that, to date, the market has become quite bad at pricing individual issuers’ capital structures for the thickness of each piece of the capital structure. It’s very important to consider that thickness, because we’ve had examples where if you are the tier two holder and there is no AT1 in the capital stack, then guess what, you’re in the AT1 hot seat to some extent when it comes to absorbing losses. 

Yet at the time of issuance that deal seems to get away with coming at a tier two-type level, because I don’t think people are clued up enough on the impact of the capital stack thickness. In some ways tier three is maybe an attempt to optimise that market inefficiency by slipping in an asset class that comes in tighter than tier two, but if there is no tier two or not a sufficient amount of tier two in someone’s capital structure, fundamentally it probably shouldn’t.

Lustig, L&G: Commenting on this point, you just spoke about loss given default, but not about the probability of default. When a new tier two deal comes to the market the most important thing from our perspective is the probability of default, rather than the loss given default. The probability of default is driven by the underlying credit fundamentals of the issuer.

Aspden, GSAM: Rating is the other thing that no one’s mentioned, which to some extent offers you that information, in terms of thickness of tranche. Where there is clearly a different bucket of ratings, say triple-B versus single-A, I think you do get some pricing differential.

Krim, Morgan Stanley: When we speak to issuers around Europe and regulators, I think they all expect the banks to have a layer of equity, CET1, then AT1, then tier two, and a debate could come in terms of total capital strategy or bail-in strategy. Once you have all those buffers in place, it’s about what you need to put in place for the purpose of bail-in, and that depends on the country.

Banks with holding companies will focus on holdco senior debt. Those in countries where there is a statutory solution will debate whether this should be tier two, issuing tier two because they believe it's more efficient to just top up with tier two. Others will prefer to have a layer in between. 

In our conversations, the layer in between is not a substitute for tier two, it is making sure that we have something on top of tier two that is buffering up senior. When I speak to regulators and issuers the question I find difficult to answer is: how much do investors, senior unsecured creditors, want to see? What is the right number? What is the expectation? Is it 15%, 17%, 18%, 20%?

The Financial Stability Board has come out with its proposals, the range is 16%-20% of RWAs, plus buffers. From the investor perspective and from a credit perspective, we also know the rating agencies are important. 

But a question I have for investors is: what is the number? Maybe it's bank by bank, how do you look at it from your perspective? We have had banks like Rabobank giving some indication about total capital strategy. Are you getting the information you want?

Aspden, GSAM: You're almost asking the wrong investors — for investors that are going to get bailed in, how much of the bail-in debt do they want issued? You need to ask the person that benefits from the bail-in: how much do you need to protect you?

Krim, Morgan Stanley: But then who's benefiting from the bail-in? The equity investors are gone.

Aspden, GSAM: Well that's why regulators are needing it, because they're the ones protecting the taxpayers and depositors.

Menounos, Alex
Menounos, Morgan Stanley: But is that the real issue? Perhaps the difference, fundamentally, between the German proposal, holdco senior and tier three is that with tier three there is a specific amount which is meant to buffer senior unsecured, whereas the holdco senior solution — assuming you migrate funding from opco to holdco — and the German proposal lead to senior unsecured effectively absorbing losses. 

Loss given default may be limited but all holders will be affected. Are you suggesting that you would find it more palatable to invest knowing that there is a specific buffer, such that your senior unsecured is not touched?

Aspden, GSAM: Not at all. I'm saying that whatever a bank decides to do, our job is to price that and that's what we would do.

Schotkamp, BBVA: But that's unfortunately for issuers not good enough. The day things go wrong, we need to know what it means for our liquidity management, because the bank is going to roll over from a liquidity problem and not from a capital problem.

And if our liquidity instruments turn into capital instruments because investors suddenly don't like too many of them and effectively stop buying, we may want to take this into consideration.

Are investors still going to be there as a buyer or are they going to strike? And that difference is determined by how much comfort they have. I need a degree of visibility on that view from investors, to go home and articulate what our strategy is going to be, because otherwise what we're going to be doing, we're going to be incredibly opportunistic and choose the cheapest insurance policy for our funeral.

Dodson, Achievement: I would push back, Erik, and say I totally understand where you're coming from, but for us to make that assessment, we need to understand how the regulator is going to behave in that situation as well. I appreciate I'm just passing the buck here. But unfortunately one thing that's been fairly consistent about European banks that have got into trouble over the last few years, and this applies across multiple European jurisdictions, is the regulatory outcome in each instance has often differed, not only from what was previously done in a different jurisdiction but, indeed, from what reading the rules at face value you would have expected the regulator to do in that scenario until they found themselves in that situation. 

GlobalCapital: Is national discretion one of the biggest problems for investors? Not understanding what might happen in each country for any given institution that runs into trouble?

Duarte, Claren Road: That's definitely one reason why we continue to say you have to understand the national regulations and the bank's relationship with the domestic regulator, and then focus on the fundamentals of the bank. It's always been a three-pronged approach, and remains that way for us. 

The few cases in Europe, as Toby says, could not have been read across from one to another. They were in different jurisdictions, different business models, different fundamental relationships and it was not straightforward to figure out what was going to happen.

Schotkamp, BBVA: Imagine that the European resolution authority is up and running, the powers are centralised in Frankfurt, so this regulator is not only supervisory but it works together with the single resolution board that will process resolution plans.

Then it turns out that senior bonds are going to be bailed in. A country that has €90bn of senior unsecured bonds outstanding in its financial system, some with retail holders, if you pull the plug on one, that may start a panic in all of them. You have to ask the question, does it provoke a systemic reaction? 

What you will find is that for the bail-in that is proposed, that theoretically is an instrument now, you've got to go to the supreme court of that country to fight and to see if this holds up versus national law.

Thinking about that real situation, you need a much more hard and determined line than this idea that senior goes in and then everybody shares, but we don't know how much. I'm just sensing that once we get there, it's much more difficult to apply the rules. 

If you listen to the Bank of England’s Andrew Gracie, one of the structural objectives of what he wants to achieve is not only that the bail-in is implemented by law, but that it is executable. I sense that he's going to completely recognise that this back door solution from Germany somehow does not completely fit the bill of what they really were thinking about. That could well be a tailspin at the end of the day of the whole TLAC proposal.

Everwijn, Rabobank: Coming back to the question of tier three versus German proposal, if you had to choose between the two, then it's better to have one additional instrument where the investor base clearly knows what they are buying.

Then in the event it might happen, then you avoid all kinds of supreme court cases. You should stay away from the whole senior stack, especially as proposed by Germany. Don't change the rules during the game. You sold it as senior unsecured, you’re pari passu with all the other liabilities. Make it that way, continue that way and then, if you want to, invent a new instrument, like has been proposed in Spain.

Duarte, Claren Road: But it then comes down to if you have a bank that is sufficiently profitable, where it can bear the cost of a tier two or three instrument, then it can issue that. But it is different for an entity in a banking system that is not profitable enough to issue a tier two, or pay an AT1 coupon, it’s different. It goes back to the point of issuing an instrument that two, three, four years down the line might not be paying.

Menounos, Morgan Stanley: But do you not think that the market is going to reward an issuer that stacks up capital, or creates an additional layer of capital buffer, with tighter pricing in senior debt?

Duarte, Claren Road: The only observation we want to make about tier three, to be clear, is that we just think from the complexity standpoint, we’re not entirely sure whether the bank has enough time or the market is deep enough to issue tier three sufficiently to the point where a new substantial layer of capital has been created. Until that happens, we think they’re likely to be priced and trading the same.

Everwijn, Rabobank: I see your point, but it's important to make a distinction between the two instruments. One is designated for a bail-in, whether that's tier two or tier three, but the other way is making senior unsecured bail-inable. Regulators should stay away from that.

Duarte, Claren Road: Absolutely.

Lustig, L&G: Tier three gives you a nice reference point for where you are in the hierarchy of claims. If it is just senior debt, you're not clear where you are in the hierarchy of claims. So, tier three actually makes a clear distinction between senior funding and bail-inable debt. As I said before, I'm OK with structural and contractual subordination, and every solution that doesn't violate our property rights and doesn't subordinate existing senior debt. So, I think tier three debt is a simple and clean solution for banks that can’t set up a holdco structure.

Krim, Morgan Stanley: Whether we call it tier three or senior bail-inable debt, does it change anything for your capacity to buy? I'm just looking back to when AT1 started, people were saying we don't have mandate restrictions. Do we have the same thing here when we look at senior versus tier three? It won't be regulatory capital, it just will be something which contractually or statutorily will be junior to senior unsecured debt.

Dodson, Achievement: It becomes quite evident that there is a rationale to capitalise on investment mandates and market technicals to exploit this inefficiency, when people ask: 'if we call this one thing or call it something else, should it price differently?'.

Because if it's the same thing, whether you call it a pineapple or an orange, it's the same. We are not restricted in any way by what something is called, but we appreciate that there are investors out there who do have those mandate limitations, and therefore that may affect their behaviour.

Particularly with the creation of a new asset class, the initial pricing should be entirely grounded in fundamentals before you can think about whether there is a technical overlay.

And to Rogier's remark, I do take a lot of sympathy with that view and the view of Bruno that tier three just introduces an additional layer of complexity. For many years we have had something that is meant to serve as going concern loss-absorbing capital. It's called tier two. I'm not going to say it's worked well so far because sometimes it hasn't, but…

GlobalCapital: If we were able to wipe the slate clean, as investors which structure would you put in place? Between holdco senior, the German proposal and the creation of tier three, which would be best for investing in bank debt?

Butler, David
Butler, Rogge: Simplicity is key. Conceptually I don't like the idea of senior debt as a mixture of funding tool and loss absorption tool. That muddies the waters and affects some bank business models more than others. 

So if I started from scratch, I think my gone concern loss-absorbing capital would be tier two, and then you have operating liabilities above that. That's the way we'd do it from our point of view. I think the consensus is probably quite positive on tier two in terms of the secondary market or in their asset allocation in banks, because it's the clearest. There's more clarity there than there is in other parts of the capital structure.

Aspden, GSAM: It's worth making the point that a lot of the regulators talk about the new world capital structures at end point, and we're operating in an environment where we're investing in debt that is transitioning through. So you've got all sorts of different types of ranking and all sorts of different types of bail-in risk, which is quite complex. So a little more guidance on the ranking in transition would be more helpful.

Krim, Morgan Stanley: Are you talking about the ranking between legacy and new or internal TLAC, downstreaming, that kind of thing?

Aspden, GSAM: Both would be helpful. Clarity in general. I meant the first but the second you bring up is an issue we've come across as well. Because ultimately, do you really know how it's been transitioned down?

Everwijn, Rabobank: Something else that's closely related to bail-in is asset encumbrance. How much do you take into account the asset encumbrance of an organisation? Is that also in your models? Is it: 'this is the probability of default, if you look at the capital at the bail-in stage, then the potential loss given default is x, but given the amount of asset encumbrance that is x plus 50%', for example? Is that how you operate as well?

Aspden, GSAM: We certainly take it into account. It depends on the bank as to whether we would look at it in that way. But asset encumbrance is something we would penalise a bank for if they had more of it.

Schotkamp, BBVA: If senior is part of that mechanism of bail-in and the market switches off, probably once the bail-in comes, then the amount of asset encumbrance you're going to find is going to be dramatic because there are no other sources of funding available.

Bian, BlackRock: It's asset encumbrance, but it’s also the quality of the assets. Some of the banks that fail, you'd look at their balance sheet one year before they went down, they have non-performing loan ratios of 1% and they are super-clean. Just taking accounting at face value, it's very tricky. So, it's definitely something to worry about.

GlobalCapital: Is TLAC uncertainty the reason tier two supply has disappointed so far this year? From a valuation perspective, is tier two fundamentally still attractive?

Menounos, Morgan Stanley: Run rate tier two supply is down almost 60% this year. What's been particularly disappointing is the number of issuers that have come to the market. We've seen some fairly chunky supply but from a handful of issuers only so far. Compared to expectations late last year of supply topping €500bn, fuelled by TLAC speculation, it seems like issuers are adopting a more conservative approach.

Aspden, GSAM: Given €500bn has been bandied around, we weren't excited about all of that issuance, so I wouldn't say disappointed is the right way to describe how we feel about it now.

Menounos, Morgan Stanley: But if you like bank X and you want to invest in it, which part of the capital structure do you currently prefer? Is there a preference for subordinated debt? Is this a good time to add?

Lustig, L&G: Tier two has its attractions. If you think about it, it’s an asset class of choice for investors which cannot invest in AT1 due to rating or other mandate constraints. Thus, for these investors it’s the way to play the high beta financials.

In terms of pricing, the sub-senior multiple for the index is around 2.3 times. Given that this ratio is a function of the differing recovery rates between senior and sub debt, then the bigger your AT1 buffers are, the more attractive this asset class. It should probably trade below a two times multiple. Therefore, for the risks you’re taking, I think it’s still an attractive asset class.

Bian, BlackRock: I totally agree, it’s very interesting as an asset class. The direction of travel has been very favourable, I can’t deny that. Banks have got much simpler, much better capitalised, and in terms of liquidity they’ve got much better as well. Because of occasional funky things in ratings or just a misunderstanding with regard to loss given default as well, you have some differentials that sometimes don’t make sense.

It is maybe the asset class that misprices the most on loss given default, in a way. There are some issuers with a thin CET1 buffer, no tier one buffer and then they issue tier two at very tight spreads. But then if you already have large CET1 and tier one buffers that’s something that can’t be ignored. You have a historical distribution of losses that you should think about when estimating the impact on a bank’s capital structure from an adverse scenario.

Ceteris paribus, you can’t assume that a 12% CET1 buffer, plus 2% tier one buffer and then a 4% tier two buffer is the same thing as having 10% CET1, no tier one and a 1% tier two buffer. There’s a spread differential that should be applied to that, and it’s not always right that one size fits all is the right way forward.

GlobalCapital: Assuming we see the pipeline of AT1 continuing to get done, and we have a little more clarity on TLAC by the end of the year, what are the pitfalls for the next 12 months?

Lustig, L&G: The AT1 asset class should continue to develop over the next 12 months and we’ll see this large amount of issuance continuing, mainly because the benefit of QE is still there and issuers need to fill their 1.5% buckets. As time passes and there is less regulatory uncertainty and more transparency, this should generally be positive for this asset class.

Bian, BlackRock: A year from now we’ll probably be discussing the SREP framework, RWAs, IFRS 9, etc. TLAC and MREL will still be the focus — how do banks plan to get there? We’re still not at the end of that road. It makes our job very interesting and makes the issuers’ job interesting too, I’m sure, and stressful at times. This is not stopping now. A new AT1 asset class is evolving, it is going to be around €200bn in total. It’s very exciting times.

Duarte, Bruno
Duarte, Claren Road: One year from today we may see a much bigger differential between the haves and the have nots. We don’t think we’re getting that now because there are still a lot of situations in flux in Europe. Over the next six months we’re going to see closure on some of them. In 2011 stress tests were about Spain, in 2014 they were about Italy. In 2016 they are probably going to be focused somewhere north of Italy and there are going to be a lot of question marks raised about some of the business models there. Some of those regions have issued AT1s or are thinking about it. That’s when we should really get an acid test for the AT1 space.

It should come down to picking out the winners from the losers because we do think there will be some accidents taking place in Europe over the next six to nine months and it’s going to make us reassess completely what bail-in is all about.

Butler, Rogge: Come back in a year’s time and we’ll be talking about regulation. That will still be a key theme. I think risk-weighted asset inflation, fundamental review of the trading book, depending on the bank can be quite significant. One thing we shouldn’t underestimate is the difficulty of secondary market liquidity now. We talk about supply and whether we can absorb it, but it’s not so much about whether we like the bank or the asset class any more. It’s if a new issue comes along, can we actually effect switches, for example, in the secondary market?

For the first time I can remember this year, there have been times when we think the switches we would probably do to participate in this new issue we literally can’t do.

Dodson, Achievement: I’d agree that regulation will definitely have moved on in the next 12 months and there’ll be some interesting new data points to digest. But ultimately we will still be talking about regulation, whether it’s the trading book review, whether it’s RWA harmonisation, whether it’s Liikanen, whether it’s a review of the Bank Recovery and Resolution Directive in Europe.

It’s a simple observation that the more issuers of AT1 we have out there, the higher the probability for an accident is, and therefore the closer we are to the asset class seeing its first true test. I don’t preclude that happening in the next 12 months. It’s not something you look forward to, but I think it’s something we’re very interested to see how that affects both that individual institution, the individual instrument, but also the asset class as a whole.

Aspden, Georgina
Aspden, GSAM: Hopefully we’ll be in a better place next year, with a little more clarity on regulation. I agree, it’s still going to be outstanding and the risk weight harmonisation is an issue. But it means banks will still hold more capital, so that’s a better place — whether it means issuance and opportunities in that, or just stronger fundamentals. So I’m quite bullish.

Everwijn, Rabobank: What I hope is that we will have harmonisation across the way we deal with bail-in, preferably with the Rabobank method. We have conversations with investors, not just from the continent or from London, but also elsewhere in the world, and for them it’s a complete mess what’s going on in Europe. So I hope from a transparency point of view that we harmonise the way we fill up our MREL and TLAC buffers.

Schotkamp, BBVA: Unfortunately the next 12 months are going to be much more dominated by regulatory news, and the ambitions of the ECB as a regulator to be on par with the Fed, the Swiss and the UK.

I am sometimes surprised to see how bullish equity investors are. The amount of push to get this industry better capitalised is still mind-boggling. That’s good news, as Georgina says, for the credit fundamentals.

I’m worried about TLAC. I’m really worried about a policy mistake there. This is the overshoot of capital regulation threatening liquidity management, asset income, and all these things.

To make a very specific observation, are we going to be able to create regulatory equivalence with our Latin American countries’ regulators, to make TLAC enforceable and implementable in a multiple point of entry resolution strategy? I don’t know.

Bian, BlackRock: You’ll be forced to shrink at that point, right?

Schotkamp, BBVA: I’ve hinted at strategic decisions. If you don’t have good market positions in non-equivalent regimes, then you’re going to be under pressure. Is it worth the complexity? But then again, that is the agenda of the regulator, to reduce complexity.