For those accustomed to seeing regulators and hedge funds as operating from opposite sides of the table, a furore in 2018 over an old UniCredit bond issue was disconcerting.
Caius Capital challenged the Italian bank over its convertible and subordinated hybrid equity-linked securities (Cashes): it said the instrument did not deserve the capital treatment it was getting.
As such, the investment firm could claim to be helping the regulator in making sure top banks meet their capital requirements and thus are resilient. And by speculating against the Cashes, it aimed to make a return too.
“It’s a business model of trying to enforce European rules and make a profit from potential mistakes in applying the rules, so that’s why I find it quite amusing,” Sven Giegold, a German member of the European Parliament in the Green/European Free Alliance group, told GlobalCapital earlier this year.
This was just one example of disagreements over the status of legacy capital, as market participants grapple to interpret old contracts, new rules and overlapping regulatory mandates.
These types of battles were not new to 2018. One investor, who remains anonymous, suggested that Lloyds Bank’s tussle over its Enhanced Capital Notes could be seen as a potential starting point.
These securities would convert into equity if the bank’s capital position fell below a certain level, but the lender decided to redeem them after the UK’s Prudential Regulation Authority (PRA) left them out of stress test calculations in 2014.
Lloyds said this constituted a capital disqualification event, allowing it to redeem the bonds at par, but investors challenged this in court. Lloyds eventually won out. Such cases have now come to seem familiar, for several reasons.
Praying for redemption
When investors place a value on debt instruments that count as regulatory capital, they price in various risks. The coupon might not be paid, the principal might be written down, and the issue might be redeemed before or after the market expects.
As regulatory capital is generally expensive for issuers compared with other instruments, the treatment it receives under the rules is a key factor behind a decision over whether to redeem it. Cheap regulatory capital is particularly useful; expensive non-compliant capital is not.
UniCredit’s Cashes, Aviva’s preference shares and HSBC’s discount perpetual bonds (discos) all swung around in price in 2018 upon sudden recalculations of the extension risk.
Aviva announced in March that it had the option to call its shares at par, shocking investors who thought they would not be redeemed. One could see the appeal of this for the insurer: the shares pay a high coupon and lose regulatory capital treatment from 2026. But as they were trading significantly above par, Aviva’s declaration led to a crash in value. After a furore, the insurer backtracked later in the month.
HSBC announced it was reclassifying $1.95bn of discos as full-fat tier two in May, from the grandfathered status they were originally assumed to have under the EU’s Capital Requirements Regulation (CRR). Investors had priced in a call for the bonds on the assumption that the bank would not want to keep capital that lost regulatory treatment from 2022, hence the price fell sharply on the announcement.
“Extension risk is something we look at in very fine detail in our financial debt strategies,” says Gildas Surry, portfolio manager at Axiom Alternative Investments in London.
Axiom is a specialist investment firm. But many buyers of financial firms’ bonds are more generalist, without the same understanding of the intricacies of capital regulations. This can make securities mispriced, and is the knowledge gap geeks like Axiom and Caius seek to exploit.
Some of the tumult also appears to relate to how the EU’s Capital Regulations Requirement was implemented in 2014.
For this new framework, it fell to national regulators to put forward information on what counted as the purest form of bank capital, common equity tier one (CET1). There are even suspicions that issuers themselves did some of the reviewing work.
It is the responsibility of the European Banking Authority to monitor the quality of types of capital. But while it reviews new instruments, other old ones have historically been left unchecked by the supervisor. It also cannot remove instruments from the list of eligibility, but instead makes recommendations to others.
So when the EBA decided in 2017 that some loyalty dividend shares issued by Crédit Agricole in 2011 breached CRR, it was the European Central Bank that asked the lender to take them out, after agreeing with the assessment.
And it is thought that the EBA had not interacted with UniCredit directly about its Cashes when Caius made its claim. UniCredit issued the notes in 2009 and restructured them in 2011. It has €609m counting as grandfathered additional tier one capital, and €2.37bn as CET1.
The EBA is now getting on the front foot. It is conducting a review into CET1 instruments issued before CRR.
But this does not necessarily mean that all discrepancies in CET1 treatment will be ironed out straight away.
“We have still not finished for the largest banks but we are progressing well,” says Delphine Reymondon, head of the liquidity, leverage, loss absorbency and capital unit at the EBA in London. “Next spring I think we will have a very good idea of the potential issues and the corrective measures that have been taken if and where needed.”
The EBA could also start to remove capital instruments from the eligibility list, under powers expected to be granted to it in the new CRR 2 legislation.
This follows an opinion paper the body published in May 2017 asking for this ability. “I think they followed what we proposed in this opinion very closely,” says Reymondon.
A Brexit disco
Away from CET1, the EBA has also been looking into HSBC’s disco bonds, after being contacted by a law firm. Some bondholders have agitated against the reclassification.
Two factors are at play: whether they count as tier two, and whether they count towards the bank’s minimum requirements for own funds and eligible liabilities (MREL).
The supervisor will send its conclusions to the Bank of England and leave the UK regulator to set out its final position.
The low-coupon bonds were issued in the 1980s by subsidiaries at the operating-company level of the bank.
The Bank of England has expressed concern about MREL liabilities issued from an operating company. It thinks that lenders with regulatory capital issued at this level could be harder to put into resolution.
A source familiar with HSBC’s thinking said that the bank took the reclassification decision after consultation with the PRA and that it expects to keep the tier twos for as long as they retain full value as regulatory capital.
But the new CRR 2 could take away the disco bonds’ regulatory treatment. If this is the case, a grandfathering period would be expected.
“There is a certain degree of posturing, where issuers and investors will disagree on the interpretation of the current grandfathering rules and the way they will be updated with a new version of the capital requirements regulation,” says Surry.
Brexit also throws a spanner in the works. “The PRA is probably less apt to interfere in what the EBA’s view is or vice versa because they just have other priorities to deal with right now,” says the anonymous investor.
And the UK may decide not to follow CRR 2, which could lead to a different treatment for the discos.
But if the country wants third-party equivalence with the EU, European authorities may use cases like HSBC’s discos in assessing the compatibility of the two regulatory regimes.
More bonds to watch
As for the Cashes, if the EBA does judge that they are ineligible as CET1, it will give UniCredit and its regulator notice to sort it out before revealing the findings to the market.
“We generally publish our investigations only after we have sufficiently discussed with the relevant competent authority so that some corrective measures can be taken if and where needed,” says Reymondon.
For its part, UniCredit has said that all relevant authorities have reviewed and affirmed the treatment of the Cashes.
More generally, old Q&A announcements published by the EBA relating to the treatment of instruments may come back into focus, ahead of 2022, when CRR grandfathering periods end. And the impact of CRR 2 on capital instruments will also come into play.
From the regulators’ perspective, the overall picture is not worrying: banks have built up their capital levels over the years, as the EBA stated in the results of its 2018 stress test.
Therefore, the supervisors are unlikely to be overly concerned if the odd instrument here and there turns out to deserve a different treatment to that previously thought, and in general even less worried if that causes isolated losses for investors.
But if the past is an indication of the future, other old instruments might well pop up to cause a nasty surprise for the buyside. UniCredit and HSBC are hardly poorly followed; if the market has got it wrong on their instruments, it could easily be making other mistakes. Of course, for other investors, this is an exciting opportunity.