Cost of hybrids set to rise as central bank gets tough
Russian banks will spend much of the second half of 2013 replacing old-style tier two capital with new, as they switch to Basel III-compliant rules. The market has already produced some successes, but not all lenders will have access at a competitive price, writes Tom Porter.
Russia enjoys doing things differently from the rest of the world. That is one of the reasons its banking system was less badly affected by the global financial crisis of 2008 than those in the West.
The state stepped in to aid the acquisition of some struggling banks by bigger players. But the country did not have to deal with a Lehman Brothers, or a Royal Bank of Scotland – banks so integral to the system that anything short of a bail-out would have meant disaster.
The Central Bank of the Russian Federation is taking no chances from now on. It is set to integrate Russia’s banks into the global Basel III regulatory framework later this year, and here, too, it is forging its own path.
From October 1, under the latest proposals, banks will have to comply with a minimum 10% total capital ratio, when Basel III requires just 8%.
But the most immediate concern for banks is the new capital eligibility rules, which all capital issues have had to reference since March 1.
The CBR has introduced loss absorbency features for tier two debt, linked to two triggers. The first is a breach of a 2% common equity tier one ratio. The second is hit if the country’s Deposit Insurance Agency becomes involved with bankruptcy prevention measures at the issuing bank.
Out with the old...
The central bank’s chosen method for grandfathering old tier two capital, which it began on April 1, should ensure Russian banks bring new trades to market much more quickly than their peers elsewhere in Europe.
“Russia is doing instrument-based grandfathering, so having old tier one and tier two outstanding will become inefficient for Russian banks,” says Gerald Podobnik, head of capital solutions at Deutsche Bank. “There is a bigger incentive to replace the old instruments, so we should see a quicker move in Russia to issue new securities.”
However, bankers don’t expect issuance to really get going until the new requirements are finalised in October.
When the supply does arrive, issuers hope it will be welcomed by international investors.
“Bank loan portfolios are still growing, though more slowly, and the need for capital continues,” says Dmitry Gladkov, head of debt capital markets for Russia at JP Morgan. “For the rest of this year I envisage a heavy focus on capital, subordinated and hybrid issuance, based on new Basel III-compliant instruments. But it will depend on the price because the domestic deposit base, corporate or retail, is providing relatively attractive funding costs [for banks] at the moment and the focus on margins persists.”
...in with the new
How new-style tier two capital should be priced, relative to old paper, has already been the subject of intense debate among emerging market bond bankers.
When Credit Bank of Moscow printed its $500m 5.5 year bullet note with an 8.7% yield in April, the leads claimed it was priced on top of where an old-style instrument would have been.
Some observers away from the deal agreed, but several others said it paid investors a pick-up of 50bp-80bp.
Whatever the premium, the bond traded down three percentage points in the first few days after pricing, suggesting investors had not been as comfortable with the new structure as first thought.
Opinion was more unanimous when Sberbank stepped up to print a $1bn new-style lower tier two bond in mid-May. The 10 year bullet note was sold at 324bp over mid-swaps, just 12bp wider than the bank’s old-style 2022s.
“The pricing on the two new tier two trades came virtually flat to the old-style tier two,” says Podobnik. “The argument was that the old tier two doesn’t have any form of loss absorption, while the new style has loss absorption — but the trigger is so low, at 2%, that this is seen as barely any additional risk. Investors accepted that logic.”
But some are already pointing to signs that the anticipated flood of tier two Eurobonds from Russian banks is cooling investors’ appetite for the paper.
Just a week after Sberbank’s success, Russian Standard Bank, rated Ba3/B+/B+, had to postpone a 10 year non-call five lower tier two bond after already collecting $200m of orders at initial price guidance of a 10% yield.
The lead managers blamed market conditions — with some justification. The deal came amid a sell-off in credit markets, the day after US Federal Reserve chairman Ben Bernanke had hinted that the Fed might begin tapering its bond purchasing programme.
But some emerging market bankers away from the deal said the large volume of Russian subordinated paper expected could be draining demand.
Another worry is whether banks can rely on enough of their typical investor pools being happy with the new-look sub debt.
“The traditional investor base for subordinated bonds from Russia — private banks in Switzerland and particularly Asia — are not yet universally comfortable with contractual loss absorption, which has moderated demand,” says Simonas Eimaitis, head of emerging market bond syndicate for EMEA at HSBC.
“As a result, issuers have been more reliant on institutional demand, primarily from UK-based investors who are more comfortable with evaluating new loss absorption features, and require a premium.”
Raising the bar
Investors have shown they don’t need much of a premium for names like Sberbank, but for most Russian lenders loss absorbency will raise their cost of capital. That could have serious consequences for some.
Subordinated debt was previously rated one notch below the senior rating, but harsher rating approaches may now be applied.
That would put some lower rated banks’ sub debt into triple-C or unrated territory. They could face a tricky choice between selling at a very steep yield and trying to pass the costs on to their customers, or not placing the deal at all.
“The advent of the new requirements may prompt some investors to differentiate larger, systemic, state-owned entities from smaller private sector banks,” says Nik Dhanani, global head of capital solutions at HSBC. The latter group, he adds, “may be assessed with a higher degree of scrutiny on a case-by-case basis, to gauge the potential likelihood of loss absorption being triggered.”
Many, perhaps including the central bank, are hoping that this raising of the capital cost bar will force stagnant smaller banks to either disappear or be gobbled up by rivals, speeding up the much-needed consolidation of the sector (see article on banking competition, page 13).
“It is pretty obvious Basel III will have a cost impact on raising capital, and that causes concern within the sector,” says Ignat Dirks, head of debt management at Gazprombank. “It will put pressure on profitability and banks will either need to scale down their growth plans or transfer the higher costs to their loan customers.”
A tougher challenge
With all the noise over tier two capital, it is easy to forget that banks will also have to issue tier one instruments at some point.
The only one that has so far done so, referencing Basel III, is VTB, which printed a $1bn perpetual tier one deal in July 2012, in anticipation of the new rules.
The bad news is the cost impact of the regulatory overhaul is likely to be even greater for tier one capital. The new loss absorbency trigger of 6.4% core equity tier one is getting awfully close to the ratios of even Russia’s biggest banks.
Investors will have to be compensated for the heightened risk of being written down.
“Banks will be incentivised to issue new additional tier one securities,” says Dirks. “But it may be tricky, because recently released data on the capital adequacy of Russian banks shows the buffers over the proposed trigger levels are pretty thin, as compared to European precedent deals.
“Gazprombank’s core tier one ratio is at 8.2% and the trigger is 6.4%. It is a similar story in the rest of the sector.”
The good news, says Podobnik, is most issuers do not need to think about raising additional tier one just yet.
“We should see banks issue some new tier one securities,” he says. “But the big Russian banks usually have quite high common equity tier one ratios, because they have equity and a bit of tier two.”
Because of this, banks are likely to wait until after the first wave of new-style tier two trades before considering selling additional tier one, should they need it, in order to have more pricing reference points and be sure of persisting demand.
Overall, bankers say the bigger banks need not worry about investor appetite for their capital trades when the market is in good shape and they are priced correctly.
“The new capital instruments and structures are all well understood,” says Gladkov. “Buyers are familiar with most of the names that would come with those structures. So it is all about the pricing, that is where the debate will be this year. We have to find a new point of equilibrium between the increased risk for investors and the price the issuer wants to achieve.”
Russian banks’ capital issues in the last 12 months have enjoyed good support from international investors, and their allocations are expected to grow as Russia further integrates into the global regulatory regime.
Foreign buyers still have concerns over certain quirks in the country’s banking sector, but those trying to sell their debt overseas can put up a robust defence of the way they do things.
“The most typical concern raised by investors is about concentrations in banks’ balance sheets,” says Dirks at Gazprombank. “Such concentrations are driven by the fact that the economy is quite concentrated, it is driven by large corporates that have substantial financing needs. To serve them properly you need banks capable of extending that financing to them.”
The more recent global ambitions of Sberbank and VTB are helping to put Russian bank risk on the radar of more and more international investors, and the new Basel III rules may allow them to draw favourable comparisons with their contemporaries in Europe and the US.
Ultimately, argues Gladkov, Russian banks do not face many challenges in the capital markets in the years to come. “The Russian market is still growing, it is still underbanked, even after years of expansion,” he says.
“The ratio of retail banking penetration in Russia is still lower than in some of its EM peers like Turkey, which are still considered to be fast growing emerging markets. The challenges will be domestic — growth, portfolio quality, risk management — but I spend a lot of time talking to investors and they are very comfortable and often excited by the credit stories in Russia.”