Bank capital is undergoing a radical overhaul at the hands of European regulators. Rulebooks are being torn up left, right and centre, and traditional investor and creditor hierarchies are being subverted.
The good news, for now, is that most in the markets seem to have accepted that big changes are inevitable. The bad news is that, precisely because the changes are so far-reaching, they are taking an inordinately long time to push through the Eurozone is not known for rapid execution at the best of times.
The year 2012 did, however, see progress. In the second half of the year, creeping clarity on how regulators will be able to impose losses on financial institutions combined with an almighty market rally to inspire a wave of tier two issuance from financial institutions, as well as several standout hybrid capital securities.
Its difficult to tell whether structurers really believed they had enough visibility around the delayed Capital Requirements Directive IV (CRD IV) and Capital Requirements Regulation (CRR) which are expected to be finalised in the first quarter of 2013 or whether borrowers had simply had enough of waiting and wanted to lock in tight spreads while the market was right.
"If issuers dont have all the pieces of the puzzle worked out they will be reluctant to launch new transactions, other than if the price is right in a good market," says Ronan Donohue, head of capital solutions at Rabobank in London. "Then they may be willing to take on board some structural risk."
Either way, the deals came thick and fast some $41bn of tier two paper hit the market over 2012. Most banks needed, and still need, to boost their capital bases. But with senior bail-in looming, issuers are likely to print more tier two, in order to maintain a proper buffer between senior and tier one.
"Senior debtholders are comfortable with old-fashioned credit risk to figure out when something will go bust, but less so with non-viability and bail-in," says Donohue. "By adding a comforting buffer between tier one and senior, tier two is increasingly popular as a means for issuers to mitigate such concerns. If the market continues to improve we should see more supply."
Towards the end of the summer, the debate among DCM bankers centred around how exactly issuers could protect themselves against unexpected regulatory outcomes relating to loss absorption, by using features such as substitution and variation language and regulatory call options.
One of the main sticking points is around how to reference Europes incoming point of non-viability rules, which are expected to be enshrined into statutory law in the European Commissions Crisis Management Directive. However, some bankers are worried that the European parliament could spring a surprise on the market at the last minute.
"A contractual route can be very complex," says Gerald Podobnik, co-head of EMEA capital solutions at Deutsche Bank. "It would mean European authorities would need to draft common non-viability language for the whole of Europe. Otherwise every issue could end up being different.
"If that happens, then obviously when the regulator wants to invoke non-viability, a thorough legal analysis of every transaction would be required, making the whole process very difficult."
The biggest challenge, he says, is to keep structures comparable and predictable.
"The current trend, where every word is negotiated, misses the point," he says. "We need to ensure people understand what we issue and why, with no hidden surprises."
Eastern promise forces western rethink
Institutional investors, in particular, have been more reluctant to buy new bank capital. However, even the most forward-thinking asset manager was always going to appear reticent when measured against the ebullience of Asian private bank investors, who piled into a raft of Reg S tier one, tier two and contingent capital deals last year.
The strength of their bid helped issuers to drive down the costs of these instruments, partly by virtue of what bankers call the "stickiness" of order books on these deals investors are less likely to drop out when pricing is tightened.
A recent 30 year non-call 10 deal from French insurer CNP Assurances attracted $10bn of orders, while a perp from Japans Nippon Life stunned the market with an almost farcically inflated book of over $20bn.
This makes allocations a lengthy and demanding process, but some market participants worry that it also warps the relationship between book size and pricing. Allianz was able to price 50bp inside its initial pricing thoughts, while Nippon Life slashed its guidance by 90bp, eventually pricing a whole percentage point tighter than initial thoughts.
Recently, order books have begun to look more balanced almost half the $10bn orders for Société Générales perpetual deal came from European real money buyers. If anything, that makes the price tension even more prevalent, says Jeff Tannenbaum, head of FIG syndicate, EMEA, at Bank of America Merrill Lynch.
"Its wrong to call the Reg S dollar market the Asian private banking market, because if you look at the composition of order books across deals, a large proportion is distributed to both private banking and institutional accounts based in Europe," he says.
"This wide distribution has created strong price tension during 2012, with the private banking investors competing for assets with institutional buyers in both Europe and Asia. Sometimes ultra-high net worth investors have an advantage because theyre driven by yield rather than spread."
Some are worried that the aspects of the structure of the Asian private banking market particularly the fact that wealth managers lend their clients money to buy bonds, making the transaction a leveraged carry trade could limit demand.
"There are other higher yielding instruments, but traditional high yield is sub-investment grade and may not garner leverage," says one DCM banker. "The reason the market is so yield-driven is because these guys are playing the carry trade. If the leverage is not there for example if the deal being bought is not rated highly enough it has an effect on demand."
Others are concerned that these high net worth individuals are not as knowledgeable as established institutional buyers, and perhaps do not fully understand the risks involved. However, BofA Merrills Tannenbaum points out that many of them invest in a wide range of products, including equity, so are probably more comfortable with the prospect of losses than those dedicated to fixed income.
"The ultra-high net worth investors have a large amount of discretion in terms of where to invest their money," he explains. "Many of them are more comfortable buying hybrid debt because they have experience with both equity and credit and have probably seen better performance for most of the year than some of the institutional fixed income investors."
Indeed, 2012 was a year of education for all investors. A perverse advantage of the repeated delays in finalising the CRD IV and CRR rulebooks was that investors no longer had to get used to the idea of loss-absorbing features such as temporary and permanent writedown or equity conversion as evidenced by the success of transactions from issuers such as Barclays and UBS.
"Its all about structure more aggressive structures will still be a bit of a turn-off for institutional investors," says AJ Davidson, head of hybrid capital at Royal Bank of Scotland.
"The yield pick-up might not be enough, and they may just reject it on principle."
Right down with write-down?
One aspect of the structure of additional tier one capital that needs to be finalised is permanent write-down, which would allow regulators to force losses on bondholders without the prospect of them ever being compensated.
Temporary write-down or conversion to equity are the preferred options, but it is unclear whether regulators will allow them. If they dont, some investors will be very unhappy.
"Some stronger names dont need it, because they can go into equity or do permanent writedown," says one capital structurer. "But temporary write-down will be a necessity for most issuers."
After a long hiatus in tier one capital issuance, the market is likely to be dominated by national champions once the rules are finalised. But they are just the tip of the iceberg, says Keval Shah, FIG syndicate at Citi.
"Depending on your expectations of what risk-weighted assets will look like under Basel III, the FIG market needs a substantial quantum of subordinated debt," he says. "I would say the figure is in excess of 300bn for the top 40 European banks for hybrid capital: both tier two and additional tier one. I would expect the market to welcome national champions first, with the others to follow."
Estimations of supply for 2013 range between 45bn and 100bn for tier one and tier two the amount of capital actually needed may be higher than that, but issuance of it is likely to play out over a number of years.
However, issuers can be happy in the knowledge that they will need to worry far less about the dynamics of the market than they do about regulation. If spreads continue to rally in 2013, and senior unsecured supply becomes scarce, investors will continue to look down the capital structure in search of yield.
"Issuers are certainly in a more comfortable position," says Tannenbaum. "Liquidity levels remain high, and theres demand from a variety of sources. Financial institutions have access to multiple markets creating competition and price tension among different pools of liquidity."But it wont last forever. Bankers and issuers, not to mention investors, will be crossing their fingers that regulators new years resolution is a simple one: to show some leadership, and quickly.