A year ago, life was all about common equity capital. Banks piled their hybrid tier ones and subordinated debt instruments on a bonfire of liability management. In the quest for strong equity levels, the importance of total capital seemed to go up in smoke.
This year, the pendulum has swung back. Markets, regulators and banks are again focusing on the total capital structure: equity, together with hybrid securities and loss absorbing debt.
In 2019, once Basel III is fully phased in, banks will have to hold tier two capital equal to 2% of risk weighted assets. Additional tier one securities as new-style hybrid instruments are termed will be equal to 1.5% of RWAs.
The trouble is, until now, European banks have had little guidance on what kinds of instruments will be eligible to fill these buckets. Issuers and structures are waiting for final rules from the European Banking Authority over how additional tier ones should absorb losses.
Tier two is clearer. Nevertheless, banks jumping into that market in early September did so without final guidance on how clauses about bail-in at the point of non-viability should be included in documentation.
And at the same time, more requirements are smudging the focus. A crucial one is the systemic risk buffer the capital buffer also known as a national finish. And as bail-in looms, banks are asking whether they need to hold extra buffer capital to reassure their senior unsecured investors.
So how will banks structure their capital in the coming years?
Hinging on systemic risk
Many of the answers to how banks will manage their capital ratios depend on the outcome of the debate around national finishes.
In a late night session in May, Europes finance ministers agreed that countries would be allowed to assign higher capital ratios to their domestic banks than what European standards call for.
This was a win for rulemakers in Sweden and the UK. Wary of the size of their banks compared to their economies, these countries are keen to have their financial institutions strongly capitalised. The decision came against the wishes of other jurisdictions which wanted a level playing field to prevail.
Under the systemic risk buffer agreement, countries can call for their banks to hold up to three points of capital above the minimum stipulated in the fourth capital requirements directive (CRD IV) and the first capital requirements regulation (CRR I).
But the size of that buffer, and the way it operates, is still to be finalised.
"That debate is still very much on-going, despite the fact that draft text was inserted in the last version of CRD," says Emil Petrov, head of capital solutions at Nomura. "That article was obviously hastily inserted at the last minute and some major European countries strongly disagree with it, so it is bound to remain a negotiation token."
The way the buffer operates could have important repercussions on banks wanting to raise hybrid capital, he says.
Under Basel III, banks will face restrictions on payments such as dividends and hybrid coupon payments once they fall below the minimum capital ratios. These capital conservation measures will kick in when a bank breaches its minimum common equity tier one ratio. In basic cases, that is 7% of risk-weighted assets. But it is uncertain how the systemic risk buffer will affect that.
"Will it be in a continuum with the other buffers?" asks Petrov. "What will be the implication for the capital conservation measures? Currently, its the combined buffer that triggers the capital conservation measures, which can give some very counterintuitive results if one jurisdiction has a national finish and another doesnt."
In a hypothetical case, a bank with, for example, an 11% common equity tier one ratio but subject to a three point systemic risk buffer would hold 100bp of capital more than regulators require. Such a bank might find it harder to sell additional tier one securities than a bank with a 9% CET1 ratio that is not subject to an extra buffer. This is because the second hypothetical bank would be 200bp away from triggering capital conservation measures.
Similarly, investors wonder when the point of non-viability will hit capital instruments. New regulations mean hybrid capital instruments will have to convert to equity or take a principal write-down when a banks common equity tier one ratio hits 5.125%.
But market participants wonder if a bank would be declared non-viable before such a trigger is hit. With capital requirements so high, a bank that has common equity of, for example, around 6% of risk-weighted assets could face severe difficulties accessing funding and hybrid capital markets.
"The big problem at this stage is the definition of point of non-viability," says Fred Zorzi, global co-head of syndicate at BNP Paribas. "Its very difficult to buy something when youve got no idea how it will behave. Investors prefer a trigger they can monitor. The question is that when the additional tier one trigger is 5.125%, a lot of people think PONV will be close to that if not before. Plus, each jurisdiction has a different view on PONV."
Hopes and expectations of hybrid structuring specialists have moved in waves. In 2010 and 2011, they pinned their hopes on the expectation that contingent capital instruments tier two notes that carry the risk of equity conversion would be the next big thing in bank capital.
When the European Commission failed to mandate a place in the capital structure for Cocos, attention moved to tier ones with temporary principal write-down.
These deals would be more attractive for investors, the thinking went, because creditors would see some recovery value. Again, the regulatory response has disappointed.
The European Banking Authority allows additional tier one notes to absorb losses through temporary write-down, but under strict conditions. Structurers and issuers are lobbying intensely on two of the conditions in particular.
One is the EBAs ruling that coupons should be switched off completely for a note that has been temporarily written down. In contrast, a deal that has been partially permanently written down will still pay coupons on the amount left outstanding.
The other point of contention is that writebacks must be limited to a percentage of the banks profits. This disregards all the other ways banks can improve their capital ratios, bankers argue, such as rights issues or asset disposals.
The effect of the draft rules has been to increase the attractiveness of notes with permanent write-down features.
"Theres a growing body of anecdotal evidence from investors that between permanent versus temporary write-down, permanent might actually be an easier outcome for them," says Ben Nielsen, head of European syndicate and DCM at Nomura in London.
"It is slightly counter-intuitive, and not completely conclusive. But were increasingly hearing that a permanent write-down instrument is clean. You know where you are. The liquidity of a temporary write-down instrument post a write-down is very challenging and whether its worth anything, is not clear."
Market rumours indicate that a smattering of European banks are scoping out their options for printing additional tier one notes before the end of the year.
In the UK and the Netherlands, rules on tax treatment of such securities are still being finalised, effectively ruling out banks in those jurisdictions from bringing deals. But elsewhere, unfinished rules are still holding back supply.
"Any bank that issues AT1 today is going to have to be overly conservative," says Thibaut Adam, head of hybrid capital at BNP Paribas. "The banks that can issue today can do so in very specific situations they have high capital levels and will issue for strategic reasons. There are not many fitting that profile. Give it six months, when we have the final view from the EBA on AT1, then the possible universe of issuers becomes wider. But its really a 2013 type of topic."
A return for sub debt
By contrast, tier two is seeing a renaissance. Four banks printed transactions in the first weeks of September, and more were lining up to follow.
To call that a rush of issuance would perhaps be an exaggeration.
"If you look at the number of euro denominated subordinated transactions in the second half of 2009, there was around 20 deals," says Karim Mezani, head of FIG syndicate at Natixis.
"But clearly theres a lot more deals coming now compared to the first half of this year. All the banks and all the investors are clearly envisaging tier two capital to be a lot more important than it was before and therefore there are a lot more issuers looking at this."
The spree of issuance came despite little regulatory advancement. Indeed, the apparent delay in CRD IV and CRR I may have provoked some banks into action. With the onset of grandfathering potentially pushed back, and the need for tier two paper increasingly important as bail-in rules take shape, banks pressed on with deals.
"When you look at the Basel III capital structure, theres a 1.5% AT1 bucket," says Romain Brive, from the global structured credit and solutions desk at Natixis. "And when banks operate with equity ratios above the regulatory requirement, the room for AT1 is not that big. Its not sure well see as big a market for that in the future as for tier two. Tier two has this role to play for protecting senior unsecured creditors. Its much more efficient to use tier two from a bail-in perspective compared to tier one."
With bail-in an increasingly real element in the future of bank financing, there is growing interest in other forms of buffer capital. In particular, banks are studying a form of subordinated capital that does not get regulatory treatment, but which provides protection to senior unsecured investors in the case of insolvency.
Ideally, such instruments would be cheaper for banks to sell than tier two paper, and they would bring down the cost of their senior unsecured funding. Investment banks and regulators are looking at the possibilities for these securities, but it remains to be seen whether the economics will stack up."For a new asset class to make sense for the issuer, it needs to offer a significant saving to tier two," says Nomuras Petrov. "But in order for investors, who are already increasing pricing on senior debt, to be interested they need to see a material pick-up over senior paper. Given the senior-tier two spreads are compressing, there is not much spread left to play with. Perhaps, the single most important way to reduce cost would be to shorten the maturity relative to tier two which is constrained by regulatory requirements. In a steep yield curve environment, you can make savings by cutting from the curve."