Basel III — through the revolving door

Basel III and its regulatory stable-companions are the banking world’s equivalent of health and safety legislation. But are the regulations in danger of suffocating the patient before it can recover? Philip Moore takes a journey through the corridors and wards of Basel III.

  • 28 Sep 2011
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First, there is the broad economic cost, which a recent OECD analysis puts in the range of 0.05% to 0.15% being shaved off annual GDP during a five year period.

Then, within the financial services sector, there are the costs of regulatory compliance. McKinsey reckons these will reach between €45m and €70m for a medium-sized European bank, the bulk of which will be swallowed up by IT spending.

There are also the hard-to-quantify costs of the time and human resources channelled by management into meeting the Basel rules, organising investor presentations, undergoing stress tests and keeping everybody from regulators to the media up to speed on their capital ratios.

As Christoffer Mollenbach, head of FI DCM at Lloyds Bank Corporate Markets, points out, since the crisis a number of banks (Lloyds included) has appointed permanent treasury representatives in the US and Asia. That can’t be cheap.

There may also be costs to be borne in terms of job losses if — as many analysts think — the new regulation puts paid to the ambitions of scores of smaller regional banks, engendering a wave of consolidation across the European banking industry.

‘Monumental’ challenges

Then there are the funding costs that will arise from the giant financing requirements that banks will face as they aim to term out their debt and bring their capital ratios into line with Basel III.

"Monumental" is one of the words used in a recent McKinsey report to describe the challenges that lie ahead for banks preparing to comply with Basel III. "As the rules are written today and based on Q2 2010 balance sheets, the industry will need about €1.1tr of additional tier one capital, €1.3tr of short term liquidity, and about €2.3tr of long term funding, absent any mitigating actions," notes the McKinsey analysis, published in November 2010.

Bankers say these figures seem high, in part because they may not put sufficient emphasis on how rapidly or extensively banks are reducing the size of their balance sheets. "Reducing risk-weighted assets, as many banks are, means that overall funding needs come down massively," says Jeff Tannenbaum, head of European debt syndicate at Bank of America Merrill Lynch in London.

Adrian Docherty, head of bank advisory in the financial institutions solutions group at BNP Paribas in London, agrees. "We are seeing dramatic deleveraging on the asset side which still has a long way to run," he says. "Banks’ balance sheets are still 10 times larger than they were 20 years ago, while the global economy is only three times bigger. So there is still huge scope for continued shrinking of leverage throughout the banking system."

True enough. And even if allowances are made for any exaggeration in the McKinsey figures on the broader challenge that is confronting banks in the Basel III era, other estimates on funding shortfalls dwindle into insignificance in comparison.

July’s stress tests from the European Banking Authority (EBA), for example, pointed to a shortfall among the eight banks that fell below the 5% core tier one of €2.5bn over the next two years.

That figure has been dismissed by many analysts as too low. As RBC Capital Markets commented soon after publication of the stress test results, with Basel III being phased in from 2013, it is likely to be difficult for banks to have core tier one ratios "substantially below 8%".

"If we calculated a minimum of 7% core tier one ratio instead of the applied 5% there would be a capital shortfall of around €39bn. Applying a minimum 8% core tier one ratio the aggregate shortfall would be €100bn."

This may still look like pocket money compared to the McKinsey numbers. Nevertheless, there seems to be little dispute that shortfalls arising from Basel III will exert upward pressure on banks’ funding costs going forward.

Towards a stronger system

The longer term, Darwinian quid pro quo is that the banking system that emerges as a result will be stronger, more stable and probably leaner, and the survivors should therefore enjoy lower funding costs. "It is clear that under Basel III banks will have more capital, and much higher quality capital, than they had under Basel II," says Andreas Boeger, co-head of the capital solutions group for EMEA at Deutsche Bank.

"If banks have a common equity tier one ratio well above the capital conservation buffer, supplemented in many cases by a G-SIB [global systematically important bank] buffer of up to 2.5%, they will be completely different animals than they were in the past. They will also be much more efficiently supervised."

"Because there is such a strong political will to give banking a business utility-style profile in which earnings are stable rather than stellar, bondholders — even at a subordinated level — may turn out to be in a very positive position," Boeger adds.

Tighter regulation is bringing with it other positive implications for FIG investors across the capital spectrum. "As well as being more strongly capitalised, banks will be incentivised not to run risky activities such as prop trading," says Raphael Robelin, head of investment grade credit at BlueBay Asset Management.

"Another positive is that as investors we are being provided with much more detailed and granular information. In the past there was an assumption that as banks were almost proxies for government debt you didn’t need to research them diligently. This has clearly changed."

The immediate outlook does not look this benign, either to investors or to banks themselves, which have plenty of more pressing distractions than Basel III to worry about. After all, if you were the CEO of a UniCredit or a BNP Paribas when bank share prices were in freefall in July or early September, the distant demands of Basel III would have looked like a mere detail relative to the storm clouds gathering in Europe’s peripheral economies.

For banks’ funding teams, meanwhile, in recent months there have also been considerably more immediate priorities than the requirements of Basel III. "There are clearly many market and regulatory factors beyond Basel III that influence banks’ capital structure and funding mix," says Andreas Weese, managing director in the FIG banks team at UniCredit. "These include stress tests and bail-in regulations as well as market risk appetite and the sovereign debt crisis."

All these influences mean that it can be difficult, if not impossible, to identify the initiatives that have been driven by regulatory change and those that would have been inherited from the financial crisis — or driven by other circumstances — even if there had been no such things as Solvency II, Basel III or CRD IV.

New model banking

Directly or indirectly, however, regulatory change is having — and must continue to have — a very far-reaching impact on business models throughout the FI space.

"There are likely further structural changes to come in the industry because some business models that survived the crisis were reliant on government guaranteed debt and that is now starting to run off," says Leo-Hendrik Greve, managing director and global head of FI strategic origination at ING in London.

"It is also clear that returns will likely be lower across the sector in the medium term due to higher capital and liquidity requirements. But the key factor will be what banks consider to be a sustainable long term business model.

"For example, under Basel II a smaller low single-A bank could function very efficiently as a mortgage provider. Under the Basel III liquidity rules there are now perhaps question marks over the sustainability of some models."

Do not, however, underestimate the progress that large swathes of the banking industry have already made towards compliance with the new guidelines on liquidity and capital. This may well have been driven more by the lessons learned during the crisis than by the Basel III rules themselves, but the net result will be Basel compliance.

Look, for example, at the way in which many banks’ business models have evolved to safeguard against the sort of liquidity crisis that did for Northern Rock. With the benefit of hindsight, it scarcely needs a Basel Committee — or any other committee — to expose the fragility of a business model based on a loan to deposit ratio of 345%. After all, the next highest in the UK banking sector in 2007 was HBOS’s 177%.

Nevertheless, it is notable that much of the business models of banks such as Lloyds TSB and RBS are constructed around paring their recourse to wholesale funding alongside balance sheet reduction and asset disposal. "Highly leveraged business models and those that depend heavily on wholesale funding will come under increasing pressure," says Weese at UniCredit.

It is also notable that considerable progress has already been made towards meeting these objectives. Lloyds TSB, for instance, has increased customer deposits from £371bn in December 2009 to £389bn in March 2011, helping its core loan to deposit (LTD) ratio to fall from 128% to 116% over the same period. It has also indicated that it sees its wholesale funding requirement falling from £50bn in 2010 to £25bn per year between 2012 and 2014.

LCR + NSFR = No. 1 challenge

While retail deposit gathering is clearly playing an important role in addressing the Basel III liquidity guidelines, it is one of a number of components in banks’ tool-boxes for meeting the challenges of the net stable funding ratio (NSFR) requirement. This, along with the liquidity coverage ratio (LCR), is generally regarded by analysts as presenting the toughest challenge for banks aiming at timely implementation of the Basel III rules.

As PriceWaterhouseCoopers (PWC) puts it in a recent guide, "for many institutions, the liquidity challenge is likely to be greater than the capital challenge. This is an area where supply constraints (such as the availability of deposits, medium term funding and high quality assets) are likely to be a key issue."

Others agree, especially given that the notion that government bonds are risk-free is now looking like a joke in poor taste. "If you stopped the clock today and assumed that current funding conditions were going to last for ever, you would struggle to see how banks are going to achieve the 100%-plus LCR and NSFR levels that Basel III envisages," says Docherty at BNP Paribas.

One clear trend that is already gathering pace as banks work on compliance with the LCR is a demand-driven move away from short dated senior funding. "On the investor side, banks will be less motivated to hold senior bank paper for liquidity purposes as a consequence of Basel III," says Chris Lees, head of European FIG DCM at Citi in London. "This is one of the reasons why we are seeing far fewer shorter dated floaters."

Senior unsecured debt will, of course, continue to play a key role in the post-Basel III world, but perhaps with a different investor base and at a higher price. "It will be tougher for unsecured debt, but there will still be demand," says Weese at UniCredit. "Banks will look to distribute senior unsecured bonds through their retail franchise, and we will also see demand from asset and wealth managers, maybe also in Asia."

At the same time, covered bonds are regarded as being a clear beneficiary of the LCR requirements. "Banks are incentivised to buy covered bonds because they count favourably towards the liquidity pool they are required to hold," says Daniel Bell, head of EMEA DCM new product development at BofA Merrill Lynch.

The appeal of covered bonds will increase even more if they are recognised as level one assets under the LCR, which Denmark’s regulator — with the support of plenty of others — is pushing for.

Under the current rules, covered bonds are categorised as level two assets under the liquidity requirements. This means they are subject to a 15% haircut and that they can account for no more than 40% of assets used to calculate the LCR post-haircut. Level one assets are subject neither to a haircut nor a cap.

A lesson in liquidity

Banks have already taken big strides towards LCR compliance, with the demise of Lehman having taught everybody a lesson about liquidity. "The Lehman collapse was obviously a function of liquidity rather than capital," says Boeger. "Since then, banks’ liquidity positions have changed substantially. Not just measured by their liquidity stocks but also in terms of liquidity planning and safeguarding their balance sheets against another liquidity crisis, it is a completely different ball-game to how it was pre-Lehman."

The extent of the liquidity challenge is clear enough from the findings of the comprehensive Quantitative Impact Study (QIS) published by the BIS in December 2010. This found that among banks below the 100% LCR threshold, requiring them to hold "sufficient high-quality liquid assets to withstand a stressed 30 day funding scenario", there would be a shortfall of €1.73tr "if banks were to make no changes whatsoever to their liquidity risk profile".

The shortfall of net stable funding, based on the same assumption, is €2.89tr, with only 43% of the banks that provided sufficient data having already met or exceeded the minimum NSFR requirement. "Banks that are below the 100% required minimum have until 2018 to meet the standard and can take a number of measures to do so," the QIS explains. These include "lengthening the term of their funding, reducing maturity mismatch, or scaling back activities which are most vulnerable to liquidity risk in periods of stress."

Banks have plenty of time to address this component of the Basel III jigsaw. "Meeting the liquidity requirements will be a challenge, which is why CRD IV did not include anything binding about the NSFR," says Romain Brive of the credit and hybrid structuring desk at Natixis in Paris. "It isn’t due to take effect until 2018 and the European Commission wants to take advantage of the long observation period before announcing anything binding."

A number of banks have already set about addressing the NSFR challenge, principally by extending the maturity profile of their funding. Take the example of a bank like ING, which has a publicly stated objective of building a yield curve of senior debt, rather than depending chiefly on covered bonds for funding in maturities of five years and longer.

Hence a transaction such as its £500m 10 year senior issue in April via HSBC, Lloyds and ING, which was explicitly aimed at lengthening the bank’s maturity profile in advance of Basel III implementation.

Only for the big boys

More broadly, bankers say that lengthening maturity profiles has been driven as much by a strategic change of focus following the crisis as by a drive towards NSFR compliance. They also say extending maturities is an option that has only been open to the strongest banks in Europe. "Choice of maturities this year has been driven more by market access than by the need for banks to extend duration because of the NSFR," says Hans Lentz, head of FIG syndicate at Lloyds Bank Corporate Markets. "Issuance beyond five years has largely been the domain of the top banks only, which in a European context means a handful of Scandinavian and other northern European banks with good ratings and high name recognition."

Others echo the view that unsecured issuance at the longer end of the market is increasingly becoming the preserve of a privileged few. "Senior unsecured deals will probably continue to focus on the short end of the curve, and the long maturities will increasingly be supplied by covered bonds, except for national champions which will have more easy access to the whole curve," says Aziza Breteau of the FIG DCM desk at Natixis.

The capacity of others to push further down the maturity curve has been further complicated by the Solvency II regulations governing asset-liability management among insurance companies. On the surface, these appear to kick in the opposite direction to the Basel III rules by encouraging insurers to focus on the shorter end of the curve.

If maturity extensions have to a large degree been the province of the strongest banks that are least threatened by Basel III, so too has capital raising, with Standard & Poor’s suggesting at the start of 2011 that in the race for capital, speed to market will be of essence.

In fairness to banks that have yet to grasp this particular nettle, meeting the capital challenge is easier said than done. That is not just because for many the cost of funding will rise with the battle to access the market becoming increasingly competitive. It is also because so many uncertainties remain at a regulatory level.

"There is now enough detail in the Basel III rules for us to have a pretty good idea about what the main trends will be and to identify where the pressures will lie," says Lees at Citi. "But there are also still plenty of question marks. The devil is in the detail."

Take, as an example, the discussion over the definition of risk-weighted assets for capital calculation purposes. "On the capital side there have been complaints from the US that European banks are more relaxed about how they calculate risk-weighted assets compared to those in the US," says Bell at BofAML. "The Basel Committee is being urged to look into the calculation of risk-weighted assets to ensure there is consistency and will begin a review later this year or early next."

While many of the doubts over the regulatory treatment of capital securities have now been ironed out, a number of uncertainties remain across the capital structure, leaving investors in many cases saying that they are being asked to price into what amounts to an information vacuum.

Ringfencing fears

Muddying the waters for senior debt is the debate over ringfencing of retail and investment banking operations. While this discussion is not directly addressed by the Basel III rules, it has the same ultimate objective, which is to prevent future banking crises and ensure that the taxpayer is protected from absorbing losses.

"The concept of ringfencing is similar to encumbrance in that by carving out significant portions of a bank’s balance sheet it could leave senior unsecured bondholders exposed to a less favourable balance of risks," says Lees at Citi. "So there is still a lot of focus among investors on the instrument they are buying and on which assets represent their recourse."

Richard Thomson, credit analyst at Henderson Global Investors, agrees. "From a creditor’s perspective, it is very difficult to know where you would sit in a ringfencing structure," he says. "Theoretically you would assume that all deposits and covered bonds would be inside the ringfence, but which other liabilities would be included would be somewhat dependent on the size of assets within the ringfencing which is currently not clear. The other question mark is whether core tier one levels outside the ringfence would have to rise to reflect the riskiness of investment banking."

Subordinated clouds begin to lift

If uncertainties over bail-in continue to cloud the immediate prospects for senior debt, there appear to be even more unresolved questions over the outlook for subordinated bonds in the run-up to Basel III.

Views on the degree to which regulatory announcements drip-fed to the market in recent months have clarified the treatment of subordinated debt are decidedly mixed. Some say they are disappointed by the implications for new issuance
volumes arising from these announcements.

Sebastien Domanico, global head of FIG at Société Générale, says the regulators’ stance on hybrid capital instruments will steer issuers towards refinancing old instruments rather than using subordinated debt to add a buffer of capital to their balance sheets.

"We all understand that following the crisis banks need more equity," he says. "But we also know that it was largely a liquidity rather than a capital problem that caused the crisis in the first place. So why are we restraining banks’ ability to improve their capital position by issuing hybrid capital which serves as a buffer but also as an efficient tax-deductible long term financing tool?"

Some say that with the release of the European Commission’s CRD IV proposals in July, there is now at least sufficient clarity to allow for the issue of hybrid instruments that are fully compliant both with CRD IV and Basel III. "Now that the criteria on areas such as loss absorption and coupon distribution have been laid out, there should be enough clarity to design hybrid securities," says Glen Leighton, head of balance sheet advisory at Barclays Capital.

Others agree that the regulatory environment is now becoming less opaque. "The relative recent inactivity in the market for capital-based products has largely been a consequence of the uncertainty around how CRD IV will implement Basel III rather than an indication that banks don’t feel the need to issue," says Mollenbach.

Nik Dhanani, global head of capital solutions at HSBC in London, adds, "we now have increasing clarity for institutions to consider tier two capital issuance, but from a technical perspective there is still some work to be done both at an international and national level. A major question for tier two instruments is whether principal loss absorption at the point of non-viability will ultimately be addressed by statutory/resolution frameworks or be implemented on a contractual basis. In some ways, it would be more practical if compatible frameworks could be developed in a reasonable time frame and in a sufficiently consistent manner across different regions."

The immediate outlook for tier one, say bankers, may be more complicated. "We know that CRD IV requires principal loss absorption for all additional tier one instruments, regardless of accounting classification," says Dhanani. "But the July 20 release neither categorically endorses nor dismisses the use of principal reinstatement features. It will be interesting to see the degree to which criteria are implemented consistently across different regions in practice."

By early August, bankers appeared to agree that it would still be a while before the first Basel III and CRD IV fully-compliant hybrid tier one instrument would be ready to see the light of day. "Even leaving aside the negative market conditions, it may be too early to start structuring fully-compliant hybrid tier one instruments outside jurisdictions like Switzerland where CRD IV does not apply," says Brive at Natixis. "Although CRD IV gave us an overview, we still lack clarity on important details like how writedowns would work and whether write-ups will be allowed."

One reason for this may be the persistence of contradictory interests among different investor groups. The dilemma for regulators is that in so many instances, aligning those interests is like mastering a treacherous Rubik’s Cube or solving a fiendish Soduku puzzle. How, for example, do they reconcile the apparently contradictory objectives of Basel III and Solvency II? How do they satisfy the public that banks are being encouraged to lend while ensuring that that lending never becomes reckless? And how do they keep bond and equity investors happy at the same time?

Coco orphans

Contingency convertible (Coco) instruments, for example, would look fine in isolation, were it not for the interests of equity investors. "Conversion to equity sounds sensible enough," says Henderson’s Thomson. "However, if a bank has material problems, equity investors may start to worry about debt conversion which could in turn encourage them to exit, creating a downward spiral."

Other bankers agree that Cocos are in danger of being virtual orphan assets unable to appeal either to debt or equity investors. "Conversion into equity has rendered Cocos impractical for large parts of the fixed income investor base," says Greve at ING. " I don’t see why a pension fund would easily put money into a product offering no upside in coupon but full downside in terms of equity risk."

The debate over writedowns versus write-ups, says Thomson, can clearly trigger conflicts between the interests of bond and shareholders. "The problem regulators have with write-ups is that they believe it may discourage equity investors from participating if they know bondholders have to be written up before they benefit when the issuer’s core tier one ratio recovers," he says. "But from a bondholder’s perspective of course you don’t just want write-downs because they limit the scope for principal recovery."

Encouraging banks to extend duration in accordance with the net stable funding requirement also creates a potential conflict with equity investors. "Immediately after the crisis there was a focus on de-risking and a shift from money market to longer term funding," says Mollenbach at Lloyds Bank Corporate Markets. "But towards the end of last year equity investors began to protest vocally that this rebalancing was eroding banks’ interest margins. The challenge for banks is to maintain a balance between profitability and extending duration under Basel III in a steep yield curve environment."

How much of an impact Basel III is having on the size and structure of the investor base for senior unsecured and subordinated bank debt is unclear. "Historically, discrete investor groups supported different parts of a bank’s capital structure, with money market funds and bank treasuries taking short dated senior FRNs and large volumes of tier two in 10 year non-call five format taken by the SIV community," says Adam Bothamley, head of FI syndicate at HSBC. "Looking forward, it seems the change in risk profile of bank liabilities and the absence of certain investors, such as SIVs, may lead to more of a concentration in the investor base."

"If senior creditors are exposed to the risk of being bailed in, the traditional distinction between the risk profile of subordinated capital and senior liabilities becomes less clear," Bothamley adds. "On the other hand, private banking networks have taken an increasing share of the most subordinated structures and are broadly asset-class ambivalent — they have no explicit aversion to owning more equity-like instruments or indeed equity itself. We have also seen the inception of new dedicated funds and activity from non-traditional credit investors attracted to the bank capital sector by the potential for higher returns."

Some shifts in the investor base are already discernible. At Henderson, Thomson says that many of the group’s institutional funds are ratings-constrained, and that downgrades in recent years have therefore led to limits on the amount of subordinated debt these funds can hold. "Across the industry as a whole a lot of lower tier two and tier one issues have fallen out of indices. This led to a shift in ownership of many subordinated instruments from traditional asset managers such as ourselves to hedge funds and other institutions."

Taking up the slack

Other sources of demand are also taking up the slack. "Don’t forget retail investors," says Karim Mezani of the syndicate desk at Natixis. "They have been used to buying tier one and other subordinated paper without proper calls or step-ups for more than 10 years." In a fixed income market in which yield is hard to come by, there is good reason to think that retail buyers will continue to be supportive of bank subordinated paper.

This wider supply-demand dynamic leaves bankers relaxed about the capacity of the market to absorb the new issuance volumes that will ultimately be required to meet the Basel III capital rules. "From a capital perspective, some investors will be lost as a result of Basel III," says Tannenbaum at Bank of America Merrill Lynch. "But at the same time new investors may be attracted by the convertibility features of some of the loss absorbing instruments. Our view is that the investor base for Basel III-compliant instruments will not necessarily diminish."

Judging from the red carpet that was rolled out for Cocos, some say it is supply of subordinated instruments, rather than demand, that may fall short of what is required. "A lot of investors have been disappointed by the FSB’s recent ruling on Cocos," says Domanico at SG. "They had put a lot of work into creating buckets for Cocos in anticipation of rising volumes and now it looks as though we’ll be lucky if there is $20bn of issuance." That is a far cry from the $1tr market that S&P foresaw in a report published last December.

At Natixis, Mezani is confident that investors will find alternatives. "Now that the Coco market will be much smaller than we expected, it will be interesting to see whether the funds that were created for investment in Cocos will be open to new hybrids and what the features of those instruments will be," he says. "Will bond investors accept conversion into equity or will they prefer permanent writedowns, which pension funds and insurance companies usually hate?"

Rapid response

Mezani suggests that if the precedent of recent hybrid innovations is anything to go by, investors will adapt fairly quickly and positively to new structures. "Credit Suisse built a book of more than $20bn for its capital buffer notes, with pricing coming in from an originally indicated level of about 9.5% to 7.875%," he says. "That shows two things. First, that investors throughout Europe, Asia and the US were able and ready to buy Coco instruments."

"Second, it demonstrates that even when you come to the market with something brand new, the market is able to respond very quickly and you can attract a lot of appetite," Mezani adds. "This makes me optimistic not just about the prospects for tier one and Coco-style instruments but also for senior debt, even allowing for bail-in."

Brive and Mezani point to two other indicators in support of the view that investors will warm to new forms of hybrids. The first is the success of Rabobank’s $2bn perpetual in January. "That was as close to a CRD IV-compliant tier one transaction as we’ve seen so far," Brive says. "It had features like permanent writedowns based on core equity but it was still a huge success, especially in Asia."

The second is the way investor attitudes have shifted in areas like high yield over the last three years. "Three years ago asset managers and insurance companies were telling us they didn’t want high yield," says Mezani. "Now many are opening new high yield buckets and issuance volume is at record levels."

For investors prepared to take a longer term view on how these apparent conflicts are likely to be resolved, current prices in the market for senior as well as subordinated bank debt, which are building in a juicy Basel III discount, could amount to a bargain hunter’s nirvana. "At first glance, many bank instruments are becoming more risky, with senior debt potentially subject to bail-in and tier two impacted by non-viability, which will lead to higher funding costs and spreads in the short term," says Boeger.

"Longer term, the price of capital, especially for national champions, will come down as the recognition grows that the risk is not high enough to justify coupons of 8%-10%. The chance to earn 7% on a highly regulated, recapitalised and strongly supervised business may be more appealing than the same return on a higher risk asset."

Bargains to be had?

Others agree that current market conditions in the FIG space could offer outstanding opportunities for contrarians able to take a long term view. "We should be positive over the longer term because there will be scope for the better positioned and capitalised players to increase margins and pick up new opportunities," says Greve at ING. "If you can take a long term, contrarian view, valuations today are extremely low."

This implies that investors’ approach to evaluating bank credit will need to change as Basel III is implemented, with the demise of moral hazard meaning that fixed income investors adopt more of the disciplines usually associated with equity investment, especially in the tier one market. "Maybe prior to bail-in investors were tempted to buy bank debt purely on the basis of spread, without paying much attention to the quality of management," says Boeger. "Going forward, confidence in management will be very important."

Perhaps. But investors say they are still plenty of reasons for either giving bank debt a wide berth or insisting on a much higher price before stepping into the market at a senior or unsubordinated level. One of the most intractable of these, says Henderson’s Thomson, is regulatory discretion.

"Regulators want to reserve the right to dictate the point at which they decide to rule on a writedown or conversion to equity," he explains. "The problem with this from an investor standpoint is that we have no way of analysing or identifying where the trigger points for those writedowns or conversions are. For instance, would their main concern be liquidity or capital, and how would they measure liquidity? Uncertainties of this kind is why we would want to be paid a lot more to buy bonds in an environment of regulatory discretion."

Others agree that despite apparently appealing spreads now available on bank subordinated debt, doubts over the regulatory outlook may still deter investors.

"We have seen a number of tier two transactions launched in Europe in the last two to three years at re-offer spreads wider than at the inception of the market in the late 1990s," says one banker. "So you could argue that across the capital spectrum we are at our near historically wide levels on a spread basis."

"The counter-argument," he adds, "is that although Basel III should help to promote greater stability, the expected loss you face as a bank creditor — regardless of where you are in the capital structure — may be higher due to additional loss absorption requirements and the architecture of resolution regimes. Ultimately, it is a question of which effect is greater, and the outcome may not be consistent across different institutions and regions."

Ominously, this is a view echoed by some investors. "At this stage, I am cautious about buying bank debt because I still see an undercapitalised European banking system," says Robelin at BlueBay. "I also see a danger that the sequencing of events is such that burden-sharing is being used to deal with this banking crisis rather than to prevent the next crisis. This means that banks that are unable to be Basel III-compliant risk needing to be recapitalised by their regulators, and even as a senior creditor I face the risk of taking a haircut."
  • 28 Sep 2011

Bookrunners of International Emerging Market DCM

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5 Deutsche Bank 7,715.91 23 5.97%

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5 Bank of America Merrill Lynch 2,765.80 5 6.67%

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5 Citi 95.36 35 5.16%

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5 Citi 280.89 2 5.37%