With banks in the most advanced jurisdictions hitting limits on innovative issuance, non-innovative structures have featured strongly in recent tier one supply. Meanwhile, more traditional hybrids are being used in other countries that are playing regulatory catch-up. Accounting standards are also an issue, but ratings are considered a side-issue.
While the development of hybrid products for corporates has generated a great deal of excitement in the past 12 months, much of the technology being used in that market might be considered old hat by those active in the bank hybrid tier one market. Much of the technology being used in the corporate arena, having already been translated into the insurance sector, has been borrowed from products used by banks for many years.
Indeed, in roughly the same time that corporates such as Casino, Vattenfall and Bayer have been taking the sector's first steps into hybrid instruments, banks have been forging ahead with just the latest generation of tier one instruments, non-step-up hybrids.
"Some of the major European banks have been tempted to look at non-innovative tier one issues without step-ups because they do not have any more headroom to issue innovative tier one with the classic step-up that is limited to 15% of tier one capital," says Franck Robard, head of hybrid capital at Société Générale CIB in London. "The natural move is therefore into non-innovative structures."
While non-step-up preference shares have been sold to retail investors in several jurisdictions, these instruments, pioneered by Barclays with a Eu1bn deal in November 2004, are sold to institutions. While the lack of a step-up means that there is less of an incentive for the issuer to call the deal, investors are compensated for the softer maturity by a higher spread.
Some of the instruments have proven volatile in the secondary market (see chapter six for further details), but the structure has appealed to a growing variety of issuers. Bank of Ireland, for example, sold a $400m non-step-up perpetual non-call 10 issue into the US market via Deutsche Bank, Lehman Brothers and Merrill Lynch in January.
"Like many other regulators, the Irish Financial Services Regulatory Authority limits the amount of step-up issuance to 15% of tier one, so if you want to get anything beyond that you have to use a non-step-up structure," says Brian Kealy, head of capital management at Bank of Ireland in Dublin. "We launched the $400m non-step-up dollar issue on the back of strong demand after we had priced an $800m step-up tier one hybrid.
"As of March 2006, we have used up our 15% innovative capacity, so if we were to do any more step-up issuance it would not qualify as tier one until total tier one expanded. We would therefore have to go for non-innovative on any further issuance."
Crédit Logement was in a similar position when it launched an Eu800m non-innovative perpetual non-call five deal in March via BNP Paribas, HSBC and Société Générale CIB.
"In France you can only do tier one with a step-up to 15% of total tier one," says Eric Veyrent, CFO of Crédit Logement in Paris, "but you can issue tier one with no-step-up to 25% of tier one as it is considered more stable by the Commission Bancaire, the French banking regulator. We were nearly up to the 15% limit, having issued a step-up hybrid in November 2004, at around 12%-13%, so it was not possible for us to issue such paper again.
"We therefore had to go for the non-step-up, which although more expensive, allowed us to raise hybrid tier one, otherwise we would have had to call on our shareholders."
The ability to raise tier one capital in the perpetual non-call five structure rather than sell new equity also gave Crédit Logement some useful flexibility in managing its capital structure.
"The deal was driven by the impact of Basel II," says Robard at Société Générale. "When Crédit Logement implements the new risk-based capital requirements its capital needs will in 2010 be perhaps an eighth of what they currently are because of the nature of its business, giving guarantees for residential loans. But in the meantime, with the French mortgage market growing strongly, Crédit Logement's business is growing and it required more capital."
While banks in jurisdictions that have had clear rules on the use of step-up innovative tier one capital have filled the buckets allowed for such instruments, and have now moved on to non-innovative structures, in other countries banks have yet to reach their limits, in many cases because until recently there had been regulatory obstacles.
"What we have seen in the last few years is more and more countries adopting the most advanced issuance procedures for tier one capital," says Demetrio Salorio, head of debt capital markets origination for financial institutions at Société Générale CIB in London. "In Italy, for instance, the market for tier one had for some time been closed, and only last year did it begin to take off.
"In other jurisdictions we have seen the distinction between innovative and non-innovative tier one capital made clear and percentage limits for each introduced. We therefore expect there to be much more issuance in the next few years of hybrid tier one from banks in these countries."
The structures being developed in such countries might not be as groundbreaking as the breakthroughs that have been made in the past, but they are nevertheless important in the respective jurisdictions.
"Regulation is the critical driver for banks when it comes to hybrids, and while we are seeing new regulations coming out in central and eastern Europe, in western Europe regulations for this type of product are largely set," says Vinod Vasan, head of capital securities at UBS in London. "But if you look more closely then you can see there have been quite a few changes to regulations even in western Europe in the last couple of years."
Bank of Ireland, which has made use of the most up to date non-step-up structures, only saw the current Irish framework introduced in September 2004. "The Irish regulator brought out the new rules then, essentially allowing banks to issue step-up and non-step-up tier one capital based on certain limits," says Kealy. "Before that there were not explicit rules about how much non-equity capital you could issue."
Even in the UK, which has been at the forefront of regulatory and structural developments in hybrid tier one, the environment has not been static. "The UK is constantly tweaking its rules," says one hybrid specialist, "and it is hard to keep up with them given the volume of information that the FSA puts out."
One recent tweak came after HBOS introduced a structure that pulled off the feat of being non-innovative and tax-deductible at the same time. "HBOS put payment-in-kind into a core tier one deal and afterwards the FSA said in their publications that no one could use that structure anymore," says the banker. "If you try to put payment-in-kind or something like that into a structure it would now count as innovative, so that deal is something of a museum piece.
"It is just the latest example of the FSA allowing things and then disallowing them, which has happened a few times in the past, most notably with the Tons (tier one notes) structure."
However, in comparison with several other European jurisdictions, the FSA has overseen a sophisticated and attractive tier one framework for UK banks. "Some central banks and regulators have been more reluctant than others to accept non-innovative structures," says one banker.
That many are shifting towards frameworks that allow banks to manage their capital more efficiently is to the benefit of their wards. "A country is at a competitive disadvantage if its regulator does not allow its banks to raise capital in all its forms while other regulators are doing so," says Société Générale's Salorio.
Italy steps in to line
This thinking appears to have been behind the change of heart at the Bank of Italy that allowed UniCredito Italiano to launch the largest ever hybrid tier one financing by an Italian bank, and the issuer's first tier one bond in five years.
The Eu750m and £300m perpetual non-call 10 issues were launched in October 2005 to support the Italian bank's takeover of HypoVereinsbank. JP Morgan and Merrill Lynch were joint bookrunners on both tranches, being joined by HVB and UniCredit Banca Mobiliare on the euro piece and HSBC on the sterling.
"The Bank of Italy had previously been very reluctant to accept hybrid tier one issuance," says one DCM official, "despite there having been lots of work done by banks to convince them that they should accept it. There had been some transactions here and there, but no clear trend of banks tapping the market as the Bank of Italy had no clear rules on the matter."
Bankers believe that the Bank of Italy's desire to support its national banks in the European cross-border M&A activity that had just begun finally convinced it of what it had not been persuaded of previously. "The change helped UniCredito a lot as it was buying a bank that had a whole heap of non-compliant capital under the Bank of Italy's previous regulations," says one hybrid specialist. "HVB had even issued the old German dated tier one structures."
Others agree. "UniCredit Group is regulated on a consolidated basis and the issuance of hybrid tier one at the level of HVB would probably have been difficult for the Bank of Italy not to accept on a consolidated basis," says one banker. "I expect that had the portion of capital that was coming through HVB not been accepted then there would have been some political pressure because the Bafin in Germany had accepted it on a European basis.
"I am sure that this logic will have helped in changing the Bank of Italy's mind."
Whatever the reason behind the change, UniCredit was able to get the go-ahead to use hybrid tier one as part of the financing of the acquisition of HVB.
"The Bank of Italy had given unofficial guidance to all banks to base their capital adequacy not on Basel tier one, but on core tier one, basically excluding the use of any hybrid tier one," says Philipp Waldstein, head of strategic funding at UniCredit Group in Milan. "That guidance was then for various reasons changed in 2005 and that enabled the bank to use the hybrid instrument as a capital strengthening tool."
However, bankers say that the Bank of Italy's new stance has not yet been set in stone. "There is nothing in writing in Italy to say what is and what is not allowed," says one hybrid specialist. "There is just an understanding that you can now do hybrid tier one and, on a case-by-case basis, get them signed off. But what is clear is that there are going to be more, and some quite soon."
While there has been progress on the innovative side in Italy, the country is still lacking non-innovative direction. "We are now in the weird situation where the Bank of Italy accepts innovative structures, but not non-innovative," says one DCM official. "That illustrates how regulators, while they might be moving with the times, still maintain their idiosyncrasies."
Spain too sees the light
The Bank of Spain had a similar change of heart to the Bank of Italy last year, allowing the use of step-ups in tier one instruments for the first time. "In Spain for many years the only way of raising hybrid tier one capital was by issuing non-step ups to retail," says Société Générale's Salorio.
But like UniCredit, Banco Santander Central Hispano had, in 2004, bought a bank that had issued large amounts of innovative hybrid capital that would not have been eligible under current regulations. Abbey, which Santander bought, had made use of the various iterations of hybrid structures in the UK, a jurisdiction where, as highlighted above, banks have been continually pushing the envelope on what is and is not permissible.
"If you look at the Bank of Spain's old rules, they didn't match up with Abbey's tier one at all, so there was pressure from the Spanish banks to be able to include step-up instruments as innovative tier one capital," says one DCM official.
It was clear that the Bank of Spain had yielded to their wishes when the executive committee of the central bank published a letter in July 2005 allowing hybrid tier one instruments with a 100bp step-up and call up to 15% of tier one capital.
Banco Pastor launched the first deal under the new framework late that month, a Eu250m perpetual non-call 10 issue via Barclays Capital, Dresdner Kleinwort Wasserstein and Morgan Stanley. "Banco Pastor was in touch with the Bank of Spain and knew that the change in rules was coming through, and put together their transaction based on this information," said a banker close to the deal. "The formal approval came after the transaction was launched."
Banco Pastor's deal was followed by one for Banco Bilbao Vizcaya Argentaria, which last year tried but failed to buy Italy's Banca Nazionale del Lavoro, but remained a potential acquirer. "The bank is likely to keep an eye on the changing European banking market in its drive to be an active participants in future cross-European deals," said Standard & Poor's after the acquisition fell through.
The demands for hybrid capital that any takeovers by Spanish banks might generate will in future most likely be met through step-up issues rather than traditional retail target sales. This is because at roughly the same time that the Bank of Spain opened the door to innovative issuance, the Spanish market regulator, the CNMV, all but closed off the retail option.
"There were concerns from the Spanish authorities about the use of the retail market," says Vasan at UBS. "Now you are not allowed to go the retail route without benchmarking pricing off the institutional market, which takes away the rationale for doing such issues."
While filling the right regulatory bucket in the most efficient manner possible is the primary aim of banks launching subordinated and hybrid bonds, another key concern is the accounting treatment that the issues will face. This has come to the fore as the result of International Accounting Standards 32 and 39 dealing with accounting for financial instruments.
"In order to have hybrids enjoy tier one recognition from a regulatory point of view, they are structured in a way that would normally make them treated as equity from an IFRS (International Financial Reporting Standards) perspective," says Robard at Société Générale. "But as a consequence of this, if a bank wants to hedge the issue with an interest rate swap, for example, taking the proceeds from fixed to floating, the associated swap will not benefit from hedge accounting from a P&L perspective."
The swap would then have to be marked to market, causing volatility in the bank's accounts. And as banks typically prefer to have floating rate liabilities to match floating rate assets, while many hybrids are fixed rate until the call — or might have issued in a currency other than that in which they want to retain the capital — ways around this situation have had to be developed.
"Issuers try to include structural features in their tier one instruments to get debt treatment for hybrids that would normally be treated as equity under IFRS," says Robard.
Several banks in the UK have tweaked their issues thus, using two general methods: a contingent must-pay, or baby prefs.
"Several methods have been used by issuers to achieve debt accounting on tier one, which is key if hedge accounting is a desired objective for an issuer contemplating a tier one offering. One method, commonly known as baby prefs has been used by issuers such as Barclays, Lloyds and Standard Life," says Amir Hoveyda, head of EMEA debt capital markets at Merrill Lynch in London. "This involves issuance of baby prefs that rank junior to tier one and are held by an affiliate of the user.
"They are must-pay instruments, redeemable at any time at the issuer's option, subject to a short notice period. This mechanism creates the contractual obligation that is required to achieve debt accounting, while satisfying the FSA's prudential requirements regarding loss absorption."
The other technique used to gain debt accounting is the contingent must-pay. "We structured a contingent liability for Bank of Ireland," says Vasan at UBS, "which had the effect of making the whole security debt. This was that if there was a takeover of the bank, the security would become must-pay — unless the regulator or something outside the bank's control prevented this.
"That was the first time that it was used, back in February 2005, but since then it has been used on a number of occasions in the UK with slightly different contingencies."
Joint default analysis
While banks do not typically tailor their structures to rating agency methodologies, one change to their criteria that could have an effect on bank hybrids is Moody's implementation of joint default analysis in the financial industry. As part of a roll-out of the methodology across all sectors, the rating agency aims to have it fully applied to financials by this autumn.
"Simply put, joint default analysis calculates the probability that two defaults would occur jointly," said Moody's analysts in a conference call to discuss proposals in April. "If we know the probability of default for each of two issuers on their own, JDA uses a basic statistical formula to estimate the joint probability of default.
"This is a well established concept. In our JDA model Moody's has taken this concept one step further by introducing an additional factor, the probability of support, which allows for the possibility that support may be less certain."
While the implementation of JDA in the banking sector mainly concerns how governmental support will affect bank ratings, the rating agency noted that it could also affect the notching between more and less senior obligations.
"Moody's believes that in a government-engineered rescue, the treatment of junior bank obligations (including bank holding company obligations) may vary widely from country to country," it said. "As a result, while the proposal could result in higher local currency deposit ratings for certain banks, it might lead to smaller upgrades, or no upgrades at all, for the ratings on those banks' more junior obligations.
"This will effectively lead to greater 'notching' for priority of claim between Moody's deposit ratings and its ratings on other bank obligations in some countries, reflecting a lower probability of support for such obligations than for deposits."
Eleanor Yeh, senior credit analyst, financial institutions, at Société Générale in London, says that there are two ways in which this could play out. "Either they lower the hybrid capital ratings, which I think is unlikely, or they raise the senior deposit rating," she says. "I think the latter is more likely."
Standard & Poor's in late March suggested a potential new approach to notching that could also have taken into account the likelihood of government support or other intervention.
This would have seen hybrid ratings being based on the probability that an issuer would be downgraded to the level at which deferral occurred. The hybrid would be rated in the rating category with the default probability closest to the probability of deferral.
The methodology was not introduced, but was seen as unlikely to have a great effect on bank hybrids.
"With respect to banks and other regulated financial institutions, the agency acknowledged that they had shown more ratings stability than industrials because troubled banks had either been bought by stronger institutions or had received government support," said analysts at Lehman Brothers. "This has introduced a quasi-floor for banks' and regulated entities' ratings.
"We infer from this that the transition statistics for banks should show a lower frequency of downward migration than those for corporates generally, which should limit the downward migration of hybrid capital ratings for banks compared with industrials."
However, S&P has made exceptions to its notching policy and this, combined with its recent suggestion, means that market participants believe that it, rather than Moody's, is more likely to change its notching policy, and more likely to change it in a way that will see the notching between issuer credit ratings and hybrid ratings widen.