Korean banks are bracing for AT1 change
South Korea’s regulators are widely expected to adopt new rules that force banks to sell perpetual additional tier one bonds, something that was prohibited until now. The move will push lenders to execute more expensive offshore capital raising and while the shift will improve the soundness of Korea’s banking system, it will take the market time to adjust to the new regime.
Under the current Korean banking laws, bond issuers are not allowed to sell debt that is perpetual. Instead, firms usually opt for a tenor of 30 years and include an automatic renewal at maturity, which effectively makes it a perpetual instrument.
But recently, that law has come under the microscope. The Bank for International Settlements (BIS) has asked Korean regulators to comply with the Basel III framework, under which all AT1 instruments must be perpetual.
The expectation is that the Korean authorities will comply with the demands of the BIS. But when the changes happen, AT1 issuers need to prepare to face some additional costs as they give investors time to adapt to the new rules.
This is because until now, much of the bank capital issuance from the country has been in the onshore market. While no official data is available, multiple sources in Korea reckon issuance has seen exponential growth from W360bn ($314m) in 2014 to W2.4tr in 2015.
That’s where the challenge arises as the introduction of perpetual AT1 bonds will most likely scare away domestic bond buyers. Sure, they have been buying pseudo-perpetual notes so far, but when the bonds are classified as pure perpetual, the dynamics change for investors.
This means that onshore accounts will stay away from undated AT1 in the beginning, which in turn could jeopardise banks’ capital raising given many are in urgent need to ramp up their common equity tier one ratios. And while admittedly the new rules could eventually end up attracting demand from equity investors, it will be a while before that transition happens.
What the impending rule change will do is push Korean banks to the international market, which will work out about 100bp-200bp more expensive than onshore. It will be even more cumbersome for smaller local banks with little exposure to international investors.
Of course, when banks go offshore for their fundraisings, they typically shell out more than in their domestic markets. But the tweak in AT1 rules will come at a tricky time for Korean borrowers, who have long had a reputation of pricing deals as aggressively as possible. What will not help is Moody’s decision in mid-April to revise the rating outlooks on major Korean banks, including Shinhan Bank and KEB Hana, to negative from stable, and downgrade Woori Bank to A2 from A1.
This particularly burdens Woori, whose CET1 ratio dropped to 8.47% in 2015 from 8.96% a year ago. In addition, because of the proposed change in rules, its plan to issue a second dollar AT1 trade by the end of April was abruptly put on hold by the regulators.
When Woori first came to the offshore AT1 market in June last year, it squeezed every penny out of the deal and achieved one of the lowest coupons (5%) in the world. This was despite its deal being the first AT1 in Asia ex-Japan from a non-Chinese issuer.
Given the current situation, the chance that Woori could see a similar outcome is slim, especially as the souring sentiment for the instrument globally means major European banks are paying almost double-digit yields.
That’s not to say Korean banks won’t be able to find investor appetite for their trades especially as many are already active in vanilla debt offshore. And as time goes by and more bank capital notes are issued, the comfort levels among domestic investors too will go up, meaning in the long-term, Korean issuers will be able to juggle both the onshore and international routes for their capital raisings.
For now though, with the BIS breathing down their necks, treasury officials at Korean banks are scrambling to change their funding plans with the offshore market becoming the first port of call. Given how AT1 debt is riskier than traditional debt, the shift also works in the regulator’s favour as the risk is then spread to offshore buyers.
But as with any regulatory change, it will take time for both banks and investors to find their feet. In the meantime, it will be issuers that have to face up to higher funding costs.