Regulatory fog begins to clear but new challenges emerge
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Regulatory fog begins to clear but new challenges emerge

Over the past two years, banks have focused on building up their core capital ratios, through a combination of equity issuance, asset disposals, RWA reduction, and liability management.

But the regulatory blocks to new capital issuance are clearing and new-style loss absorbing instruments are almost ready to hit the market. BBVA has already brought the first.

But plenty of challenges remain for this remodelled bank capital market. New regulation does not stop at minimum standards for bank capital instruments — it goes further, turning senior unsecured funding into another form of capital, and laying the ground for an integrated European bank resolution framework and banking union.

The overall picture is still confusing, and issuers are constantly having to adapt to this changing environment. 

To discuss how they are meeting these challenges, a number of issuers and several investors gathered to compare notes at the Morgan Stanley Bank Capital Issuer Roundtable in late May.

Participants in the roundtable were:

James Macdonald, credit analyst, Bluebay Asset Management

Juan Cebrián Torallas, head of capital management and planning, CaixaBank

Anne Reinhold, chief analyst, regulatory affairs and rating, Nykredit

Vishal Savadia, capital issuance and structuring, Lloyds Banking Group

Georgina Aspden, executive director, global fixed income and currency investment management division, Goldman Sachs Asset Management

Norbert Dörr, managing director, group treasury, Commerzbank

Khalid Krim, head of capital solutions EMEA, Morgan Stanley

Alex Menounos, head of European IG debt syndicate, Morgan Stanley

Rogier Everwijn, director, long term funding, Rabobank

Stephen Roith, partner, Sidley Austin

Will Caiger-Smith, moderator, EuroWeek

EUROWEEK:  Let’s start off with a question around regulation. There are many moving parts — the CRR, CRD IV and the CMD. What’s still missing, and what are the most important issues that need to be resolved, from a bank capital point of view? 

Anne Reinhold, Nykredit: When we are discussing the possibility of issuing capital additional to tier one, we find it difficult at the moment because, with the draft EBA guidelines, writedown is a possibility, but not a very favourable one. Since we are mutual, having a conversion to ordinary shares is not possible for us. So additional tier one is a difficult issue. We want to have a very strong capital position, so we want to be able to issue different kinds of instruments, but especially core tier one. We hope eventually to have some form of core tier one instrument, like Rabobank’s. That will allow us to issue AT1, which can be converted into this kind of instrument. 

Otherwise your only option is temporary, rather than permanent, writedown. Temporary writedown is not very beneficial for us. So what we need is a good tier one instrument, and we are trying to work around that by having a CT1 instrument instead, and then afterwards it will be easier for us to also issue tier one capital. 

At the same time, we are also interested in boosting our capital base through increased earnings. Since we have quite low prices in our markets, that’s also a possibility. 

Khalid Krim, Morgan Stanley: What Anne has been describing is exactly what a number of issuers and also investors are waiting for, which is regulatory clarity. It took us some time to get clarity in Europe and to get implementation of Basel III. We are getting there. So we have pillar one — the definition of capital that the European Commission and the Parliament adopted, with CRR I. On the liquidity side there is some fine-tuning to be done. A couple of points are missing, which are technical standards on tier one capital, but they will be published very soon. 

And we are missing some clarity on how regulators will look at capital across Europe. We need more guidance from regulators on that. But on the structure, I think we’re getting there, and we will have a European version of Basel III, whether it’s harmonised or not. Hopefully it will be harmonised and we’ll have the same instruments, the same definition of capital instructions across Europe.

The question that people will have is how Europe compares with banks in the US and in Asia, and I think that’s step two. Over the last 18 months, there has probably been some concern and frustration on the issuer side, on the intermediary side, on the investor side, about the lack of clarity. That is behind us, and we are moving to a stage where this new regulation is forthcoming on January 1, 2014. Then we will have clarity.

Rogier Everwijn, Rabobank: Clarity is there, that’s true, but what we are missing is an agreement between all the European countries, and maybe also a global view. In Europe, the national finishes are really important. Some of the non-euro countries are looking at other possibilities, like here in the UK where you have primary loss absorbing capital, while other countries are not using it. And then in the crisis management directive, there is even more national discretion around these national finishes. We need harmonisation in Europe and maybe on a global basis.

Norbert Dörr, Commerzbank: I believe we are entering an important second phase. The first phase was the CRR and CRD IV. This is now being approved by the parliament, while there are still technical aspects to be finalised around gold-plating, common equity tier one, G-Sifis and D-Sifis. Attention now turns to things like bail-in, and that will really drive the focus on total capital. Other aspects of that debate, like depositor preference, will drive the focus on senior unsecured, which sits above tier two. All of regulators’ initiatives, like the asset quality review, or the delayed EBA stress tests, will play an important role in sorting out that area. That is the focus now.

Vishal Savadia, Lloyds: I agree. But what I’m slightly cautious about is that, while we’re taking a big stride forward, there’s still a lot more to be done, be that around technical standards and getting full clarity around treatment of some instruments across different jurisdictions, or work around bail-in. 

The key point is around national implementation, or the transposition of this new regulation into a framework for open issues. That affects everyone around the table, for example on issues like tax. That will ultimately drive issuers’ appetite to access these markets. We have made massive strides forward, but there is more work to be done before issuers have the full picture around regulation and treatment of capital instruments.

Reinhold, Nykredit: Even though we are approaching clarity on capital, liquidity and how the LCR will be implemented is still a big issue for us. There are some very important issues coming up in the next couple of years where the EBA will play a very important role, and they have lots of technical standards to implement. 

Stephen Roith, Sidley Austin: I think there are possibly 50 separate sets of technical standards required from the EBA in connection with CRR and CRD IV.

Juan Cebrián Torallas, CaixaBank: I heard that, from now until the end of the year, there are 153, adding up the guidelines and technical standards. We now have a single rulebook, but if you read it thoroughly, you find out there are little details which could lead to big differences in the way you apply it. That’s why discretion is critical, and how the EBA supervises that process is very important. 

The other critical thing is the resolution regime and bail-in, particularly how it’s going to be applied in different countries. That will define the risks on different capital instruments or even senior debt. So what is the optimal capital structure for a bank? 

Krim, Morgan Stanley: We are talking about a two-phase transition process. But people are now trying to navigate within banking union, and I think this means that different sets of rules should be harmonised by the EBA, with one rule-making authority. 

During this push for harmonisation, we need to continue to issue, and regulators will continue to give us time to manage that. We also need to proofread for the future of regulation, to see as much as we can of what is coming. But the EBA has a huge task in terms of putting together a harmonised framework at a time when we have issuers across the EU with different issues, different priorities, and investors trying to understand what it means for them when they buy a piece of paper. They are not buying that piece of paper for one or two years — they are buying it for at least five or 10 years, or even a perpetual basis. They want to know what will happen to the securities on an ongoing basis. 

Dörr, Commerzbank: What worries me is that while we are seeking transparency and clarity, the number of different structures and the variety of trigger points in recent issues were all done for very idiosyncratic reasons and they create less transparency. It worries me, because in the next downturn, these instruments could react dramatically in different market environments.

EUROWEEK:  On that note, is there a danger that you get a very confusing market, with lots of banks issuing different structures with multiple objectives — say ratings agency credit or EBA stress test credit? Could we end up with a capital arms race, where everyone’s trying to do everything at once?

James Macdonald, Bluebay Asset Management: That actually offers us great opportunities to find value. But it’s key to understand the transition phase that we’re in now and the rationale for different structures. Investors are just starting to understand how point of non-viability and bail-in are going to interact with different parts of the capital structure but we’re a long way away from real clarity on precisely how these instruments will work in practice across jurisdictions. We may not really get clarity until there’s another crisis and we see how the different instruments react, and how regulators react to the situations they find themselves in. 

Georgina Aspden, Goldman Sachs Asset Management: From the investor point of view, it’s still not clear to me who’s really driving the idiosyncratic issuance we’ve seen to date. But if you’re thinking about the future and what you’re trying to create, which is a market, you’ve got to think about what you want that market to look like and who you want to invest in it. Because currently, the securities we have and the opportunities they provide mean that maybe you’re not getting the bulk of investors that you really want — precisely because the structures are so idiosyncratic. 

Krim, Morgan Stanley: I think that is high on the regulators’ agendas. When we interact with regulators, they ask us questions — who are the buyers, compared with the previous generation of bank capital securities? And how do we move on from legacy sub debt in a way that allows the investors of yesterday to be there in tomorrow’s market? 

Alex Menounos, Morgan Stanley: I think there’s a natural evolution to the process. Some regulators and issuers are perhaps a little bit more forthcoming with new structures, and some instruments were designed with legacy rules in mind. We expect this to evolve over time but ultimately to result in a core structure and amount of supply in the product, because regulators, issuers and investors alike would like to see a deep and liquid market, with multiple issuers from multiple jurisdictions, of varying quality. 

My biggest concern is around national finishes and gold plating. Ultimately we may end up with a large variance between what is acceptable in one country versus another in terms of basic structure, like for example where you set the contractual trigger. Investors are becoming quite technical in their analysis of triggers — but still, is a bank that is able to issue with a low trigger going to have an advantage over another bank that cannot issue with a low trigger, even if they have a comparable buffer to trigger? Despite the CRD IV blueprint for AT1, we may not end up with something uniform across Europe.

EUROWEEK:  Let’s talk about total capital. Norbert, does Commerzbank have a specific target for total capital? 

Dörr, Commerzbank: It’s very difficult to come up with a target number for total capital at this moment in time. I expect that, depending on the jurisdiction and the approach of the regulator on recovery or resolution, each individual institution will require a different target in terms of total capital ratio. It is not one size fits all. Investors can’t price a senior bond based only on a rating any longer. They need to look at the individual bank and the environment in which it operates, and consider the regulator’s approach. So yes, there will be at least a minimum level of total capital. You can say you want to be about 4% higher than common equity tier one. But that might not be the end of the story. 

For the CRR and CRD IV, for common equity tier one, we want to be well above 9% on a fully phased-in basis. I expect we will have 3% or 4% in other forms of capital.

Everwijn, Rabobank: We always have been targeting a total tier one ratio, but with the incoming bail-in regime, we also think it is important to provide investors more comfort, to mitigate risk, at the lowest possible price.

So, the focus is on tier two going forward as well. Our core tier one ratio will be 14%, and our total tier one ratio will be 17.5%. And then our total capital ratio is floating. It partly depends on what the competition is doing. But we want to operate at a minimum total capital ratio of 20%. 

Cebrián, Caixabank: I agree that there is no magic number. There are a lot of things to consider — your funding structure, your depositor base, your senior debt, your risks. You have to plug it all into the formula to work out the optimal capital structure. We’re planning to run above 10% on common equity tier one. Obviously, the phasing-in period is going to affect this number, and we’ll see it differently in different jurisdictions. And obviously with the three, four, or five extra percent of tier one, additional tier one and tier two instruments, it should be a minimum total capital target of 14% or 15%. And depending on your pillar two issues, or your different aspects of risk, you could always run with higher levels. 

But we have to transfer from the old style to the new style at the same time, and we need a market that can support this level of polarity. So even though these are rough numbers that we have in mind, the targets are not yet set in stone until we move towards the new framework and things start to stabilise.

Aspden, GSAM: Can I just ask, in relation to all your answers, are you answering with respect to total capital as a proportion of risk weighted assets?

Cebrián, CaixaBank: Yes.

Aspden, GSAM: Do you think that’s the best way to measure total capital?

Cebrián, CaixaBank: No. But it’s a reasonable metric that we’re all using. From the beginning, I said there was no magic number. Obviously, you just have to look at your risk-weighted assets and come up with a percentage. That is easy to transmit, but you also have to take into account your total assets, and other risks that might be arising from other businesses, which are not clearly reflected in your risk-weighted assets. In terms of funding, you need to consider how many depositors you have, and how well they have to be covered. The regulator, whether your national one or even the ECB, is going to be very aware of that — how much senior debt you have and how much pressure you have on senior debt spreads — because the capital you hold as a cushion for senior debt could eventually not be enough to prevent it from being hit in a resolution scenario. So it’s a lot more complex. But we look at RWAs because it what’s we’re used to. To offer an analogy, you’re either used to measuring in Celsius or Fahrenheit. 

EUROWEEK:  Let’s carry on with that debate shortly. I’m just going to give Vishal and Anne a chance to explain their positions on capital.

Savadia, Lloyds: Our position is slightly different by virtue of the Independent Commission on Banking proposals. As a large UK retail bank we have a target core tier one ratio, but through the ICB framework it could be 10% or possibly slightly higher, and we have a transition timeline to get there.

Then we also have a total capital requirement, which we see as potentially part of what the ICB calls the Primary Loss Absorbing Capital (Plac) requirement. That suggests holding 17% in loss absorbing capital instruments, so we’re running that alongside a total capital ratio at the moment. 

But when you incorporate items like bail-in, are you looking at total capital, are you looking at subordinated debt, or bail-in-able liabilities? And what is the scope of those bail-inable liabilities? You’ve got to work through all of that, but our position is that it doesn’t matter what measure you look at — it is simply that the broader the bail-inable scope, the better for the market. 

Reinhold, Nykredit: We always have had a very high core tier one capital ratio and of course we want to continue being very well capitalised. We already had a high voluntary buffer, but now that’s being replaced by the buffers in the CRR and also the proposed Danish national finish, which adds 2%. They also had the idea of having an extra crisis management buffer, but we can discuss that later. All in all, we would like to have at least 15.5% core tier one capital and around 19% total capital. That is also partly due to our structure.

Krim, Morgan Stanley: It’s interesting that total capital was less a focus both for issuers and investors before the crisis, and I think it’s only becoming a focus because of bail-in. It comes down to the loss of sovereignty that we will see in the European banking sector. 

Once we have full clarity on bail-in, the next step is for the fixed income market to tell us about the direction for total capital, and what they expect from banks — because they will have to look at banks versus one another. We are currently probably above 18%, and we need to adjust the number based on what competitors are doing. So there will need to be a benchmarking exercise, where you face the other layer of the market, which is not the capital itself but the people that provide you with liquidity and that worry about bail-in risk and loss absorbing capacity. 

Menounos, Morgan Stanley: Can I ask a question for Georgina or James? What do these very different targets for CET1 and total capital mean for you, can you make sense of it? Is there an easy way of benchmarking one jurisdiction against another? Does it throw up investment opportunities, like you were saying James?

Macdonald, Bluebay: I think we’re definitely just still in a state of flux with regards to how you can view it, because you don’t know how regulators are treating different parts of the capital structure. A lot of investors are not just buyers of bank capital, but also buyers of senior debt, which is a liquidity instrument. And investors who are buying senior debt don’t expect to be the capital providers. They don’t expect to be taking losses, especially for banks that are going concerns. To get a better sort of benchmark across jurisdictions is still really difficult, until we get more certainty on how the capital stacks will look in different countries, and how different regulators are going to treat them.

Aspden, GSAM: I agree. I think the point James makes about being in flux is related to the transition stage and not only determining what kind of instruments banks issue, but also what investors want or need. We look across the capital structure, including senior unsecured and covered bonds, so what we get concerned about depends on what part of that structure we are looking at. But ultimately this is still in transition and as a result, bail-in will be taken more into account in some jurisdictions where there’s clearly a high risk of losses. 

Banks in those regions will also obviously seek higher capitalisation levels at the moment because of the conservatism of the community. The only thing I would add, though, is that as an investor we are not just looking at target percentage figures. We are stress testing banks’ balance sheets in all the ways you describe, and we’re looking at nominal amounts of capital to work out where we think the different types of capital should be applied for senior relative to the potential offer.

Menounos, Morgan Stanley: Can I ask one more question in case we move off bail-in? Increasingly, investors looking at senior unsecured debt are focusing on the risks of bail-in, one being encumbrance, two being depositor preference, and three being the amount of capital that can absorb losses. Is there one of those three that concerns you more than others? Is there a difference across jurisdictions?

Macdonald, Bluebay: I think it varies by jurisdiction. It can vary across the board but at the end of the day you need to believe in the bank’s business model and understand its capacity to absorb losses so I would say those are the most important factors. The way we invest now we’d expect that most national regulators would enact depositor preference. Questions may arise still around uninsured deposits but we certainly wouldn’t be counting on them being parri passu with unsecured debt within our analysis for the time being.

Krim, Morgan Stanley: What we’re hearing from Brussels is that we are moving towards depositor preference, which will probably be part of the European version of bail-in. What is interesting is that in Europe it took us some time to get used to the idea of bail-in and whether it was positive or negative. How many people think bail-in is a good thing? Or do you think that bail-in is going to create more issues than it solves? 

The reason I am asking is because if I look back at the initial proposal from 2011, when the European Commission was testing the water, it took a number of months to confirm that bail-in would feature in the CMD. A number of times we discussed with issuers and investors what was the alternative to bail-in. And the answer was always that it’s either liquidation or bail-out. Bail-out is no longer on the table, so that leaves us with liquidation. If we were to have, as part of the framework, a tool that guarantees more stability and something that is equivalent to liquidation but done in a different way, is that really that bad?

Dörr, Commerzbank: When this topic came up for the first time we were still in a situation where you had banks that couldn’t go insolvent because they were too big to fail. And you can’t liquidate them either. Bail-in was never a real possibility. But those times are over. People now accept that there needs to be an equivalent to insolvency for banks, and that is bail-in. 

Krim, Morgan Stanley: Well, it’s more that there is a resolution package and bail-in is one of the tools that may be used. 

Dörr, Commerzbank: Of course. I think later we will probably also touch on the aspect of contractual versus statutory loss absorption. And if you put that all together, bail-in can only be part of a bigger framework, which is the equivalent of insolvency for a bank.

Savadia, Lloyds: Bail-in is definitely the direction of travel for regulators. There was a point at which we were trying to achieve too many things at once. We had CRD IV on the table, the CRR, as well as a general ongoing focus on regulation and the notion of bail-in. Bail-in is now very much entrenched.

We’ve touched on what I think are the most important things around bail-in, such as harmonisation of the framework across jurisdictions, just to give everyone a level playing field. I think it’s also important that, as the bail-in framework is introduced, we and the regulators continue to stress the importance of the capital hierarchy. Then investors are made comfortable that this hierarchy will be preserved in a bail-in scenario. Then you can base the amount of bail-inable debt you have on a very clear waterfall of instruments.

Everwijn, Rabobank: And regulators and politicians should refrain from adding everything up together. So we have CRD IV, we have the CRR, and that gives you a new capital requirement. Then you have bail-in on top of that. And what they are now also suggesting is to add an extra layer to protect investors in a bail-in scenario. It is just adding up and adding up, and it will not stop. At some point you have to pause for a moment and ask if banks really are safer than they were in the past.

EUROWEEK:  We seem to have got on to the subject of bail-in so we might as well carry on with that topic. Arguably, there’s a quasi-political risk to investing in banks now, because who will pull the trigger when it comes to bail-in? How close are we to having an EU resolution authority? How do you model for bail-in risk?

Everwijn, Rabobank: A resolution authority in itself isn’t a bigger risk. The risk is who will be the resolution authority and at what point they will be in charge, and what is the interaction with the national central bank or the ECB. Are you forced to have a double reporting line? Is there any communication between the two entities? Or is it that initially you deal with the national central bank, and once you get into trouble the file is handed over to the resolution authority, where there is no proper relationship with the issuer? That is the scariest part of it.

Dörr, Commerzbank: One very important aspect is the boundary between a recovery and a resolution scenario. For me, a recovery is where the regulator calls the shots, asking for more capital within an early intervention. At that point the bank is still a going concern. When you enter into the resolution scenario, in my opinion, some really hard-wired things start to happen, and it’s closer to insolvency. 

The regulator cannot do that — it’s down to the people who usually deal with insolvency in that jurisdiction or an adequate resolution authority. That is the defining connection point of these different aspects of dealing with bank failure. That gives me some confidence that if that process is respected, the capital hierarchy will be respected as well as possible and that there are clearer rules and the current arbitrary feeling around resolution will be mitigated.

Krim, Morgan Stanley: One problem is that in Europe, we’re lacking a track record in resolving banks quickly. They have closed 500 banks in the US. We have closed 10 or 11 in Europe. We are missing expertise in resolution. That’s not a criticism — the philosophy in Europe is different to the US, and we need to learn from that and understand how to resolve banks and give the market confidence things are under control. We will have the tools and the ability to do it quickly, to keep the market stable.

Dörr, Commerzbank: That is true — bail-in is pretty much a non-issue in the US market.

Krim, Morgan Stanley: Correct. We will have it eventually. But they don’t call it bail-in in the US. It’s not something people have focused on, because they know that the FDIC is around the corner and can act quickly if there is an issue with a bank.

Reinhold, Nykredit: One of the reasons they can react quickly is that they already have their recovery and resolution plans. They have had a resolution framework for many years so they very much know where they stand and what to do. That is one of the benefits of the new directive. However, you also have to take into account the differences between banks and their varying business models when it comes to working out these issues. 

Of course you want harmonisation, but at the same time you cannot have one clear overall procedure because we all have very different business models. If you were to look just at deposits, you would say it is very good to have deposits, and banks could stick to that to be safe. But if your business model is to fund all your loans by covered bonds, as we do, it’s not a problem if you don’t have deposits. In fact, it could be an advantage because you don’t have to protect them if you run into problems. So it’s difficult to have a one size fits all approach, because you also have to look into very specific models. That can make it very complicated.

Cebrián, CaixaBank: The question is not actually who is going to take the decision to go into resolution — it’s how the framework is going to be set up for a true banking union within Europe. Legally it could be very complicated. That leads to a lot more uncertainty about our capability to resolve a situation like this even over a weekend. If we can’t sort out the framework of banking union, investors are not going to be so confident on the EU’s ability to run a sound financial system. The question is not so much about who is going to make the call as much as it is around the framework. If we can do it legally, we need to sort out banking union.

EUROWEEK:  There’s one specific legal aspect of the CMD that I want to touch on, which is Article 50 of the CMD. Stephen, maybe you could just outline that for us?

Roith, Sidley Austin: Sure. It remains to be seen whether it will be an obstacle, but it’s certainly an issue at the moment. In the draft CMD we have this provision that is without any historic counterpart, which says that if you are issuing an instrument — not just capital but also senior debt (in fact, any ‘eligible liability’) — that will be governed by the law of a non-EU member state, which in practice is most likely to be New York, then you have to essentially incorporate the future bail-in regime into the contractual terms of the instrument by having a specific contractual term that you wouldn’t otherwise have. 

Without Article 50, you would probably disclose the outline of the future bail-in regime through the risk factors, rather than through the contractual terms. But in this situation, if the security is to be governed by New York law, or Japanese law, or Swiss law, then under the current draft of the CMD an additional term would have to be included. 

Dörr, Commerzbank: I want to comment on that, and I also have a question. Situation A is you have a European entity issuing out of the European entity but through a programme that is under US law. Situation B is that you have a US subsidiary of a European bank that is issuing locally. 

In my opinion, under situation A, this entity is clearly regulated by the European regulator, which is different to situation B, where the host regulator also enters the game. In all of the instances we have seen so far, with European issuers issuing under European law, you have risk factor language pointing to the bail-in regime. But we also have a blueprint, which is the US tier two bond issued by Deutsche Bank. That deal was registered by the SEC, and Deutsche also took the risk factor approach.

Krim, Morgan Stanley: I think what we’re touching upon here is exactly what the EU will face when dealing with cross-border issues. Not just cross-border issues within groups, but also cross-border offerings by European banks, when they issue abroad.

We need New York law to access the market in SEC-registered format, and that is unlikely to change. Some adjustments are probably required to make sure that European banks are not penalised when they go to US investors and present accounts with a security that carries an identical risk to the one they are selling in the European market. It’s a disclosure promise — making sure that we are explicitly telling investors around the world that when we raise capital, the bail-in risk is governed by the issuer’s jurisdiction.

Norbert alluded to that being used by Deutsche Bank recently in its tier two deal, and also by Barclays in their Coco transaction. You should always be aware that if there is a bail-in or resolution scenario, the entity that deals with that is the FSA for Barclays and the German regulator for Deutsche Bank.

Once we’ve established that, attaching a cost or premium to it is debatable. It isn’t a contractual point. It’s an area where you’re taking more risk, but it’s just putting you on a level playing field with European investors. We want to make sure European regulators are comfortable with foreign issuance, and that’s something which in the last couple of months has actually become quite blurry. We should try to keep it simple if we can. 

A question for the investors: does this make you nervous? Does it make you demand a premium when you’re looking at tier one and tier two?

Aspden, GSAM: There’s one answer, which is the theoretical and logical one, which is, yes, we would require some sort of additional premium for it. Because this is all untested, so you want as much protection as possible, and if it’s written in contractually, you have less protection than if it was in the risk factors. Until that’s tested we have no proof one way or the other, so we should get compensated for that to an extent.

However, because it’s untested, I do have sympathy with the issuer’s point of view that ‘when push comes to shove’ the logical conclusion is that the home regulator is the ultimate one to decide, and issuing your capital through a foreign entity shouldn’t change that.

But during this uncertain time, while we’re in a state of flux, we need as much protection as we can get, and that’s understandable, considering what investors have experienced over the last few years.

Roith, Sidley Austin: I think there are going to be a lot of variations. But just look at this year’s issue from Barclays. They went all the way. That instrument is governed by New York law, but in the documents, there is a note saying the PRA has requested them to include a contractual term regarding the UK authority’s bail-in power. 

That probably has the effect of accelerating or pre-implementing the inception of the bail-in regime. ‘UK bail-in power’ is very broadly defined for this purpose and, of course, the UK authorities already have broad and expanding powers under the UK Banking Act 2009 so, hypothetically, by virtue of this specific term, the exercise of those powers would arguably be recognised as a matter of New York law for the purposes of this Barclays issue even if the CRD were never passed and implemented.

Krim, Morgan Stanley: For me, it’s nothing more than explicitly saying the FSA has authority. It doesn’t accelerate or pre-implement bail-in in the UK. If there is an issue, and a problem with Barclays as an entity, then the bail-in powers used would be the ones that exist with the UK FSA, and not any US institution. Even if the deals are contracted with New York law, the UK FSA is still competent.

Savadia, Lloyds: I completely agree. It is a disclosure point. It is to be transparent, and specify how you expect these instruments to work in a bail-in scenario. I take some comfort that investors appreciate that there should not be a distinction between instruments with contractual or statutory point of non-viability features. They should be treated in exactly the same way. 

We get ourselves into tangles if we expect instruments to be treated differently, even in a single jurisdiction, because one has a contractual non-viability clause and one is caught under statutory framework. 

That is not the intention of the regulation. We are caught in this window where it is not entirely clear, or has not been entirely clear, how that legislative framework needs to be applied, and so we’ve seen a host of different instruments transpire. But I think the ultimate goal is to simplify the capital structure and make sure these instruments are treated equally. 

Roith, Sidley Austin: It’s also not clear from when the bail-in regime may first be applied. The ECON committee of the European Parliament has asked for the bail-in regime to be in force no later than January 2016, whereas the original Commission proposal specified no later than January 2018. That’s quite a big difference. But if it were to be 2016, we will still have this interim situation. 

On the other hand, the regime is slowly taking shape. The issues about depositor preference and preference of deposit protection schemes are slowly being resolved. Some regulators, like in the UK and Spain, are at the forefront of wanting the shape of the regime to be foreshadowed clearly in disclosure documents now, whereas I understand the Italian regulator is taking a completely different view. But if it is to come into force in 2016, the interim period will obviously be a lot shorter which should help to bring about greater consistency of approach more quickly. 

Dörr, Commerzbank: Yes, but what if right now you have a big bank, and they start to issue, and the regulator asks for contractual clause, because he says the whole framework is not yet in shape and he wants something now. Firstly, such an issue won’t provide enough capital in a resolution scenario, unless you have it applying to the whole stack of instruments, and secondly, investors may ask for a higher premium because of the contractual clause. 

Once the framework is in place, that investor is definitely worse off, because he’s first in line. And then there is the statutory bail-in framework. So when we’re talking about the terms of a deal, in my opinion the best option is to wait for a statutory scenario, and include that in the risk factors. In Germany, our lawyers say you can’t really do more than that. 

Roith, Sidley Austin: That’s not what happens here in the UK.

Savadia, Lloyds: Is it not the case that both in the CMD and also in the CRR you are not required to insert a contractual non-viability clause if there is a cross-border agreement between regulatory authorities around how the resolution framework may be applied? So you can override the need for a contractual clause if there a regulatory agreement in place. 

I think what we’re saying is we hope that there’s a point at which there is a cross-border agreement in place between regulatory authorities, but we don’t want to be caught in the interim and be unable to issue. That’s why issuers are being pushed to put in additional contractual features to access, for example, the SEC market. 

Roith, Sidley Austin: I’m sure you’re right. The regulators wouldn’t want or expect there to be a significant pricing difference, but I think the broad regime will presumably come to pass within the EU. Article 50 is specifically about whether that regime would ultimately be respected in the US by the FDIC and the US courts.

EUROWEEK:  Can I get a sense from people around the table about the different capital instruments that we’re looking at under CRD IV? What instruments are you going to focus on, and why?

Everwijn, Rabobank: We have a clear strategy to issue tier two, old-style tier two in terms of the language. That’s purely because our core and total tier one ratios are already high enough, and because of the bail-in regime we want to add an extra layer of protection for senior debtholders.

Dörr, Commerzbank: We’re similar. We’re focusing on common equity tier one. We want to fulfil the regulatory requirements, which includes tier one, and then we will focus on tier two. Keep it simple.

Cocos, for us, are a non-issue as long as there is not any regulatory benefit for it, and to be honest, I only see them working in very specific situations. It will be very interesting to see what happens when the first Coco is triggered. 

Reinhold, Nykredit: We have a difficult situation, because our authorities have put forward proposals for the Danish finish. That complicates things because they are suggesting an additional buffer. So right now we are finding it difficult to issue. But our focus is also on tier one. We also want to strengthen that through increased earnings.

Cebrián, CaixaBank: In this new environment everyone’s started building up a more robust common equity base, and the commitment is to fill up with more capital. In that sense additional tier one could be our initial focus, because it allows you to boost common equity tier one during the phasing-in period. But that will be an individual decision and it might not be the case for everyone.

As for Cocos, I guess there’s one issue with the ECB taking over supervision from next year.

We don’t know how they are going to focus on pillar two, and what their requirements would be on that front.

We’ll end up with more homogeneous types of Cocos, as we’re going to have a lot of large banks under the same supervisor.

Savadia, Lloyds: Like everyone around the table, we are focusing on organic build-out of our core capital and our CEO has clearly stated a fully loaded core tier one target for both 2013 and 2014.

In terms of contingent instruments, we’ve all pointed to the additional work that needs to be done, and clearly the specifics will drive whether that contingent instrument is in AT1 format, which is clearly defined under that regulatory framework. But in the near term it’s about getting up to speed: building up core capital, getting through the regulations and understanding what the instruments will need to look on the additional tier one side. 

Krim, Morgan Stanley: There’s a semantic point here that we need to address. We talk about Cocos a lot, and we talk about AT1, but Cocos are specific to some countries. Switzerland, for example. We’ve had a focus on Cocos in the UK, because the PRA is giving clear direction to UK banks about their utility value on the regulatory side, but I think if we export it into CRD IV and CRR I, that makes it gone concern capital that is tier two capital, and there is no capital ratio-based trigger. 

The only alternative left is additional tier one, and that’s where we will have a Coco feature, or a capital ratio based trigger. Then when we extend it, additional tier one can be in conversion format or in a writedown and write-up format. 

For the conversion format you have to consider national law, because it affects how quickly you can get approvals in place for share issuance, whether you can dilute shareholders, and generally, how quickly you can execute tier one with a conversion feature. We’ve seen it from the Swiss, so we’ve had a precedent there. What we’ve seen recently, at corporates and banks, is them building in the option and the ability to issue convertible AT1 and Cocos if there is a need to. 

In the UK, for instance, we’ve seen Lloyds, Royal Bank of Scotland and Barclays going to shareholders to make sure they are equipped to issue convertible structures. It doesn’t mean that they will issue a tier one convertible, or a tier two convertible, but at least they have the capacity. AT1 is what European banks would be looking at, in terms of going concern capital, rather than Cocos. 

EUROWEEK:  So how do you go about choosing which structure you use in additional tier one? Is it going to be a function of timing? Is it going to be pricing? Or is it going to be a matter of satisfying your investors? What are your priorities?

Everwijn, Rabobank: In the absence of shareholders, conversion into shares is not a possibility. So for us the option is quite simple. It will either be permanent or temporary writedown, so we have to wait for the final technical standards to be released by the EBA. But you have to work out how high the coupon should be versus the return on equity the company is making. The higher the coupon, and the lower the return on equity, the longer it will take to be written back up. The preference will be for temporary writedown. But they will take a very long time to recover before being written back up, so there’s still the possibility of losing some principal.

Cebrián, CaixaBank: I would like to hear about investor’s preferences. The level of discretion the issue has over temporary writedown actually means it could be very, very similar to permanent writedown. Conversion seems to be the cleanest option, and the most likely. But it has a lot to do with how the current shareholders feel. Some might take a position, and say they refuse to be diluted. It’s not just about the process of conversion or the process of writedown, but also about the management and the sort of reactions you will get well before the trigger is being pulled. You will always try to avoid hitting the trigger. 

So from our point of view, it will have to be a cost-benefit analysis. But I guess the preference, and the best price, will be for equity conversion, rather than permanent or even temporary writedown.

Macdonald, Bluebay: I guess the first thing that I would mention is that whether you’re looking at equity conversion or permanent writedown, there’s probably still a question in my mind of whether you ever get to the 5.125% trigger or whether you hit point of non-viability before that.

That being said, I think between the three structures we would definitely have a preference for equity conversion. That’s the best way to respect the hierarchy of subordination.

The way writedown and write-up are structured right now doesn’t really do that and permanent writedown has the least respect for the hierarchy of subordination, effectively subordinating credit investors to the equity investors, which is not reflective of how a fixed income investment should work.

Dörr, Commerzbank: Are you more nervous about the issuer breaching the trigger, or about the issuer deferring your coupon?

Macdonald, Bluebay: I’d be a lot more nervous about coupon deferral.

Dörr, Commerzbank: That’s what I would have expected.

Reinhold, Nykredit: But you already get coupon deferral when you hit one of the buffers, don’t you?

Dörr, Commerzbank: Well, technically, CRD IV says that if you are within the combined capital buffers within the different quarters you can pay a dividend or AT1 coupons. In practice, I expect that as soon as you hit the 7% buffer, or whatever the top buffer level is, you don’t pay. You will want to get out of that buffer as soon as possible. 

That’s the easiest way the management of the bank can treat all investors equally. We don’t have dividend stoppers or dividend pushers, so you either are in a position to pay everyone, or you don’t pay anyone.

Reinhold, Nykredit: Yes, that’s where the regulators will also probably have a say. I’m not sure that issuers will be making that decision for themselves. 

Menounos, Morgan Stanley: When it comes to investors evaluating loss-absorption mechanisms, is there a technical consideration around how mandates are structured, whether you are able to take equity conversion, for example? Is there also a theoretical evaluation of some of the structural features, like for example structural subordination? Have mandates evolved far enough for you to be equally capable of buying a conversion and a write-off structure, leaving the decision down to valuation?

Macdonald, Bluebay: Our mandates vary across the board. For the majority of the money we manage, we can invest in either. I think that’s a really important point that you raise though. What’s really important is that managers are investing their clients’ money in the way that their clients expect it to be invested. Even if some investments are technically allowed within the mandate, managers should only be investing within the spirit of what they’re supposed to be doing. 

If we take our investment grade credit mandates and consider an instrument that we would see as subordinated to equity as an example, even if the mandate says we can buy that instrument, it wouldn’t be within the spirit of what we’re supposed to be doing for our clients and so its difficult how to see how we could justify investing in it.

Any managers that focus purely on what they can or can’t do within the wording of the mandate, rather than what they should be doing are not doing a just job for their clients.  

Aspden, GSAM: I would agree. From a theoretical point of view we have the ability to invest in all types of structures, but the reality is that our mandate is to get a good return on a risk-adjusted basis. If that risk is too high, it’s not good value for clients, especially when their mandates are quite specific sometimes about what you can and can’t invest in. Not only with things like equity conversions, but also ratings, and whether these things are investment grade, which then begs the question of to what extent are these instruments actually investment grade assets.

Krim, Morgan Stanley: How important is rating? Banks are starting to focus on supporting their rating with capital. 

Also, we’ve seen a lot of liability management activity, with everyone around the table having different experiences about how they have handled liability it. Until now that has been about generating core tier one. How do the issuers see liability management as means of generating total capital? 

Dörr, Commerzbank: Having been quite active in liability management, because of generating core tier one, I don’t think there will be any liability management on tier two, because that is taken care of by the statutory bail-in regime.

With many of the grandfathered additional tier one instruments, when they lose AT1 recognition, they’re simply tier two. Many of them are perpetual tier two, I think, so you just have to look at the economics to work out whether it’s worth doing a liability management exercise. 

It really depends on the situation, but what I mean is that the grandfathering rules of CRD IV give you a lot of options. 

Krim, Morgan Stanley: Doing an exchange from old to new tier one is what remains to be tested. But we still don’t know whether investors will be comfortable flipping from the existing tier one. It will be grandfathered. Some of those deals already have writedown features, and some of them already have non-cumulative coupons, but in the UK, for instance, we didn’t have any write down or write up deals. 

So to go from current UK tier one to CRD IV-compliant tier one is a big step, compared to the hybrid tier one paper that we’ve seen issued around Europe, like in Italy and France.

Cebrián, CaixaBank: I totally agree with Norbert. I think the picture’s going to change, because of the sovereign support aspect that used to affect ratings. Your level of capital is defined by a far more complex equation than the one that is used to calculate your S&P risk-adjusted capital (RAC). But we can’t complain about that — the only thing we can do is show a larger RAC.

Savadia, Lloyds: Liability management has proved to provide one effective way issuers can optimise capital structure, and it can work both for issuers and investors. I agree that the rationale for such exercises may well be different now than they have been previously, but we’ve seen that liability management does provide an effective solution for specific needs, and it can be structured in a way that works for the relevant stakeholders.

As for rating, we need transparency from the rating agencies, as methodologies have changed. This must have affected their relevance from an investor standpoint. I suspect investors are doing a lot more of their own work now, and will additionally assign securities with internal ratings. 

However, I suspect mandate restrictions around the ratings will continue, so it’s really for investors to determine how important ratings are when determining their investment criteria. 

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