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Emerging Markets

Cocos pose bank capital a trillion dollar question

An increasingly diverse and liquid asset class in instruments across the capital structure is taking shape. But there are plenty of unresolved questions facing investors in instruments such as Cocos and additional tier 1 (AT1). To discuss how they are meeting these challenges, a number of investors and several issuers gathered to compare notes at the Morgan Stanley Bank Capital Investor Roundtable in late May.

Participants in the roundtable were:

Georgina Aspden, executive director, global fixed income and currency, Goldman Sachs Asset Management (GSAM)

Dierk Brandenburg, senior credit analyst, fixed income, Fidelity Worlwide Investments

Vincent Cooper, BlueMountain Capital Partners

Dr Norbert Dörr, managing director, group treasury, head of capital management and planning, Commerzbank

Bruno Duarte, analyst, Claren Road Asset Management

Rogier Everwijn, managing director, head of capital issuance and structuring, Rabobank

Andrew Fraser, investment director, Standard Life Investments

Khalid Krim, head of capital solutions EMEA, Morgan Stanley

James Macdonald, credit analyst, BlueBay Asset Management

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

Simon Morgan, Moore Europe Capital Management

Phil Moore, moderator, EuroWeek

EUROWEEK: It has been estimated that by 2018 the market for Cocos and AT1 will be worth $1tr. Is this realistic?

Alex Menounos, Morgan Stanley: The $1tr number sounds too high, but it is clear that this has to be much more than just a niche market. A couple of years back, we saw the emergence of Coco and Basel III opportunity funds. But if the market is to grow to anything like what 1.5% of bank RWA suggests, it’s going to have to be a mainstream product for flagship funds — not just a niche investment. 

It’s likely to be a product with multiple types of investors, ranging from real money to hedge funds and high yield or distressed debt investors. In order for this to happen, a few technical issues need to be addressed, one of which is the need for mandates to be sufficiently flexible to accommodate new structural features, including conversion to equity.

There is also a ratings issue. Given that a large amount of Cocos and AT1s will be sub-investment grade, some funds may not be able to adapt. High yield and distressed funds may step in and make up the difference. 

Then there is the question of index eligibility, which is obviously not an issue for all investors around the table. Even for those where it is a factor, most investors are able to make significant off-index investments. 

From a fundamental perspective, there are other challenges that need to be addressed. Investibility for one, given there are still structural features that some investors have not got comfortable with, like subordination to equity.

Finally, there needs to be a common basis from which to approach relative value and pricing. The market will find a way of comparing instruments across different jurisdictions, looking at the size of the buffer to trigger and the capital flexibility of the issuer, as well as the specifics of the structure. 

EUROWEEK: How do mainstream investors address the technical challenges arising from mandates, for example, that Alex mentioned?

Andrew Fraser, Standard Life: With difficulty. Most of these instruments are non-benchmark dollar issues, while most of our funds are either euro or sterling denominated. So as Alex said, for us most of them are off-index positions. 

That is also true of our high yield funds, which are ex-financials, so when our high yield fund managers are looking at these instruments they are competing with other high yield instruments. We like the asset class as a concept, but our ability to invest is relatively limited.

Because these are new instruments, their loss-absorbing characteristics need to be explained to our clients, some of whom don’t want to take the risk of having these in their portfolio. So a number of mandates will exclude them completely.

Dierk Brandenburg, Fidelity: For long-only managers the index question is always going to be an issue, particularly with regard to secondary market liquidity. 

Andrew mentioned that a lot of these issues are dollar-denominated, so we have to ask how yield-driven the current investor base is, and how their appetite may change in an environment of rising dollar rates. 

Broadly speaking, we have now reached a point where CRD IV is coming in, and a lot of headline regulatory initiatives are coming to an end. So we are moving towards regulatory consensus, which may include a number of features that neither investors, nor banks, nor even regulators themselves like. But the key challenge is to make it work, and to price instruments correctly. 

Our view is that contractual contingent capital bonds are particularly cheap at the moment. They are being issued at big premiums, and given that we are headed for more stringent bail-in regimes anyway, I would question how much cheaper traditional instruments are. So overall we see it as an attractive asset class. 

Simon Morgan, Moore: Firstly, my comments throughout this forum reflect my own personal views.

It’s a question of creating value across structures. I believe you have to return to basics, which means doing your credit work, knowing the issuer and understanding the buffer to the trigger. After that, the various write-down mechanisms work in different ways for different investors. They work for some mandates and not for others. 

Over time I think that the market will evolve and converge towards a core set of structures across euros and dollars, and with some sterling issuance. That will make it a lot easier to invest in. 

I’ve seen some research pieces that look at valuation based on a breakdown of the sum of the parts — host pricing, subordination risk, distance to buffer, conversion optionality, and so on. I’m not sure how helpful that is, because it’s very difficult to ascribe a point estimate of value for any of these factors and, from a hedging perspective, it’s not possible to monetise many of these options. It’s all theoretical — which takes me back to the notion of employing fundamental credit work and not being distracted by structural tweaks whose real purpose is to navigate through mandate limitations and expand the buyer base.

This is clearly a nascent market. If you think back to interest rate swaps, investors tried to quietly extract value by taking advantage of compounding or day-count nuances, because the market wasn’t fully developed, fully standardised or fully understood. I suspect we’re at a similar stage today in the Coco bank capital market. 

I question the $1tr figure you mentioned at the beginning, which seems quite high. I recently saw one piece of sell-side research that said there was $260bn of tier two securities outstanding and $160bn of tier one. If Cocos can develop to a similar scale, and currently there is a question mark over that in my own mind at least, it will clearly become a very meaningful market.

Bruno Duarte, Claren Road: We find the $1tr number a bit sensationalist. When the first ECNs were issued, the consensus was that the market was going to open up and that the majority of the banks were going to issue ECNs. Only last week we had Lloyds and RBS both saying they no longer need to issue ECNs. 

With margins under pressure, the current fundamental operating environment for banks makes it very difficult for the vast majority of them to print these instruments. Besides, some banks don’t even have a full capital structure curve out there. So to think that all of a sudden the floodgates open and we have $1tr of these instruments is perhaps somewhat unrealistic. It may happen in the long term, but for the time being there are perhaps 10 or 12 banks that can print these structures and do so at a level that makes economic sense. The rest of the sector is still in a rehabilitation phase following the financial crisis. 

Alex Menounos, Morgan Stanley: Hopefully we are close to getting clarity on CRD IV. But what does that actually mean, given that we have different jurisdictions across Europe, with different national finishes? Although we expect to get a blueprint for what an additional tier one structure looks like, it’s clear that issuers across different jurisdictions will gravitate towards different structures based on these national finishes.

How as an investor do you then assess the investment opportunity and relative value? How do you compare the instrument, the issuer and the jurisdiction, given the diverging views on bail-in, different trigger levels and minimum capital requirements?

Georgina Aspden, GSAM: As an investor the relative value assessment starts with the credit. When you’ve identified which credits you like, you look for where the best value is within the capital structure. 

At the moment, because the new instruments are so idiosyncratic, and because there isn’t a full capital structure across all issuers, we have to pick and choose where we see best value. That might be in a new structure or an old structure, because I don’t think the old and the new are necessarily fungible just because bail-in is coming in. The reality is that there is a difference between contractual and statutory, and there is a difference between a trigger that you can flip versus a point of non-viability (PONV) that we are all still uncertain about. All these factors will have an impact on pricing.  

James MacDonald, BlueBay: I agree that you have to start with the credit, and beyond that it is more of an art than a science. Given the variety of instruments in the market and the number of moving parts, trying to develop a specific mathematical formula for identifying relative value is next to impossible. 

On the question about mandates, one of the messages we’ve been sending to syndicate desks is not whether these instruments can fit into our mandates, but the degree to which they are appropriate for our clients. A lot of people have pointed out that traditional long-only funds can’t buy equity conversion, but they can buy permanent writedowns. The question that we’d ask is: what makes more sense for your clients? 

Vincent Cooper, BlueMountain: We aren’t in any way restricted as to what we can buy. I care about ratings and indices-eligibility only because of the impact they may have on mainstream investors and on the liquidity and size of the market that is available for these instruments post-issuance. Will there be other buyers out there if we change our view on the credit?

Broadly speaking, we take a barbell approach. We’re open to all types of structure but we prefer to look at secured debt at the higher end of the capital structure, where we can do fundamental, intrinsic assessment of the value of the secured assets we’re buying. And then we’ll look at the higher yielding, higher volatility opportunities offered in the Coco and AT1 space, where you can be better rewarded for taking views on the credit and the fundamentals of that credit. 

Fraser, Standard Life: That will definitely be true as we move into a bail-in world.

To come back to an earlier point, I do believe that existing capital instruments probably are fungible with new ones, because if the bank runs into trouble, you’ve lost money across the capital structure, even as far up as senior. That’s the world we’ll be living in from 2015 onwards. 

EUROWEEK: Are buffers more important than the triggers themselves?

Brandenburg, Fidelity: We all spend an awfully long time calculating buffers, and in CRD IV there will be a lot of intangibles in these buffers, such as goodwill and DTAs. You can’t really buy these securities based on today’s buffer. If you invest in these securities you’re making a call on the future earnings power and diversification of the issuer, because the leverage in the sector as a whole is still so high that it’s very hard to come up with a model that tells me whether or not a 4% or 5% buffer is enough, because that could get wiped out very quickly.

Intangibles can disappear very quickly if there’s a problem. For example, in a crisis it doesn’t take much to cause a $5bn goodwill writedown, which is why I am always wary of goodwill. The same is true of DTAs, because again, in a crisis the first thing you realise is that your DTAs aren’t worth what they used to be. So it’s important to strip them out.

I think this limits the use of these securities to organisations at the larger end which have earnings power and diversification, which can only be delivered by the large cap banks. 

Khalid Krim, Morgan Stanley: So what should the minimum size of the buffer be? Should it be 1%, 2%, 3%?

Aspden, GSAM: You don’t necessarily look at it as a percentage. Yes, you look at how close it is to the trigger, but what is more important is to look at the balance sheet and the risk of burning through the buffer. So you can’t just say it should be 1% across all European banks. The risk of getting to the trigger will vary, depending on whether you’re an investment bank or a small, domestic retail bank. That’s where we add value with the credit work we do.

Duarte, Claren Road: Adding to Dierk’s point, we believe that market sometimes gets carried away with looking at just the capital ratio, taking the RWA for granted. The danger there is that if those RWAs start changing, all of a sudden you could lose 50bp or 100bp, which creates a different ballgame. You can assume a 2% buffer is fine, and then get blindsided by RWAs going up by 10% because the regulator has decided that it wants to be more conservative on risk weights across the whole sector.

Brandenburg, Fidelity: So accounting changes that may come in over the next couple of years could also influence your capital calculations.

EUROWEEK: So from an investor’s perspective, the credit work is much the same as in the senior unsecured market?

Brandenburg, Fidelity: Yes. Except that you’re much more leveraged to the issuer’s earnings power. So recurring earnings power is quite important for these securities. 

Krim, Morgan Stanley: How much and what kind of information do investors expect from issuers in the market? We’ve been hearing a number of investors saying that it’s difficult if they have an instrument with a capital-based trigger — a Coco or an AT1 — to monitor it, unless they are given more details by the issuers themselves on how their ratios are evolving. What information can issuers give you that would make you more comfortable with the risk that is linked to AT1 or Cocos?

Duarte, Claren Road: It comes down to doing your homework and analysing the worst-case scenario. In the case of BBVA, for example, if it decided to sell some stakes in Mexico or in China, would that give a sufficient buffer to move away from the trigger? 

Then you have to look at the issuer’s track record. If management has a great track record and has never done anything untoward, as an investor you can get more comfortable and it becomes a more palatable investment.

Overall, we wonder if we’ll eventually go down the US path where you basically have equity and senior. In-between, you might have some plain vanilla tier twos, because in a point of non-viability (PONV) world, why issue a 10% coupon when 5% serves the same purpose? 

Rogier Everwijn, Rabobank: I can imagine that a tier two investor is looking for more protection than a tier one investor. So having additional tier one layer on the balance sheet can help provide the cushion you’re looking for.

Norbert Dörr, Commerzbank: If you have an instrument that includes specific triggers or features that are relevant to the time of issuance you only get a very specific investor base that is able to price and trade them. It gets even more interesting if you have triggers and features that currently don’t matter but suddenly start to matter in the future. 

As a consequence, I think people need to stand back a bit and try to achieve more standardisation. This would also allow for the development of a broader investor base.

Menounos, Morgan Stanley: Standardisation from the perspective of structure, or in terms of national finishes?

Dörr, Commerzbank: Overall, there needs to be transparency on the capital hierarchy, on when the regulators will intervene in a soft way by asking banks to do something in normal markets or when they will intervene in a recovery scenario. And there should be transparency on the criteria at which they will intervene in a resolution scenario. 

There also needs to be standardisation of the instruments themselves, so that every investor knows that if he buys an instrument from a given bank in a given jurisdiction, he knows how all the regulators and relevant authorities will act. 

Krim, Morgan Stanley: CRD II in Europe, before Basel III, was meant to provide a framework for a harmonised structure, especially for hybrids. Frankly, we ended up with structures that weren’t harmonised across Europe. 

So the challenge for CRD IV and CRR I is to reach a level of standardisation where investors can benchmark and compare structures across the EU.

Fraser, Standard Life: Banking union across Europe should deliver this standardisation, with the EC deciding when a bank is non-viable rather than having the Germans, the French and the Dutch regulators making the decision on an individual basis.

Krim, Morgan Stanley: It is important that banks in different European jurisdictions come to you as investors with comparable instruments and help you to become comfortable with how their various capital securities fit into the capital structure. That would also make it easier to have a discussion about pricing and relative value. 

We haven’t yet seen a harmonisation of structures, because we’re still in a transition phase. 

In talking about the size of the market, we already have a pool of legacy subordinated debt that banks have, during the last decade, sold to investors around the table in tier one and tier two format.

Today, issuers are looking to transition, and to recycle these securities into the next generation of tier one and tier two instruments. 

Cooper, BlueMountain: It’s interesting that all the investors here have talked about the importance of knowing the credit, or being comfortable with the credit quality. But we still spend an enormous amount of time — arguably wasted time — talking about the technicals of bond structures, which ultimately leads to poorer fundamental analysis of credits and poor asset allocation across the whole credit space. So the quicker we can move to a harmonised, homogenous-type product, the better for fundamental credit analysis. 

RWAs and core tier one calculations also need greater clarity. Core tier one as a trigger metric is clearly flawed, but in our opinion it’s the best of a bad bunch as a trigger for a Coco conversion security.

It would be very helpful to have more clarity around RWA calculations. Most of us probably look at things like average RWAs to asset ratios across the banks in Europe and try to dig down where we can into specifics. 

It would be helpful if issuers could provide a lot more colour about what their RWA calculations entail, because there are some enormous differences in the size of RWAs to size of assets that are difficult to explain. 

EUROWEEK: Are other investors spending more time looking at RWAs?

Duarte, Claren Road: Definitely. It has been an important issue across the European banking sector for some time. If you look at where RWAs were two or three years ago compared with today, capital ratios are indeed higher, but RWAs are lower despite greater asset bases.

The absolute amount of capital has been raised in the last two or three years but the sector’s recapitalisation has come also from the optimisation methodology that banks have used. If we’re looking at RWA metrics of a second tier issuer, what assurances do we have that the national regulator does not decide mortgage risk weights should be 25% rather than 15%? 

As an investor, do we have the information to do the calculation accurately ourselves? The answer is no. We think that as this market develops the issuer will have to provide more of this information so that investors can do their own homework.

Dörr, Commerzbank: Regulators are addressing this issue in various ways by introducing risk weight floors for certain asset classes, for example, or counter-cyclical buffers on the capital requirement side. 

Brandenburg, Fidelity: Some more initiatives on leverage ratios would be helpful for Coco investors. Right now banks have various different ways of computing their leverage ratios and there is very little regulatory push towards uniformity. 

Fraser, Standard Life: More balance sheet disclosure on a quarterly basis would be appreciated. I’m not talking about issuers like Rabobank or Bank of Ireland, but about the French banks, which don’t publish quarterly balance sheets, which for major global banks is incredible. They publish their core tier one ratios but they don’t give any breakdown, and they hardly ever provide you with a total assets number.

Krim, Morgan Stanley: We have the EBA now tasked to draft the regulation and the ECB which will supervise the European banking sector. How much comfort do you take from that in terms of having an entity that oversees national regulators and can help to promote transparency and comparison of banks across Europe? 

Cooper, BlueMountain: I place very little reliance on regulators, based on the experience of multiple stress tests in recent years which were unable to pick up on banks which subsequently failed. Even in 2013 we’ve had two effective failures in the UK and the Netherlands, and it’s clear that in those instances the regulator was not in any way on top of the situation. 

My guess is that the regulators have limited manpower. So I wouldn’t expect that when we move towards a pan-European supervisor things will improve much.

Brandenburg, Fidelity: I think the only country which has defined a PONV is Canada. There seem to be schedules out there between regulators and banks that say if the capital ratio drops you do x, y and z. But what we don’t know right now is where dividends stand relative to alternative tier one coupons. Will the coupons be suspended at the same time as the dividends, or will the dividends be suspended first, then the coupons? And at what levels does this kick in? Particularly in the case of AT1, this is clearly an unresolved issue, which was not answered in the BBVA issue.

And then, what is really the difference between a 7% and a 5.125% trigger? And how does this relate to PONV? What happens right now is everybody puts the PONV very high — at about 10% — which is clearly not in the interest of the banks.

But my hunch is that PONV could actually be quite low. On systemic banks it will still be difficult for any regulator to put them through any of the existing bail-in and resolution regimes. So at the moment there is something of a stand-off, whereby the regulators like to talk tough but it’s not clear how realistic all this is. What needs to be cleared up is: is the PONV a last resort or a first resort? And where do all these triggers in the middle fit in? 

Menounos, Morgan Stanley: So, in a high trigger instrument, do investors think regulators will allow this to be breached before triggering PONV, and conversely for a low trigger instrument, will PONV come before the contractual trigger? 

Fraser, Standard Life: Before you even get to the trigger or the PONV, you have the regulatory discretion to go in and tell the bank to switch off its coupons, and by doing that you signal to debt investors that there’s a problem. That language will start to worry AT1 investors long before you get to the PONV or the trigger. 

Menounos, Morgan Stanley: Some may even go as far as suggesting that a low-trigger AT1 instrument — where market perception may be that PONV comes before the contractual trigger is reached — would leave investors more focused on coupon and extension risk, rather than going-concern loss absorption, and may therefore not be a huge departure from what we had in the past.

Cooper, BlueMountain: Maybe we should be thinking about these additional tier one coupons much more like dividends. I think the investor base is still coming round to this, or hasn’t quite grasped the risk of this being a dividend rather than a coupon.

We as a firm have an issue with the fact that the new AT1 is not going to have any kind of dividend stopper language, because we typically like to have very good, clear legal recourse and hierarchy. It feels as though we’re investing on the basis of reputational risk, which as we’ve seen in the past can change quite quickly. I don’t think it’s a great investment thesis to assume that an issuer is OK and is going to keep paying the coupon. 

The only argument I would have against this is that previously, under the old tier one structure, you could in theory have had a situation where a bank decided that for every five or 10 years, say, they wouldn’t pay any dividends or any tier one coupons. Instead, every five or 10 years they would pay a massive extraordinary dividend alongside a single tier one coupon. And you wouldn’t have been in that much better a position, as an old-style tier one investor with your dividend stopper, than you are now.

So while I don’t like the structure as it is, it’s not a million miles away from what we already had anyway.

Everwijn, Rabobank: There are ways for an issuer to at least provide comfort to an investor that it won’t have a preference for paying dividends over tier one coupons. What we did in our latest tier one structure was to align the coupon dates with the dividend dates of our CET1 instrument, so at least the investor knows that the issuer’s decision to stop paying your dividends or on your tier one securities occurs at the same time. 

Fraser, Standard Life: Do you think the Dutch regulator would allow you to pay an equity dividend and not pay a coupon?

Everwijn, Rabobank: I don’t think so. I think once you are forced to stop paying dividends the question also arises of whether or not you should stop or will be required to stop paying on your AT1 coupons. 

Macdonald, BlueBay: The first point Vincent made is key, which is that previously when people looked at tier one instruments they were seen very much as fixed income products which were expected to pay a coupon every year. Given the way people look at AT1 instruments and their subordination features, the coupon looks much more like a dividend now.

So I think people’s expectations are that it is optional rather than mandatory. That optionality raises the question of whether we should look at these as pure fixed income instruments.

EUROWEEK: Does this mean that AT1 is as close to equity as you can get?

Brandenburg, Fidelity: There’s the obvious difference that there’s a call date which you don’t get with equity, but apart from that I’d agree that it’s as close to equity as you can get. 

Cooper, BlueMountain: One other aspect which credit investors may still be gaining awareness of, is that with the new buffers we have now, and particularly with the capital conservation buffer, in the future we will potentially be reaching situations where the regulators are going to be forcing banks to stop paying the coupon. So there are going to be threats to the coupon much earlier than investors appreciate right now. 

Menounos, Morgan Stanley: Does that mean that you would prefer a high-trigger, tier two host instrument with certainty on coupons and no extension risk versus a low-trigger tier one instrument? In other words are you prepared to take the write-off risk as opposed to taking the lower trigger, but with the extension risk and the potential coupon risk?

Cooper, BlueMountain: I tend to prefer not having the extension risk. I typically don’t like the callable-type structures because I don’t feel I’m getting sufficiently well paid for the credit risk I’m taking. But it’s a tough question, because it will vary from issuer to issuer. It’s almost impossible to give a generic answer, particularly without any kind of prices.

Everwijn, Rabobank: What’s your definition of a high trigger?

Menounos, Morgan Stanley: That’s a good question, but let’s call it 7%.

Everwijn, Rabobank: In that case I think the risk of non-viability is always there and that under the new bail-in regime PONV risk probably occurs above 7%. That makes it an attractive instrument for an investor; one can argue that they get compensated for a risk that is unlikely to be triggered.

Duarte, Claren Road: We agree that if the issuer is going to stop your coupon it becomes more like equity. However, we believe that reputation still plays a part for most issuers that will be in the market constantly refinancing securities. Management should be willing to pull all possible levers to ensure that the bank stays comfortably away from the trigger.

However, with a one-off issuer that plans to rely more on equity, then clearly there are higher risks. But for a global Systemically Important Financial Institution, irrespective of how unfriendly the structure may appear to be, there is a vested reputational interest on the part of the issuer to honour those coupon payments. 

On the question of the PONV, what is very important is that this has historically been determined by whether or not there is a run on deposits. What we saw with certain banks in Europe is that the moment regulators start to get nervous, the first thing they have to do is to intervene in order to safeguard the system. So it doesn’t matter if your core tier one ratio had been 10% or 12% the previous quarter, the reality is that you could have a PONV of 5-1/8th but if there’s a run on deposits that PONV will be invoked.

So as an investor you have to go back to asking yourself how stable the franchise is, how comfortable you are with the assets on the balance sheet, and do you feel fundamentally secure that in a worst-case scenario this won’t happen?

Menounos, Morgan Stanley: Therefore the jurisdiction must come into play in terms of your analysis, as well as buffers, earnings power, RWA and capital flexibility?

Duarte, Claren Road: Absolutely. We think investors are very cognisant of issuers across the different regimes. A Sifi in southern Europe is probably going to get more forbearance from the local regulator than a bank in the UK where there is more clarity about what will happen in a bail-in scenario.

Menounos, Morgan Stanley: On the question of relative value, we find that most investors will try to find somewhere to anchor the pricing. Most take a fundamental view that they will buy a deal because they don’t expect it to ever get triggered. But once you go beyond that decision, relative value has to come into the analysis. 

If you take something as crude as the premium to host instrument, among the issuers that have already come to market such as Barclays, KBC and even the Lloyds ECNs, there is a pattern in how these trade. Do investors assign a weight to the size of the buffer, the capital ratio, RWA complexity and jurisdiction and come out with a fair value over host, comparing it to existing deals?

Morgan, Moore: I’ll answer that by asking you a question. I haven’t had a single bank come to me with a pricing construct that begins with equity and works down from there. It’s always bottom up. Why don’t the banks come to us with a construct which begins with the cost of equity?

Menounos, Morgan Stanley: It’s a good question. Do people look at the relative value question fundamentally, and adopt a bottoms-up pricing approach? Or do they look at value in the context of what is already out there?

Cooper, BlueMountain: We try to place value in the context of what is already out there. We don’t just say, ‘the structure is brilliant and we love the credit so let’s buy it regardless of the fact that it trades 300bp through its peers’. This is why Coco relative value analysis is quite difficult right now, because there aren’t that many instruments out there for comparative purposes.

We do think about the cost of equity, and the extent to which we would rather own additional tier one than equity. But one of the difficulties I have personally with the callable structures — particularly when you have a short call with a potentially long extension — is that it’s very difficult to price the option that you’re selling the issuer for a long period of time in these instruments. I think investors are undervaluing the option they’re selling to issuers.

Krim, Morgan Stanley: But if you compare these instruments to the previous generation of tier one and tier two that banks used to issue, there has been a repricing post-crisis. We used to price these instruments at a very different level to what banks are paying today and will be paying going forward. 

Morgan, Moore: Things have changed as well in the sense that sub debt used to be ‘faux’ sub debt — there was the contractual possibility of loss absorption but with a very low perceived probability. Now, as a function of tightened regulatory focus on account of instances where sub debt has not performed as advertised or designed, there is a very realistic risk of loss, which is why there has been an element of repricing. There has to be a repricing to reflect the new risk paradigm.

BBVA is a very good example. It came well inside where people thought it should have priced, which, according to some banks who weren’t involved in the deal, should have been at least 10%. That tells me that we’re in a market place where we’re not pricing credit. We’re pricing vast pools of liquidity that are competing for limited yield opportunities.

In 12-24 months’ time there may not be the same easy liquidity out there. But at the moment, everything is being priced relative to other issues, rather than with an eye to the actual fundamentals and risks. The lead managers force that on you. If you try to price an issue according to a rational, fundamental view, and you go to the syndicate desk at a bank that’s running the deal, they laugh at you.

The demand-supply equation forces you to either pass or acquiesce to the false consensus, because, as I said, there is a strong element of pricing liquidity rather than real risk.

I don’t feel that people are currently able to adequately price in the equity exposure that has been grafted on to what is primarily a fixed income instrument. 

Menounos, Morgan Stanley: So do you believe that given bail-in and PONV, a Coco or AT1 is closer to equity than it is to sub debt? 

Morgan, Moore: Yes. I also think the nature of the subordinated debt discussion has changed in line with the change in the regulatory environment. 

EUROWEEK: Would others agree that pricing is being driven by the rates environment rather than by fundamentals?

Brandenburg, Fidelity: Yes. There is definitely a strong rates component to current Coco pricing.

Fraser, Standard Life: One of the problems is that BBVA priced the first AT1 structure at a 9% coupon, which in a normal environment is fantastic for the issuer but for me as an investor is the wrong level.

EUROWEEK: What would be the right level?

Fraser, Standard Life: Double figures.

EUROWEEK: How has the evolution of the investor base influenced pricing?

Menounos, Morgan Stanley: We have seen a significant evolution in the investor base over the last 12-18 months. Historically, we would have expected demand for dollar-denominated Reg S transactions to be led predominantly by Asian high net worth investors. We’ve seen the emergence of a US institutional bid, and over the last few months, Reg S have achieved a larger proportionate distribution into European institutional investors versus Asia or high net worth.

So do issuers have a preference around the composition of the investor base, and do investors buy Reg S dollars because they perceive that market to be broader and deeper with Asian high net worth? And are we ready for the first euro-denominated transaction?

Dörr, Commerzbank: I agree that there has been a shift in the investor base. The real objective should be to find the right balance between Asia and elsewhere. It is important to get clear signals from the institutional side about what they do and don’t expect from a deal. For example, they don’t want you to move too much into Asia and create flowback as a result, which might damage the secondary market for the deal.

I think for issuers it will be vital to ensure they have a functioning secondary market that is accommodative of multiple issuance.

Everwijn, Rabobank: It’s also important not to design instruments that are targeted just at retail. You need to focus on the Asian private banks and on the institutional base in Europe and the US.

Krim, Morgan Stanley: Having spent quite a lot of time with regulators I would caveat that. There is a big focus in Europe on MiFid, and on ensuring that products aren’t mis-sold to retail clients and this is right. I would not go as far as stating that regulators prefer or are keen to see bank capital raised outside Europe.

For instance, we’ve had the EBA and other European regulators and policymakers asking us why we haven’t seen more European investors playing in this space, and why recent deals have been denominated in US dollars rather than euros. Is it because of the regulatory framework or because investors still have concerns about banks in the Eurozone?

MacDonald, BlueBay: I’m not sure the currency is a big issue. My feeling is that far from dumb money it is probably smart money that is leading demand for these investments. These investors are getting coupons of 9% when rates are at zero, but in normal circumstances I doubt that demand would come from the same investors. These are investors whose mandates allow them to buy dollars, euros and sterling, and to invest across the whole of the capital structure. So the currency is a different argument to whether it’s going to be a purely institutional deal that will go to long-only investors who will be regular participants in these products on a long-term basis.

Krim, Morgan Stanley: For issuers, currency does matter, and euro in particular, for two reasons. First, it gives them confidence if they know they have strong domestic demand and are not dependent only on the dollar market. Second, for accounting reasons, if AT1 is accounted for as equity, issuers don’t have to worry about how they should hedge their currency and/or interest rate exposure.

MacDonald, BlueBay: I agree that it is beneficial for the issuers. But for the type of investors who are buying the product I’m not sure it makes much difference. 

Brandenburg, Fidelity: I like transacting in the US dollar market, although maybe not in Reg S format. I think the structures we saw in the dollar market last year were positive because I suspect they will help generate broader interest in these securities and potentially support index inclusion. 

On the European side, what concerns me is that there still seems to be a high degree of non-participation because the insurance sector which was a big buyer in the past seems to have checked out of this market altogether. So there doesn’t seem to be the depth of investor base which is a concern.

The good thing about the US market is that liquidity is such that issuers can always transact. The risk in Europe is that it’s a one-way street which will be driven by a handful of investors while the others stand back. I think a lot will depend on whether or not insurance companies are going to participate in the market because they control a large part of the long-dated pools of capital out there. 

Fraser, Standard Life: Solvency II is a big issue for insurance companies, given the amount of capital they have to hold against these low-rated instruments.

Dörr, Commerzbank: I think that a sufficiently strong bank could do a European deal. We may not see order books of the same size that we see in the dollar market for the reasons Dierk mentioned, but a deal could certainly be placed. The question is: do you need to place a deal in Europe right now, or are you better off waiting until the recovery in the banking sector is reflected in spread compression.

EUROWEEK: Alex, do you think an issuer like BBVA would be able to issue AT1 in euros today?

Menounos, Morgan Stanley: The type of investors we’re seeing participate in Reg S deals today are far from being Asian only. There is definitely a skew towards institutional investors, and there is a good balance between real money and other investors.

That gives me a good basis to be constructive on the buyer base for a euro-denominated institutionally-targeted transaction. 

EUROWEEK: Going back to the discussion about resolution, would anybody like to comment on the two recent precedents we’ve seen, namely SNS and Cyprus? What lessons can investors draw from those events?

Cooper, BlueMountain: As a credit investor, I have some issues with what happened with SNS. I understand equity investors were given a lot of time to try and find some capital for that institution going back to the middle of 2012. 

Because they couldn’t find enough, the regulator decided that not only the equity investors but also the credit investors all the way up to but not including senior would be written down to zero. It seems wrong to me that the credit investor community wasn’t given those same opportunities to find the necessary capital. A far more optimal solution to me would have been for the regulator to have put out a statement that said investors were going to get expropriated over the next two weeks unless they could find some kind of solution, with a senior or liquidity guarantee also provided.

The bonds would have dropped in response, but probably not to zero. Investors would then have been able to make a decision on whether or not to inject the capital based on whether they saw some franchise value. That would have been a better way of tackling the situation than assuming that credit investors were meaningless.

Cyprus highlighted policymaker risk in Europe. The silver lining I take from Cyprus is that it did ultimately raise awareness of the importance of capital hierarchy, which Draghi spoke about afterwards at the ECB press conference. 

Brandenburg, Fidelity: What Cyprus and SNS both point to is that banks will have to run higher levels of total capital. So far, I think the whole capital debate has been focused too much on core tier one. The fall-out from Cyprus is that we’re going to get depositor preference which means senior will be squeezed from above, whereas SNS tells us we’re going to get squeezed from below because the capital will be wiped out more easily. The answer in both cases is that there needs to be a bigger buffer in the middle. 

Krim, Morgan Stanley: In conclusion, a lot of work has been done but we are still in a transition phase. I’m pleasantly surprised at how much information on the developments that are happening on the regulatory side is already flowing to the investor community. As a result, investors are much more sophisticated and aware about where we stand. But there is still plenty to be done in terms of giving investors confidence that European banks are investable across the capital structure — not just the national champions. 

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