Carson Welsh has been busy. The London-based partner of law firm Linklaters has had clients stream into his office for more than a year seeking a better understanding of what changes Basel III has in store before the January 1, 2013 deadline for compliance.
“Banks clearly know Basel III’s timeframe and know that if they don’t have their capital in order now they’re going to have to have it fairly sho rtly,” Welsh says.
Welsh should know. He advised on Dutch lender Rabobank’s US$2 billion perpetual Tier I bond issue in November, the first sale of a bank note with Basel III-compliant features.
For Welsh’s Asian colleague Andrew Carmichael, the Tokyo- and Hong Kong-based joint managing partner of Linklaters, it’s a different story.
“When it comes to Basel III banks are asking, ‘What did they do? Oh that’s interesting’. But then there will be no further preparation …until final rules emerge,” says Carmichael, who advised on Asia’s first Basel III-compliant bond issue.
As Europe’s financial institutions brace for Basel III, many of their Asian counterparts have yet to register more than a passing interest.
Their lack of enthusiasm stems from a mixture of financial strength and complacency. While many European banks are working hard to meet the minimum 8.5% Tier I ratio demanded by the Basel Committee on Banking Supervision, lenders in Asia are some of the best-capitalised in the world.
Hong Kong’s banking sector, for example, enjoys risk-adjusted core Tier I bank capitalisation of 9.2%, while in Singapore it’s 8.3%, according to Standard & Poor’s (S&P).
The region’s banks also have a relaxed attitude towards Basel III-compliant capital. As banks, auditors and lawyers advise European institutions on how best to structure subordinated bonds that comply with Basel III, few Asian banks are even considering such deals.
“If a bank is able to issue in the old format they would do so because it’s … more investor friendly and there’s pricing certainty….” says Mark Leahy, head of debt syndicate and debt origination for Asia ex-Japan at Nomura.
While Basel III is inevitable, the question for Asian banks is when to start taking it seriously.

Changes to CAR
From January 1 under Basel III, banks must retain a capital-adequacy ratio (CAR) of 8% at all times, plus a capital conservation buffer of 2.5%. The CAR is divided into Tier I and Tier II.
The former comprises of equity or equity-like capital. Historically, Tier II is chiefly made up of debt instruments, typically subordinated bonds – where the holders have a lower priority than other creditors in the event of liquidation.
The new Basel rules have several consequences. Firstly, they raise the minimum level of core Tier I capital that a bank must have from 2% to 4.5% of risk-weighted assets. Additionally banks must maintain the 2.5% capital conservation buffer comprised solely of core Tier I capital.
Secondly, the rules tighten the guidelines on the debt instruments that are applicable as bank capital.
The biggest change is that perpetual Tier I and II bank notes have to include loss-absorbency provisions.
The provisions have two parts. Under the first, if a bank is declared “non-viable” by the regulators, any CAR-applicable bonds would either dissolve into equity or have their principal written down to zero.
The second trigger is a numerical capital ratio, determined by the bank. It has an identical effect to the first, providing the issuer liquidity in the event it falls under the preset ratio. Bank treasuries will set this ratio higher than the government’s ratio, “by about 1%”, says Peter Leung, deputy chief executive and chief financial officer of Industrial & Commercial Bank of China (ICBC) (Asia), the first bank in Asia to issue a Basel III-compliant bond (see box on page 18).
The provisions are to ensure the banks get immediate capital in the event that their capital structure comes under duress, without having to ask for a public bailout.
There are other changes too. From January 1, the principals of all subordinated bonds raised under the previous Basel rules will amortise by 10% a year into senior, non CAR-applicable notes. Banks that have relied on such debt for their Tier I or II capital needs will need to find alternatives.
Subordinated bonds issued after 2012 can no longer include step-up coupons, a popular feature.
Issuers can also cancel coupon payments at any time, and if the bonds end up converting to equity they can choose not to pay dividends. A bank may do this at any time during the life of a bond.
All in all the changes give banks more security, but raise the risk for investors. As a result, banks can expect to pay up when issuing bonds.
“Bonds with Basel III-compliant characteristics could easily be anywhere between 100bp [basis points] to 200bp more expensive to issuers than old-style bonds, depending on credit quality,” Michael Gower, head of long-term funding at Rabobank, tells Asiamoney.

Asian interpretations
While the Basel III guidelines are universal, their interpretation will vary. Country regulators will offer definitions of bank capital appropriate for their own market conditions.
Some Asian countries are better prepared than others. As of March, regulators in Singapore, Hong Kong, China, the Philippines and Malaysia have published preliminary drafts on Basel III regulation. South Korea, Taiwan and Thailand have not.
Those regulators that have issued guidelines do not necessarily agree with each other. One example is whether to allow Basel II-compliant subordinated bonds to be grandfathered beyond 2013 – meaning that the old-style bonds’ capital will still count toward Tier I or II ratios.
Singapore and Japan look set to allow Basel II-compliant bonds issued throughout 2012 to be grandfathered. But the Philippines’ regulator has said non-Basel III-compliant bonds will not count towards Tier I or II adequacy from next year.
Another disparity involves Tier I and II adequacy ratios. Basel recommends that banks hold 4.5% of core Tier 1 capital, 6% of Tier 1 capital, and 8% total capital, respectively. While Hong Kong is poised to follow these recommendations Singapore’s preliminary guidelines overshoot, mandating a respective 6.5%, 8% and 10%.
In addition, the regulators’ drafts are just that – guidelines. Finalised laws regarding capital adequacy will be announced throughout the year.
In other words, structuring Basel III-compliant bonds comes down to a case of best guesses.

Cost of capital
Issuers in Europe have been willing to brave this regulatory uncertainty with bonds because they badly need to raise capital ratios and beat competitors out of the gate.
Institutions including Credit Suisse, Lloyds and UBS have all issued bonds with (what they hope will be) Basel III-compliant features.
But Asian banks are, by and large, far better capitalised, with few refinancing needs.
Data provider Dealogic notes that US$24.67 billion worth of bonds issued by financial institutions are due in the first quarter of 2013, and US$38.28 billion in the second quarter.
Over the year US$131.41 billion worth of bonds will come due, mostly from Australia, India, Japan and South Korea.
Take Australia and Japan out of the equation, and Asian financial issuers are facing just US$45.7 million of subordinated bonds up for call in 2013. Dealogic figures show that 2013 is a lighter year for calls, with no Tier I debt due at all and only US$1.2 billion of Tier II. That compares to US$200 million of Tier I debt up for call in 2012 and US$5.7 billion of Tier II.
Regional borrowers understandably see little incentive to issue expensive debt based on guidelines that may not end up being the final iteration of the rules.
Treasury executives from Korea Development Bank (KDB) and the Export Import Bank of Korea (Kexim) tell Asiamoney that they are not considering issuing Basel III-compliant bonds because their capital ratios are sufficient.
An Oversea-Chinese Banking Corp. (OCBC) spokeswoman notes that “as Basel III-compliant bonds are very new in Singapore”, the bank cannot comment on its funding plans. Rival United Overseas Bank (UOB) and Malaysia’s Public Bank echoed this sentiment.
National Australia Bank, DBS and Commonwealth Bank of Australia could not be reached for comment.
Going for grandfathering
Augusto King, head of Asia debt capital markets at the Royal Bank of Scotland (RBS), says he has spoken to several banks about issuing Basel III-compliant bonds, but the prevailing sentiment is that they don’t feel the need to do so while their capital ratios are healthy and the guidelines uncertain.
Most importantly, King notes, “issuers are considering the cost impact”.
“It’s true that the banks are advocating for clients to issue Basel III-compliant securities,” agrees Dana Kulik, a credit sector specialist at Citi. “But it comes down to cost – the price of Basel III Tier I securities is going to be high.”
Lenders that need capital prefer issuing Basel II-compliant bonds. This is especially true in markets where it looks likely that grandfathering such debt will be allowed – Bank of East Asia, Dah Sing Bank, Woori Bank and Maybank have all issued old-style Basel II bonds.
For such clients the 10% in annual amortisation that such bonds will suffer is a small price to pay.
“We think that a bond, after the 10% amortisation, will be about 50bp-100bp more expensive than what they have now, compared to 150bp to issue a Basel III-compliant bond,” says one bank’s head of FIG coverage for capital markets treasury solutions.
However, the spreads between this subordinated debt and senior bonds will widen during the amortisation process – 90% and 10% in year one, and 80% and 20% in year two. At around the 50% amortisation mark the old-style bonds are likely to become more expensive than equivalent Basel III bonds.
China and Japan’s capital outlook
Yet the time for Asian subordinated issues will come, says Kulik at Citi. Bank figures show that the majority of regional Tier I debt becomes callable in 2015, 2016 and 2017.
Added to this, regional banks are not universally able to disregard their capital needs. S&P states that banks in China and Japan are most likely to struggle to meet the Basel III capital deadlines.
Japan’s largest lenders have extensively used hybrid securities over the past decade to recapitalise after losses posted during the late 1990s. These will need to be recalibrated to meet Basel III standards.
Chinese banks, meanwhile, record an average of 15%-16% annual balance-sheet growth, which means they must consistently raise Tier I and II capital in proportion to keep up.
Despite this, neither country is likely to supply a rush of Basel III issues. Chinese banks still enjoy 6.6% Tier I capitalisation, according to S&P, which provides a base to grow core capital organically. And Japanese banks are likelier to tap equity investors to boost their capital reserves than issue costly bonds.
“There will be a wave of Basel III issuance in Europe this year, and then will come Japan followed by a trickle of Asian banks looking to recapitalise their Tier II debt next year,” predicts the head of FIG. He notes that the well-capitalised positions of the region’s banks mean they can delay their bonds for as long as possible.
Those in need are likely to use other methods to raise capital. Banks in India, Indonesia, Malaysia, the Philippines and Vietnam may shed assets or sell equity rather than issue expensive Basel III-compliant bonds.
Waiting for clarity
Emily Lam, private banking advisory services partner at PricewaterhouseCoopers, believes that it’s a mistake for Asian banks to disregard Basel III deals.
Her argument: the changes are inevitable and it’s wiser to partially meet the regulations in 2012 than face repercussions in 2013.
Lam forecasts that Asian banks will face higher pricing levels in 2013 and 2014 as other financial institutions around the world begin issuing bonds to recapitalise.
Ultimately, Basel III will be implemented. Asia’s banks do not need to borrow yet, but they would be wise to become as informed about the new regulations as possible, while awaiting regional regulatory interpretation, including whether existing Basel II debt will be grandfathered.
Regulators must act soon, ideally during the second quarter. Until regulation is set, no bank will want to be caught in the crossfire.
Once this is clear, the region’s borrowers will be well positioned to decide whether to issue small Basel III benchmark deals this year, before a global rush for capital ensues, or wait it out with their high capital positions.
“Asia faces the same capital-adequacy pressures as everyone else,” Linklaters’ Carmichael concludes. “It’s unavoidable.”
