Policy holds key role in China's TLAC task
Chinese banks will require a helping hand to comply with international standards on loss-absorbing capacity, as they go from being part-time users of the global capital markets to big players in debt financing. Luckily for them, domestic regulators appear increasingly keen for the banking sector to be recapitalised. Tyler Davies reports
A cheer echoed around China in late 2014, when the Financial Stability Board (FSB) said that the country’s big four banks would initially be excluded from having to comply with its newly floated proposals for total loss-absorbing capacity (TLAC).
The feeling among China’s global systemically important banks was that they were simply not ready to begin raising the large volume of subordinated debt required by the rules, which have aimed to end the idea of ‘too big to fail’ in international finance.
In separate letters to the FSB, Agricultural Bank of China, Bank of China, China Construction Bank and Industrial and Commercial Bank of China praised the decision to delay TLAC implementation in emerging markets, highlighting their reliance on deposits as a form of funding and pointing out that China’s domestic bond market had a limited capacity for absorbing new issuance.
Fast forward four years and many of the same difficulties still plague Chinese banks, as they look to make their first steps towards hitting their TLAC targets. But there is a crucial difference — these institutions no longer have time on their side.
China’s biggest banks will have to sell huge volumes of debt if they are going to be able to make TLAC-eligible liabilities account for 16% of their risk-weighted assets by January 2025, and 18% by January 2028.
Making matters worse is the fact that these deadlines could even be brought forward if the outstanding amount of corporate and financial debt moves above 55% of GDP in the next two years — a trigger set by the FSB. In its last financial stability report, the People’s Bank of China (PBoC) indicated that this ratio was at 50% and rising.
“There is a circa $300bn-$500bn shortfall for the big four banks, depending on who you talk to,” says Lee-Shin Koh, a director of FIG DCM at Citi in Hong Kong. “It will definitely be a challenge.”
Although market participants are largely still in the dark about how China intends to implement TLAC, local regulatory authorities have been ramping up their preparations over the course of the last 12 months.
In March 2018, the China Banking Regulatory Commission (CBRC) made its first public moves aimed at encouraging the big four banks to comply with the FSB’s standards. It suggested how these financial institutions could develop new instruments to meet the TLAC criteria, which require debt to rank below a variety of protected banking liabilities in an insolvency scenario, including deposits.
The CBRC, which has since merged with the insurance regulator, hinted at a preference for banks to use contractual clauses if they want to achieve this level of subordination — an approach that would bear similarities to how some European financial institutions began issuing non-preferred senior debt.
But Chinese banks are not expected to jump into the market until they have received much clearer guidance about how exactly they will be expected to meet TLAC over the coming years.
“We think the Chinese regulator has moved from the studying phase to actually drafting regulations,” says Nicholas Zhu, a senior credit analyst at Moody’s in Beijing. “We are hopeful for a more concrete announcement on TLAC later this year.”
It is unlikely that China will limit its policy response to a set of issuance guidelines and product specifications, given the sheer volume of loss-absorbing debt that the country’s banks must issue to meet the FSB’s minimum TLAC requirements.
Regulators will also have to work on making it easier for banks to place funding and capital instruments with investors in the domestic bond market, which lacks depth and maturity by international standards.
Part of the problem is that China’s deposit-laden G-SIBs have never needed to access the capital markets for large volumes of bond financing. In times when they do approach the market, their deals have also tended to be heavily supported by other Chinese banks, rather than a more diverse set of investors.
None of this has escaped the attention of banking authorities in China, with the PBoC having acknowledged many of these difficulties in its latest financial stability report, published in November 2018.
“There are a number of tools at the disposal of the Chinese regulators to improve onshore TLAC demand, including widening the investor base — to insurers, for example — and allowing such instruments to be eligible for central bank liquidity facilities,” says Timothy Chan, a director in the Financing Solutions Group at HSBC in Hong Kong.
Chan says that China has precedent for implementing similar measures to create demand in the domestic bond market.
Having lifted a ban on onshore perpetual bond issuance by Chinese banks in January, the country said that bank investors would able to swap these instruments for central bank bills, clearing a path for Bank of China to raise Rmb40bn ($5.9bn) with the mainland’s first additional tier one bond.
“I would expect that the same thinking would apply to non-preferred senior bonds for TLAC as well,” says Zhu at Moody’s.
Even with new policy measures from Chinese regulators, it remains unclear whether there will be sufficient depth in the domestic market to absorb the mass of new debt issuance expected out of China. This is especially the case given that G-SIBs are not alone in needing to raise capital.
China could roll out TLAC to domestic systemically important banks, many of which already need to work towards meeting regulatory buffer requirements equivalent to at least 1% of their RWAs.
A crackdown on the country’s shadow banking sector is increasing transparency around lending practices, a process that will eventually require banks to raise more capital as their balance sheets grow with new loans. As a way of coping with the likely boom in debt supply out of China, the big four banks are therefore expected to diversify their financing sources across a number of different markets.
“One of the questions that everyone is asking is how much of Chinese TLAC issuance will be issued offshore versus onshore,” says Citi’s Koh.
China’s G-SIBs already have a footprint in offshore bond markets. But their activity has mainly been limited to deals in the Reg S dollar market, a format that allows issuers to sell to international investors but not onshore US accounts.
Koh says that the treasury books of other Chinese banks have remained the key investor base in many of these trades, despite them being launched overseas. That is because issuers can drive tighter pricing by targeting these accounts, which are often able to use investments for liquidity purposes with the PBoC.
There are big questions as to whether this will be possible for TLAC offerings, not least because the FSB’s standards discourage cross-holdings of debt between banks by forcing institutions to deduct holdings from their own loss-absorbing capacity ratios.
“It could be more challenging for issuers to access these markets for TLAC debt if the same benefits are not available,” says Koh. “The banks may need to be more flexible on market pricing if they want to raise more debt for TLAC, and they may also have to look at other investor bases, like the 144A market.”
Who is on the hook?
One factor that should support Chinese banks in international markets is that investors are likely to recognise that there is less risk of them losing their principal in TLAC investments from the country.
In China, as in many Asian countries, including Japan, there is a strong sense among market participants that the government would not allow banks to rack up large losses without stepping in to shore up capital levels.
“The Chinese banks can almost certainly issue huge amounts of TLAC debt to meet regulatory requirements but it will be meaningless as just about everyone will assume the government will not impose losses on such instruments,” argues David Marshall, co-head of Asian bank research at CreditSights in Singapore.
“This suggests that in future we are going to have a situation where western banks are raising potentially loss-absorbing TLAC debt at relatively high cost while their Asian competitors can raise their TLAC debt more cheaply, as it is perceived to be government-guaranteed.”
This could even be hard-coded into instruments through better ratings from global rating agencies.
Zhu says that Moody’s does not transmit any likelihood of government support into the ratings of tier twos or AT1s from Chinese banks. But he says that the agency has not yet decided how it will apply its ratings methodology to TLAC in China.
“We notch down by three notches from standalone baseline credit assessment for AT1s and by one notch for tier twos,” says Zhu. “But TLAC bonds rank between tier twos and ordinary senior debt.”
“The question is whether we notch down by one notch, by no notches, or whether we can factor the possibility of government support. We have to answer that question.”
These discussions highlight the tension at the heart of TLAC preparations in China — that the standard was never drawn up with the country in mind.
The main idea of TLAC is that banks should have enough resources to be able to deal with their own failures independently, without having to resort to the sorts of taxpayer bailouts that western banks required after the 2008 financial crisis.
But the Chinese G-SIBs are already state-owned and it would be reasonable to assume that their main shareholder would play a role in a recapitalisation if it proved necessary.
When the big four banks sent letters to the FSB in early 2015, they called on its members to consider the realities of China’s banking sector when thinking about any possible deadlines for TLAC. But they also asked the policy-drafting body to think about whether its proposed reforms were a good fit for the country — whether they were necessary in all cases.
That ship has already sailed. All eyes are now fixed on the domestic regulatory authorities, to see if they can guide Chinese banks safely towards their destination.