SLBs have been growing in popularity in the capital markets, appearing as the hot new ESG alternative to tried and tested “use of proceeds” bonds and loans.
The sustainability-linked deals require borrowers to commit to achieving sustainability targets within a certain timeframe. If they fail to meet their goals, they may then need to pay a penalty to their investors in the form of a larger coupon.
Berlin Hyp became the first bank to issue an SLB this month, when it sold a deal with a coupon that will step up if the company fails reduce the carbon intensity of its loan book by 40% over the next 10 years.
But the German issuer stripped its bond of any language relating to “bail-in”, side-stepping what many market participants are calling “the key question” for bank SLBs — will the structures conflict with the eligibility criteria for capital instruments and other forms of loss-absorbing debt?
The question is important because the vast majority of banks in Europe only really need to issue bonds to comply with capital targets or meet their minimum requirements for own funds and eligible liabilities (MREL).
Clearly there is some risk that banks go too early with new SLBs and end up being caught offside by their regulator.
In particular, bankers are worried that coupon step-ups will be seen as unwelcome “incentives to redeem”. They also fret that sustainability targets will be viewed under the umbrella of an issuer’s “credit standing”, which could also render deals ineligible for MREL.
But the risk may not be as great as it would be if issuers were innovating to optimise their capital structures or meet new demands from investors.
Because of the environmentally friendly nature of SLBs, regulators have found themselves between a rock and a hard place.
On the one hand, they don’t want to encourage banks to bring more complexity into an already very complicated rulebook for capital and MREL. On the other, they are keen for firms to think more deeply about sustainability and about how ESG considerations can be included in their business planning and risk management processes.
Take the European Banking Authority as an example.
Delphine Reymondon, head of the regulator’s liquidity, leverage, loss absorbency and capital unit, told GlobalCapital last week that she wanted to send a “cautious message” to issuers that have been looking to the EBA for some kind of guidance as to whether SLBs can be eligible as MREL or capital under EU rules.
“Generally, we do not like to see links between the fulfilment of certain targets — being sustainable ones or other types — and the performance of a bond,” Reymondon said. “But we want to take a bit more time to investigate this specific aspect of sustainability-linked debt and possible diverse structures before making our final decision.”
In the same breath, however, some of Reymondon’s colleagues are rolling out advice to banks on how to develop the kinds of key performance indicators (KPIs) that would underpin SLB transactions.
In a press release at the beginning of March, the EBA said its new KPIs, which included the possibility of a green asset ratio, were “a key means to understand how institutions are financing sustainable activities and meeting the Paris agreement targets”.
None of this is to say that regulators will simply overlook any structural problems with SLBs, just because they are green.
But there is very clearly a desire for firms to link their business practices with sustainability targets. Banks just have to work out how to do it.
We’ve been here before
Much of the conversation has so far centred on coupon step-ups. Will a bond remain eligible under existing rules if its step-up is distanced from a call option or if it is printed in bullet format? Could banks just use an alternative incentive mechanism, such as a redemption premium?
There will be some degree of regulatory risk in whatever structure is first proposed for an SLB in an MREL or capital format.
But there is also a big opportunity for the banking sector to set its own standards as regulators agonise over how to get their guidance right.
An issuer brave enough to kickstart the SLB market for regulatory debt is also likely to influence whatever regulatory opinions come later.
“Use of proceeds” deals are already very common across the capital structure, but it has taken several years for the EBA to nail down its guidance for these products.
The authority is expected to say in June or July that firms should make more of an effort to disclose regulatory risks to investors when they issue in ESG formats. Importantly, its guidance will have no retrospective impact on green and social bonds, so as not to punish the good work that has already been done.
SLBs will present more of a regulatory challenge than “use of proceeds” bonds, of course. But banks still have a chance to forge their own path.
Issuers should be proactive in bringing forward proposals to the authorities, rather than waiting to be told what to do. The future is very much theirs for the shaping.