A new day has dawned in European banking. After years of waiting, banks are on the cusp of finally being able to issue a new breed of capital securities that are intended to protect them — and society at large — from the catastrophes that befell not just individual lenders but entire countries during the financial crisis.
The main missing pieces of the puzzle are the first pan-European Capital Requirements Regulation and the fourth Capital Requirements Directive, which effectively transpose Basel III into European Union law.
They will be backed up by a raft of technical standards from the European Banking Authority (EBA), and form a solid foundation for the EU’s grand plan for banking union.
Under CRD IV, banks will be required to hold common equity tier one capital equal to 4.5% of their risk-weighted assets, supplemented by a 2.5% capital conservation buffer and another 2.5% for systemically important financial institutions.
That will take them to a 9.5% common equity tier one ratio. Sitting on top of that will be 1.5% of additional tier one capital — replacing old-style hybrid tier one debt — and 2% of tier two capital, which will be similar to old-style tier two but subject to being bailed in under the incoming Crisis Management Directive (CMD), often referred to as the Recovery and Resolution Directive.
This amounts to a lot of new issuance. But the pieces are slowly coming together, and issuers and capital structurers are ready to usher in a new generation of capital instruments.
“We are basically just waiting for regulators,” says Khalid Krim, head of European capital solutions at Morgan Stanley. “The markets are supportive to a certain extent, and almost all the stars are now aligned. It’s time to move to the next stage.
“We have CRD IV, the CRR, and we also have the CMD coming in, which includes bail-in. So we have connectivity between the capital side and the funding side.”
Over the past couple of years, most European banks have focused on bolstering their core tier one capital ratios, through a mix of equity issuance, liability management exercises, asset disposals and retention of earnings.
Now that most are comfortably above the EBA’s 9% minimum core tier one ratios, and CRD IV has been finalised, issuers are turning their attention to total capital ratios — which includes additional tier one securities, tier two debt, and in some jurisdictions, contingent capital, otherwise known as Cocos.
Assuring functionality
Additional tier one capital will incorporate triggers for loss-absorbing features such as temporary or permanent write-down, or conversion into equity, as well as coupon deferral.
Estimates of potential supply of AT1 vary, but the consensus figure is around €250bn, based on assessments of the RWAs of Europe’s 40 largest institutions. That could rise if banks use AT1 to satisfy leverage ratio requirements, which national regulators are still wrangling over. Cocos will also be seen in some jurisdictions, such as the UK, the Nordic area and Switzerland.
Early indications would suggest that there is enough demand to meet that supply. The depth of the market may be exaggerated by the low yield environment at the moment, which has forced investors towards riskier instruments as they search for yield. But with more and more European and US institutional investors building dedicated platforms to invest in this new class of securities, the buyer base is looking far more permanent today than it was in 2011, when most deals were built around a strong bid from high net worth individuals in Hong Kong and Singapore.
“This is now truly a global investor base, spanning the US, Europe and Asia,” says Alex Menounos, head of European IG debt syndicate at Morgan Stanley. “Demand was initially driven by high net worth investors, but as yields continued to fall, institutional investors were compelled to allocate more time and resources to investing in this developing asset class given the relatively attractive returns on offer.”
No more bail-out
After the financial crisis laid bare the faults of the previous generation of capital instruments and the lack of a coherent — and swift — framework for recapitalising banks without opening the public purse, regulators are determined to redesign the European banking sector to make it possible for banks to fail without threatening the economies of the countries in which they operate.
The CRD package was agreed in late March 2013, after numerous delays. It is expected to be officially published by June 30, and if it is, it will take effect from January 1, 2014.
The EBA’s technical standards for own funds, which flesh out the finer details of how CRD-compliant additional tier one and tier two deals are to be structured, will be officially published alongside the CRD package. However, the EBA published a near-final draft in early June.
The reforms don’t stop at new-style capital. The bank Recovery and Resolution Directive is being thrashed out at EU level and will feature a raft of measures intended to nurse failing banks back to health or swiftly resolve those that are already past saving.
One of these tools is bail-in, which will apply on a statutory basis to tier two debt and, controversially, to senior unsecured, forcing losses on those creditors when a bank fails, to avoid taxpayers footing the bill.
The much grander plan overarching these new regulations, however, is European banking union. This project features three pillars: central supervision by the European Central Bank; a Europe-wide resolution fund; and an EU-wide deposit insurance scheme.
The march towards this goal is a slow one, and it throws up many potential issues for banks. But the finalisation of new capital rules is a solid foundation for the new face of European banking. The door is open — let the money flow.