Choose your instruments

While European policymakers have been dithering over bank capital rules, regulators have been busy telling banks to raise more of it. Most have done so via cash-generative liability management exercises, asset sales and deleveraging, and now comply with the 9.5% core tier one capital requirement laid down in the European Union’s fourth edition of the Capital Requirements Directive (CRD IV).

That is just one part of the puzzle, however. There are other buffers to fill to comply with CRD IV, the accompanying Capital Requirements Regulation (CRR) and Europe’s various national finishes (see chart). 

But until now, banks have not known exactly how to structure instruments to fill those buffers, leading to a huge amount of pent-up supply. Combine that with a low-yield environment which is pushing investors towards riskier credits and structures as they search for better returns, and you have a perfect storm for capital issuance.

“This market has come from nowhere, to now having traders dedicated to the product and investors allocating money,” says Claus Skrumsager, co-head of global capital markets EMEA at Morgan Stanley. 

“Three years ago people were sceptical. Obviously we have been helped by a very constructive fixed income market, where low yields have incentivised investors to look at higher yielding products such as hybrid debt.”

Several jurisdictions still need to give clarity on tax deductibility for additional tier one coupons. But after the publication in early June 2013 of what was termed a “near-final draft” of the European Banking Authority’s regulatory technical standards for own funds, tax is basically the final piece of the puzzle for additional tier one issuance.

But it should not be a barrier to issuance, says AJ Davidson, head of hybrid capital for EMEA and APAC at Royal Bank of Scotland.

“As the dominos start to fall across Europe, that will force those banks to sort out the tax issue, either through a statutory framework or obtaining ad hoc or bilateral clearance from the tax authorities,” he says. 

“There are banks in those jurisdictions which have been active in pursuing solutions directly with the tax authorities to make sure they sit on a level playing field with the rest of Europe.”

Stephen Roith, partner at Sidley Austin, says governments have little option but to give in on tax deductibility.

“The loss of tax deductibility would be fatal,” he says. “But we are now in an environment where governments realise that unless banks accumulate more capital and then can lend to the economy, Europe is never going to recover. 

“It took quite a while, but there is now an appreciation at a government and regulatory level that banks need to be able to issue these instruments in an efficient manner — and making coupons tax deductible is part of that.”

After a long hiatus, tier two supply resumed with a vengeance last summer, with even banks in peripheral jurisdictions like UniCredit and Bank of Ireland printing deals.

But now, with the official publication of CRD and the EBA’s technical standards just around the corner, banks are expected to focus on building their total capital buffer from the ground up, with additional tier one capital, as well as contingent capital (otherwise known as Cocos). 

Under the CRD package, additional tier one instruments must have a perpetual maturity, discretionary and non-cumulative coupons, and incorporate a loss absorbing feature which is triggered when the issuer breaches a 5.125% common equity tier one capital ratio.

Issuers have three options for that loss absorbing feature: equity conversion; temporary write down; or permanent write down. Additional tier one capital will also be subject to losses if the issuer is judged to have breached the point of non-viability — but this feature can either be written into the bond contract or left to the statutory Recovery and Resolution Directive (RRD).

BBVA’s deal, the first AT1 deal to hit the market, took the equity conversion approach. For investors, this is by far the preferred structure — if the trigger is hit, you lose your principal, but you are at least left with shares.

For issuers, though, structuring an equity conversion trade can be an arduous process. It may be unpopular with shareholders, because conversion would dilute them, and issuers may have to ask those shareholders for pre-emptive approval for share issuance before they can even begin to structure a transaction.

“There is a fascinating tension here because investors would almost always prefer a conversion structure, so that if the worst is to happen they will be left with something in their hands,” says Roith at Sidley Austin.

“On the other side, shareholders are very suspicious about these instruments — because of the potential dilution, because they are rather complex and because they might not fully understand the implications. It can give an opportunity to activist shareholders to make a bit of a fuss at the AGM.”

At the other end of the spectrum is permanent write down, which has been used by Barclays and KBC in tier two host Cocos but is yet to be tested in an additional tier one deal. Permanent write down is unpalatable to some fixed income investors — many argue that it subordinates bondholders to equity investors.

There is no denying that permanent write down structures — or “wipe-out bonds” as they have been called — are at the more aggressive end of the loss absorbing capital menu from an investors’ point of view.

There are concerns that because Barclays and KBC have set precedents for this type of structure, issuers may be less inclined to issue more investor friendly structures — and that because they are searching for yield, investors may continue to bite on the riskier permanent write down structures.

Alex Menounos, head of European IG debt syndicate at Morgan Stanley, agrees that had the market developed on a more even keel, permanent write down deals might not have gained so much traction. But that doesn’t mean issuers now have a captive market for that structure, he says.

“I don’t believe investors have lost negotiating power when it comes to some of the finer structural details, but favourable market conditions have created a healthy tension between different investor types. High net worth investors were dominating distribution but the low yield environment and a lack of alternative investments with comparable yield characteristics led to a meaningful shift in distribution to institutional investors. The hunt for yield has even stimulated investor reverse enquiry for certain issuers and structures. 

“Real money investors are not just buying everything — they are investing in credits and structures they feel comfortable with, where their view is that a breach of the trigger is an extreme tail event.” 

Menounos argues that structural subordination may be less of an issue in this context, if the probability of breach makes the weighted expected loss immaterial. “In other instances, where breach may be viewed as a less extreme probability event, equity conversion structures may be more appropriate,” he adds.

There is a middle ground — of sorts. The market has had to wait a long time for the EBA’s technical standards to detail exactly how temporary write down will work, and the industry’s massive lobbying effort has paid off. The near-final draft, published on June 5, made a crucial concession on the conditions of temporary write down. 

Market participants were worried that after the write down had been triggered and coupons suspended, it would be down to regulators to decide when to resume paying coupons and return investors’ principal — potentially leading to a situation where a bank could resume paying shareholder dividends while leaving bondholders out of pocket.

The EBA has now left those decisions to the issuer’s discretion. It is expected that the market will impose its own discipline, says Rob Kendrick, senior credit analyst at Legal & General Investment Management.

“Management will have a lot of explaining to do if they choose dividends and not coupons,” he says. “This at least gives issuers the capability to act in bondholders’ interests.”

It also offers a solution for banks that cannot issue equity, but do not want to pay up for permanent write down.

“The whole reason temporary write down is supported is because regulators need to make sure the going concern loss absorption trigger is implemented on a fair basis across Europe,” says AJ Davidson at RBS. 

“There are many banks in Europe that are not publicly listed or held, or are not even joint stock banks. They cannot issue shares, so equity conversion is not an option. Temporary write down and write-up is fundamental to the Europe construct. 

“Even banks that can issue equity conversion trades may opt for a non-dilutive instrument to keep shareholders happy, while at the same time potentially achieving better pricing because we expect deeper and wider support from fixed income investors for temporary write down AT1 instruments.”

Another consideration for additional tier one is the leverage ratio, which limits the amount of debt banks can issue according to how much equity capital they have.

But regulators are still wrangling over how high the ratio should be. The Basel III guidelines set the ratio at 3%, but the UK, for example, is pushing to raise the bar to at least 4%. That jump could significantly increase the amount of additional tier one capital banks need, because apart from equity, AT1 is the only form of capital that counts towards the ratio.

“You need more capital, but if you issue equity you dilute your shareholders,” says Khalid Krim, head of European capital solutions at Morgan Stanley. “If you issue tier one it can be non-dilutive, and it is also more cost-efficient because it is tax deductible where equity is not.”

Additional tier one capital will be banks’ immediate focus, but it is only one part of the story. Under CRD IV, banks will also have to hold a 2% buffer of tier two capital, or subordinated debt.

Rather than incorporating contractual write down or conversion language, tier two debt will be subject to point of non-viability loss absorption under the incoming RRD. To be counted as tier two under the CRD, it must have a maturity of at least five years and pay non-deferrable coupons.

The CRD package also discourages banks from issuing callable tier two debt with a step-up coupon after the first call date. Step-up coupons are seen as giving banks an artificial incentive to call their instruments no matter what, when calls, theoretically, should be made on an economic basis.

Tier two debt also acts as a host instrument for Cocos. These will be an important form of capital for banks in certain jurisdictions, such as the UK, Denmark, Switzerland and possibly Sweden. The Danes are yet to come up with their debut Coco, but Switzerland and the UK have been at the vanguard of this new and exciting product.

In the precise use of the term, Coco stands for contingent convertible. If it is convertible to equity, CRD-compliant additional tier one capital is also a form of contingent convertible — it converts once the issuer breaches a 5.125% capital ratio trigger.

But the term “Coco” has become a catch-all for any form of loss-absorbing capital that incorporates a loss absorbing feature based on a certain trigger. But Cocos are generally intended to fill a regulatory capital buffer other than AT1. That buffer is generally the pillar two capital buffer, which is implemented on a national basis.

These Cocos generally have a tier two host structure, although some early deals took a different tack, such as Rabobank’s senior subordinated notes or Lloyds’ equity capital notes. 

Issuance of these structures is ad hoc, as they generally respond to a specific regulatory concern and as a consequence are designed bilaterally with the relevant national supervisor. As a result, the potential Coco market is somewhat disparate — but it is developing.

Swiss banks are required to hold a 9% Coco buffer on top of their 10% common equity tier one ratio. Two-thirds of that must have a high trigger, and the rest must have a lower trigger. 

Danish banks will most likely be able to issue Cocos to count towards their pillar two capital buffers, and UK banks already know they can do so, because Barclays had its two 7% trigger Coco trades signed off by the Prudential Regulatory Authority.

Andrew Bailey, the head of the PRA, said at the start of June that UK banks would soon reveal how they planned to make up the £25bn shortfall the Bank of England identified in the sector in March. 

Cocos were expected to fill the gap. But after Lloyds and Royal Bank of Scotland — the institutions which were expected to have the biggest contributions to the £25bn — publicly announced that they would fill their respective capital shortfalls through asset disposals and internal capital generation, those who had expected a slew of Cocos to hit the market fell quiet.

Still, banks have been busy preparing themselves. Lloyds, RBS and Barclays all asked for approval to issue new shares at their 2013 AGMs. That could facilitate Coco issuance as well as equity conversion additional tier one deals. 

“There has been a very active dialogue with UK issuers around Cocos,” says the head of FIG DCM at one London-based investment bank. “Given that the UK has really adopted contingent capital, Cocos are perhaps the lowest cost option to fill that capital shortage.”

Nordea and Swedbank have also obtained approval for share issuance, and the Swedish regulator is looking into how Cocos could feature in banks’ capital structures.

Banks can also use loss absorbing capital to improve their ratings. Specifically, Standard & Poor’s counts some types of capital as risk-adjusted capital (RAC), counting a portion of such deals as equity when it considers a bank’s capital for its rating methodology.

Before March 2013, S&P was counting tier two debt — subject to certain minimum criteria — as RAC compliant. Danske Bank and Société Générale both printed such deals, and were told they would get the ratings boost.

But S&P has since announced it will  no longer count tier two debt as RAC-compliant, and it will not grandfather deals it had previously given that credit to. 

Now only additional tier one capital will count towards the RAC ratio. That leaves issuers affected by the change in methodology with two options, says Krim at Morgan Stanley.

“Generally, issuers will have paid up a little to make your tier two structure RAC-compliant,” he says. One reason that a bank may be happy to do that is if the deal gives it access to a new investor base, as Société Générale and Danske Bank found when tapping the Reg S dollar market for their deals.

“Or you make the bond RAC-compliant, either by amending the terms or by offering holders the option to flip into a new RAC-compliant tier one security,” Krim adds. “That option is always on the table, but to do that you need to have an additional tier one product available. 

“Yes, it is frustrating to lose ratings agency recognition for a bond you specially designed for that purpose. But at the end of the day, the prime reason banks issue capital is for regulatory reasons, not for rating agencies; and in the RAC context it is one agency out of the three that usually rate these institutions.”