No clear picture

Even in deposit-rich Asia, the introduction of Basel III rules is pressuring banks to boost capital. Regulators have given a cautious thumbs-up to loss-absorbing subordinated debt, but recent issuance in the region has failed to create a model for others to follow.

Major banks in Asia have weathered the credit crisis better than those in Europe and the US, allowing them to satisfy Basel III capital requirements with relative ease. Yet, as Asian economies grow and existing regulatory capital is redeemed and phased out, lenders in the region will need to raise billions of dollars to bolster their Tier 1 and Tier 2 ratios.

Despite the three Basel III-compliant trades already priced in Asia Pacific, bankers, analysts and issuers are still unsure just what shape the new regulatory capital securities will take under the new regime.

Starting next year, the Basel Committee on Banking Supervision will gradually implement new capital requirements, including a minimum common equity T1 ratio of 4.5% by 2015. Unlike when it drew up Basel II accords, this time the committee is focusing on quality of capital – not just level of capital. This means the types of regulatory-capital securities available to banks are also changing.

In major Asian financial markets, however, there is no specific legislation or regulatory framework that spells out the risks associated with the new kinds of securities the Basel accords endorse. So far, regulators have been consulted on a case-by-case basis and the deals that have priced have come with enough differences to confuse investors and confound other potential issuers.

Analysts say this is where regulators need to step in. Hong Kong, bound to be one of the most active markets for bank capital, is no exception.

“I think in Hong Kong and, generally, across Asia, if there were legal frameworks for bank resolution giving the authorities the ability to initiate statutory debt-equity conversions and notional write-downs, it would make it easier for new issuance,” said Sabine Bauer, director, financial institutions, at Fitch Ratings in Hong Kong.

As present, this is not the case. Issuers have had to spell out the risks for investors in deal documentation, in lieu of a more uniform list of caveats or regulations from local bank watchdogs.

“In the absence of such regulation, to achieve Basel III recognition, banks need to give that discretional power to their respective regulators on a trade-by-trade basis, such as by adding a non-viability clause to each specific trade’s documentation,” Bauer said.

Bad example

ICBC Asia did just that when it came to market with Asia’s first Basel III-compliant subordinated bond in any currency, in late last October. The Chinese bank priced a Rmb1.5bn (US$236m) offering of 10-year, non-call five Lower Tier 2 notes in the Dim Sum market.

The security satisfies Basel requirements because it forces investors to bear losses if the bank eats through other sources of capital. Essentially, it provides for, what is called, a bank “bail-in,” rather than bailout, where certain creditors’ positions are converted or wiped out. In bailouts, public funds would be used to make creditors whole or nearly whole.

According to the ICBC Asia bond documentation, the paper will be written down to zero, if the Hong Kong Monetary Authority rules the bank to be non-viable. That stricture allows the security to count towards regulatory capital, based on Hong Kong’s interpretation of the rules. The non-viability clause is triggered if the bank’s T1 capital decreases to 4.3%, or if public funds have to be injected in the event of a catastrophe.

ICBC Asia was able to achieve an enviable 6% coupon on the deal, despite the permanent write-down to zero. Earlier T1 contingent capital deals, such as that from Credit Suisse, had features allowing bonds to be converted into equity. Even though those deals prevent investors from immediately being wiped out, giving them equity in a struggling institution may, in effect, be little better.

However, critics of ICBC Asia’s trade point out that its small size and Dim Sum structure were responsible for much of the demand. At the time, investors were looking for ways to invest in renminbi-denominated securities, and the currency could have provided an allure that offset the other obvious risks related to viability triggers. As such, it is difficult to tell what features of the bond actually drove the demand and pricing.

In addition, state-owned ICBC enjoys an implicit guarantee from the Chinese government. It is unlikely that a Hong Kong regulator could deem a China-owned entity non-viable, without the blessing of the PRC itself.

“I’m not so sure ICBC Asia’s deal will be a blueprint for other bonds,” Bauer said. “The focus of Basel III’s higher capital requirements is on quality T1 capital and this was a subordinated bond, which only counts as supplementary capital. Also, it was denominated in renminbi and benefited from implied support from its Chinese parent. “

Fonts of demand

However, whatever the ultimate structure of continent capital trades in Asia, the region’s lenders have at least one important thing going for them – a robust base of private-banking investors keen to invest in new, potentially risky securities.

When it comes to callable bank bonds, private banks have picked up where traditional bond investors have left off.

“The most important implication of Basel III rules is that it will become even more difficult for traditional fixed-income investors to invest in T1 bank capital,” said one FIG-focused DCM banker. “Basel rules are making the bonds more and more equity-like. It’s worse for the issuer because it’s more expensive and, for fixed-income investors, they’re too risky.”

That is where Asia’s private banks come into the picture. In the past year or so, they have bought many of the higher-yielding and higher-risk securities on offer in Asia, while other investors have opted out. It is an ideal situation for banks in need of regulatory capital, because Asian private banks, for the most part, buy names they know, and they know Asian banks well.

“The major buyers for this stuff are Asian private banks,” the banker said. “So, when it comes to Asian issuers, you have the natural advantage of name recognition. They have the biggest market for the securities, so it will be easiest for them to issue. ”

In fact, London-based bankers said European banks would also look to Asian private banks to place contingent capital. Banks from two regions vying for the same investor base will create some friction.

“There will be competing supply, with deals coming to Asia from Europe, too,” a London-based syndicate banker said.

Form and function

Still, there is the question of how to structure these securities.

The first US dollar T1 deal compliant with Basel III in Asia Pacific came from Macquarie, in March. However, the bank bond struggled to clear the market, in part because of the way it was structured, critics of the deal said.

Macquarie’s US$250m hybrid T1 was only 1.5 times covered and ended up half the US$500m maximum target size. All that, and the deal printed at the wide end of the 10.00%–10.25% price guidance.

One of the gripes about the trade was that it was too complex: the securities convert into shares on both the upside and the downside. At the first call date, the bonds are mandatorily exchangeable into shares if the bank’s share price is above 50% of the level at the time of issue.

If the price is below 50%, the deal remains until the next call date six months hence. However, after 45 years the securities convert into shares. On the regulatory front, too, should Macquarie breach a 5.125% Core T1 ratio or be declared non-viable, a mandatory exchange will be triggered.

T2, not second rate

The market for T2 debt is a different category. Basel III accords allow banks to use certain existing subordinated debt towards T2 ratios, but that debt amortises at 10% a year over a decade. At that rate, banks will likely have to top up T2 exposure gradually.

Bankers and analysts expect T2 deals to be accessible to a wider variety of investors – and, therefore, easier to price.

“Compared to T1 perpetuals, for example, the yield on T2 debt with 10-maturity will be lower,” the FIG banker said. “But, at those yields, the bonds will be attractive to both institutional investors and private banks.”

In December, Nomura introduced another investor base into the mix – the retail side. The bank priced the first T2 deal from a Japanese firm, a ¥170bn (US$2.2bn) offering that included tranches tailored to retail and – much less so – institutional investors. Only ¥15.7bn went to institutions – the rest to retail investors.

Not that urgent

Any near-term concern for Asian banks, especially excluding Japan, may be overblown. The rapid growth in South-East Asia and China has meant that the region’s banks are well capitalised. There will be no rush to come to market.

Because the lenders have sufficient capital ratios, when they do decide to raise regulatory capital, investors will be even more willing to participate. It is easier to lend to a stronger borrower.

In addition, Asian bank executives may feel even less urgency to raise capital lately, owing to the slowing economic growth in the region. As revenue growth slows, so will the need for regulatory capital decrease. China’s GDP growth in the second quarter fell to 7.6%, its lowest level since the first quarter of 2009.

“The challenge is to increase regulatory capital in relation to growth,” said Naoko Nemoto, managing director of financial institutions ratings in Tokyo for S&P. “But, on that, things are changing. Growth is slowing, in China and in other parts of Asia.”

Indeed, for now, banks are flush with both capital and time.

“Banks have comfortable levels of capital, and they have taken the approach that they have more time,” an analyst said.