To see the digital version of this report, please click here.
To purchase printed copies or a PDF of this report, please email gloria.balbastro@thomsonreuters.com.
Dominique Jooris, Goldman Sachs:You’re absolutely right on that point. The Lehman case was in an environment where all banks were leveraging their equity 30 or 40 times. The numbers were staggering, and the smallest disturbance indiscriminately wiped out every tier of the capital structure. Nevertheless, the theoretical argument is that these cataclysmic events are unlikely to be quantifiable.
Bryan Collins, Fidelity:And then there’s the potential for some of these instruments to be called back at par if there are regulatory changes. It just defeats the purpose from an investors’ perspective. You’ve got equity-like downside during periods of stress, no additional compensation, and your upside – if any – is completely capped. In those sorts of situations those benefits of what are inherently over-engineered instruments become quite diminished. If it’s not going to be economic, perhaps it’s going to become a bespoke subset of what is already a pretty complicated market.
Sumit Bhandari, BlackRock:In my judgement, the reasons for offering a premium may not be just limited to fundamentally what happens in periods of distress. As an investor, if you’re buying the security, you don’t know who the buyer base is for it exactly right now, or how it will behave in times of market volatility. The very fact that you know all that going in means you have to require a premium because you know it will suffer more in a selloff. From that point of view, if you look at the security itself, people are going to require a higher premium, notwithstanding some of the fundamental reasons you mentioned.
Ben Sy, JP Morgan Private Bank:Just for the complexity you should compensate the investor more. All the European and Asian T1 instruments are different, and you’ve got to spend a lot of time to find out what is different and what is the situation in each case. We’re concerned about the complexity. The whole sector has become so complex, I doubt anyone can really understand those products, especially if you go to retail. Even the professionals find it harder to understand.
David Lai, Eastspring:I think there is some difference between the situation we’re facing and the Lehman case. There you’re talking about bankruptcy. As an investor in debt or equity you always have to assess your downside in case of bankruptcy. We think about where we rank in the capital structure in a bankruptcy, and the likelihood of that happening, and then think of the potential loss and price the securities in the market appropriately. That’s in the case of bankruptcy, where we have ways to assess that kind of risk.
But in the new regime the difference is that all this bail-in language is to avoid bankruptcy in the first place. So at the point of non-viability or at the point these hard triggers are activated and the bondholders have to suffer losses – especially in the case of permanent writedowns – there’s no guarantee that the equity holders will be written off at that moment. In that case it seems the bondholders are not ranked senior to equity holders, as they would be in a bankruptcy. And in some cases T2 investors may not be ranked higher than T1 either because they all have to suffer losses. So in this case it’s a bit different from a bankruptcy case and I think bondholders should be compensated for that kind of uncertainty in the new regime.
Sean McNelis, HSBC: Maybe a few points on that. To Brian’s point about some of these instruments being over-engineered, the PONV [point of non-viability] language that we need to include is set out by Basel and gives the regulatory authorities significant power and wide discretion, but unfortunately there’s nothing we can do about the language because it’s stipulated at an international level.
There are some things we can do in terms of making the instruments better for investors and more marketable. What you’ll have seen, with APRA [Australian Prudential Regulation Authority] for example, is that banks are permitted to have T2 PONV kicking in after AT1 PONV, so basically this is relevant for banks that do a lot of hybrid T1s, since they would be written off first before any losses are imposed on the T2 bonds. This isn’t set out as a requirement in the regulations but if banks choose to do so they can have their T2 be senior to AT1 in terms of non-viability determinations.
The second thing, and we were talking about it earlier, is that most of the transactions have been writedown or writeoff structures with no reinstatement, and very few have been conversion to equity. Credit Suisse did the first CoCos with conversion to equity and Macquarie used the conversion to equity in their T1. One of the factors for state-controlled banks, where there is limited appetite for equity conversion that would lead to dilution, is a write-up T1. This is certainly something we’ve been speaking about to regulators like the CBRC. It’s very relevant for banks that are not going to be able to use conversion to equity to allow them to use reinstatement.
To date, only one regulator in Asia has permitted reinstatement – the RBI in India. Basically once the bank starts paying dividends again the AT1 that had been written down can be written back up, subject to a number of conditions, so I would expect that, when we see Indian bank AT1, you will see that type of structure. Those are some of the tweaks you are likely to see in the next six months for some of the transactions coming out of Asia. I would caution though that no regulator that I’m aware of has permitted write-ups in AT1 other than the RBI. APRA has specifically disallowed it, but other regulators are still considering it.
Jonathan Cornish, Fitch Ratings:HKMA [Hong Kong Monetary Authority] are not very keen on it.
Bryan Collins, Fidelity:Interestingly, for HKMA, there’s the idea that you have the point of non-viability to be dictated by HKMA or CBRC for Hong Kong entities of Chinese banks. That’s “or”, not “and”. I appreciate the complexity is derived from the regulatory environment – it’s not just for fun – but those sort of additional layers of competing regulatory bodies in the case of CBRC and HKMA makes those sort of moral hazard and high-level game theories even more complex.
Jonathan Cornish, Fitch Ratings:I think you’ll probably only get both regulators involved in assessing whether a bank has hit the point of non-viability when it’s a Hong Kong subsidiary issuing what will qualify as capital for its parent. If it’s only capital for the subsidiary then the HKMA itself would have the sole discretion to make that call.
Sean McNelis, HSBC: That is correct. If you look at ICBC Asia’s 2011 transaction they elected solely for Hong Kong capital and not for the parent. In that case, if they had wanted to get consolidated capital, they would have needed to have a CBRC trigger as well. The recent ICBC (Asia) US dollar Tier 2 incorporated a dual trigger, referencing both the Hong Kong and the home authorities of the parent, allowing for both solo and consolidated capital.
Jonathan Cornish, Fitch Ratings:What we’re looking at, to pick up on a couple of points that Dominique mentioned earlier, given that the volume of issuance at an institutional level is not going to be that significant in Asia Pacific, we’ll probably see a fairly stark contrast in the level of buffers put in place between Asia and Europe. We generally expect buffers to be quite significant in Europe – and in some cases sufficiently so that it might even provide for uplift to the banks’ senior debt – but in Asia they will be fairly thin. So if we do have a spectacular failure then you probably are going to have to wipe out everything.
The second point I wanted to make, is that it is very difficult for us as an agency to consider whether or not support needs to be factored in. I think we will probably not consider support for T1, it’s just debatable whether or not T2 would see support. In that regard when I talk to regulators around the region about their tolerance in terms of bail-in and losses being imposed, their initial response is they just want to make sure there is stability in the banking system. That is very significant in certain jurisdictions, probably none more so than in China given that the banks pretty much all engage in the same activity. If the CBRC were to call one of the large state banks non-viable I think the risk of contagion would be very significant.
IFR: We’ve noticed that in some jurisdictions there seems to be a big difference in rating treatment on local scales versus the international one. Indian T2, for instance, tends to come flat to senior. What’s the rationale for that?
Jonathan Cornish, Fitch Ratings: I think with regards to India it is very much the local agencies’ practice. The logic is that there is no difference in terms of recovery prospects anywhere along the capital structure. It is such a debtor-friendly environment in India that it doesn’t really matter if you’re talking about something close to equity, or senior or secured debt. We rate on a national basis in Indonesia, Thailand, Taiwan, and I think in those instances the approach we would take for rating issuance in local currency would be consistent with the international ratings – that they would essentially be mapped off local currency equivalent ratings. You might have a little bit more differentiation between issuers because the highest rating in any of those jurisdictions will be Triple A on a national scale, but it might be Triple B minus or Double B plus on the international scale.
Desmond Lee, Morgan Stanley: It goes back to the point about the home bias. If you’re a major government-owned bank in Malaysia selling an instrument to a local currency market, the local investors will buy with limited pick-up over old-style bonds. They clearly don’t think the government is going to impose losses on a government-controlled bank. The investors in India may look at the T2 debt from a government-owned bank and think the recovery prospects are the same, whereas, if you’re an international investor, you may take a European lens and look at it rather differently.
I agree with what Jon was saying before – many Asian banks carry more systemic importance, given that many are owned by the government and many have policy roles. For these banks, the point of non-viability would be imposed probably only under extreme situations. The definitions of that point of non-viability language in some Asian countries are actually closer to liquidation than western standards, and Basel is not going to force every regulator in Asia to follow the same point of non-viability definition. If their banking sector is state-owned and the sub debt outstanding is too small to generate much economic savings, would they really want to impose losses? Probably they would rather want to forgo that and preserve confidence in the banking sector.
That all means there will be bifurcation: the larger, systemically important, banks will trade in a different universe compared to the smaller, private-sector banks where you may get double-digit yields. Our view is that for the big public-sector banks these Basel III securities maybe should trade closer to the old-style securities. But when you’re talking about a smaller private-sector bank where there is limited systemic importance those should be trading more like high-yield.
Bryan Collins, Fidelity:I think your point about the different investor bases and different motivations is a really important one. It’s the technical nature of Asian markets, full stop. Currency, secondary market liquidity, mark-to-market volatility, all these issues are important. People can hold things for different motivations. I think that’s really important. Depending on how it’s placed or targeted, the nature or the investor base is going to play a really important role in terms of how something is priced and how it performs in the secondary market.
It points to one of those big-picture issues that have been around since the beginning of the Basel III negations. That is, all this points to the strong banks having access to capital at relatively affordable levels. The strong get conceptually stronger, while for the weak, marginal banks that cost gets much more punitive and it becomes much more difficult for them to access capital. That bifurcation of the market is a real risk and one of those unintended consequences.
Sean McNelis, HSBC: On the point about state-controlled banks and PONV, if you look at the Banco do Brasil T1 deals there’s actually a carve-out for ordinary government support, and you may see something similar in India in the short-term. Obviously we’d prefer to include that language as a carve-out in the terms and conditions but, of course, while the Brazilian regulator allowed for it, not every regulator may do so. Where it can be included it should give more comfort to investors that ordinary injections do not constitute a NVLA event, though of course even if you include that language you will have the argument of what is in the ordinary course of events.
On the local agencies, I think TRIS Rating in Thailand and RAM Ratings in Malaysia have been basically notching these in line with old-style instruments. If you look at what they say, for instance, on the CIMB transaction, RAM views the likelihood of the bank being non-viable as already sufficiently reflected in its long-term financial institution rating. They’re essentially equating it to a liquidation scenario, as already an existing risk. Clearly S&P, Moody’s and Fitch take a very different view and will notch both T1 and T2 off the standalone rating. So, even for T2, where there is contractual NVLA, it will end up being two to three notches below the issuer’s standalone rating, and T1 four to five notches down.
IFR: After the Lehman example, I’d like to propose an alternative, the SNS Reaal scenario, where it becomes clear to regulators that they can impose a bail-in and not undermine the financial system. Do you think we could see that here in Asia?
Bryan Collins, Fidelity: I can’t say I’m an expert on it, but that’s an especially dangerous situation to be in. What I would say is that it all took place after a period of extreme crisis and in a political environment where there is extreme animosity towards banks, to government support of banks and to the financial industry in general. Within a regulatory environment that is arguably a little more palatable, to see that first-off here in Asia, before we have some of the other scenarios play out, I think that’s an outside prospect.
Jonathan Cornish, Fitch Ratings:It comes down to the magnitude of cushion for these instruments as to whether or not it’s going to be effective. In theory, under our criteria, partial writedowns are only notched once, for loss severity, but our starting case for a full writedown would be two. But in practice it really comes down to what is likely to happen. And I think the cushions that the banks currently have in place are insufficient to expect that an instrument would only be partially written down.
IFR: What are the attitudes then to some of these new structures coming out of Europe? There are new deals coming out from Societe Generale with a write-down, write-up, and there’s one out at the moment for Credit Agricole that look very different to anything we’ve seen here so far.
Sean McNelis, HSBC: Credit Agricole’s is a 20 non-call five T2, but it’s also got a trigger that it gets written down if the Core Equity T1 ratio breaches 7%. That allows the Tier 2 to get equity recognition under S&P’s methodology. Under Basel III you’re not allowed to have rating agency early-redemption events before the first call date, only for regulatory or tax reasons, so what they’ve done is something we used on Chong Hing Bank a few years ago. If it’s no longer compliant with S&P’s methodology they don’t have an early call but they can actually remove that 7% writedown trigger and reduce the coupon – it’s a step-down event. You may see more of those to address evolving rating agency regimes. Where in the corporate world we’re able to include early-redemption rights for such an event, in bank capital under Basel III you can no longer do that.
IFR: That does mean that an investor goes into that transaction not knowing what coupon they will be getting for the life of the bond.
Sean McNelis, HSBC: Well, the issuer will be paying a reasonably significant premium to get that S&P equity credit, even though it looks like a vanilla T2. S&P did change their risk-adjusted capital [“RAC”] methodology in respect to some previous 2012 transactions – Danske, Gazprombank, SocGen did three of these RAC-compliant transactions last year – so if S&P were to do so again, Credit Agricole wants to have a way to avoid paying such a high coupon for something that is otherwise just vanilla T2.
Bryan Collins, Fidelity:Is this next iteration of instruments coming up because it seems like a good idea to circumvent some investor concerns, or because, for right or wrong, investors are already full on them? What’s the justification?
Sean McNelis, HSBC: The drivers in Europe are very different. I would think in Asia you’re going to see issuers structuring largely for pillar one regulations. They’ll do 10 non-call fives with NVLA for T2, and T1 will be perp non-call five with NVLA and a numeric trigger where it’s required. What you’ve seen some others doing are CoCos, where they’re actually getting contingent equity. That’s not required under the regulatory regime but they see a benefit in paying a premium to get equity should their core equity T1 ratio ever fall below, say, 7%. It’s almost like an insurance policy on their capital position, and they’re paying a premium for that.
European banks will continue to issue those kinds of CoCo instruments, but we certainly haven’t felt there is a huge demand for that type of capital from Asian banks. In terms of Asian issuance, I would expect it will be more focused on the T1 and T2 regulations.
Bryan Collins, Fidelity:To your earlier question, the addition of another layer of complexity and different triggers at different institutions I don’t think is helpful. The European market is large and sophisticated, so it’s quite efficient at being able to mark these at least in the secondary market whether or not they are mispriced in primary. From an investors’ perspective it does reduce your incentive to participate in the primary market because there’s a good chance the market will sort it out in secondary. The big picture here is that you’re moving further and further away from actually determining if XYZ bank is a good institution, and making these assumptions on rating agencies, secondary-market technicals and issues around the jurisdiction and the regulatory body. So, you’re moving further away from fundamental research to sort of tea-leaf reading about what various parties may be thinking. That detracts from the process.
Dominique Jooris, Goldman Sachs:I would maybe take the mirror argument. Ultimately, you look at these instruments as having been issued by a known financial institution with its own rating. What you’re looking at are the nuts and bolts of how the instruments have been structured. These instruments have evolved with rating agency treatment, regulators’ views, market appetite and tax analysis, and ultimately there is a degree of stabilisation in the secondary market because the thought leaders are able to trade the securities to where they like it. It’s not so much a market driven by fundamentals, but one where technical expertise is important, and the better analysts will be able to make outsized returns.
We’ve been discussing the difference between Basel II and Basel III securities and the migration of old securities into Basel III because of the resolution regime. I think we have to take a step back and consider the premium over senior bank debt. Do, I as an investor, have enough firepower to really understand these securities? You make a valid point about the early redemption clauses that effectively pull the spread rug from under your feet, and these instruments are going to have more volatility than senior bank debt. All of these need to be priced in. But there will be some arbitrage, some situations where the value of these securities over senior debt far exceeds the sum of the risks there.
Bryan Collins, Fidelity:From an active investor’s perspective, I would totally agree that you can then come in and overlay your expertise and sort the wheat from the chaff. Does it make them good instruments? That’s debatable. Does it make the risk-return on these instruments attractive for our investors? That’s also debatable. The more complex it gets, the more resources you have to put out, and if I’m dedicating a disproportionate amount of my time to understanding the fine print within these instruments to get 30bp pick-up, it’s debatable whether that additional value for money is there.
In a primary market perspective I have to ask the question: what incentive do I have to participate in an untested market with an untested instrument, differing language, and am I getting that premium? With the premiums on the securities that we have seen to date, that risk-return analysis is a challenged one.
IFR: Let’s bring Singapore in on that point. How do you decide whether these securities are worth your time?
Sumit Bhandari, BlackRock: I think this goes back to the earlier comments I made on price discovery. For institutional investors such as ourselves, what premium are we going to require for our investors? I totally agree with the comment that right now it’s insufficient because they are retail-targeted instruments with a home bias, and investors there tend to think that a UOB is well-capitalised and regulators are never going to impose losses on these instruments. We agree, at the moment, that where they are being priced is so far away from the zip code of what institutional investors, who have done their credit work and understand under what circumstances these instruments would bear a loss, would price them. We have not been involved in these so far.
David Lai, Eastspring:I agree that the complexity and uncertainty of these instruments is not very appealing to us at this moment, but going forward I think you will also see a bifurcation of the market. For the very strong banks I guess investors may not require a very big premium for these new instruments, because the chances that they will be bailed-in are very low, but for lower-tier banks the market will require more premium depending on the specific structure of the bond we are talking about. I think that will be the trend going forward.
Sean McNelis, HSBC: One of the concerns we hear, and we certainly make Asian banks aware of, is the potential glut of supply coming out of Europe into the Asian investor base – especially into the private banks. I’m interested to hear Ben’s views on this.
Ben Sy, JP Morgan Private Bank: I think three years ago, private banks were certainly big buyers for those European bank T1s. But there has been a big shift in the last 12 months. If you look at the recent deal from SocGen, I heard that Asian private banks only got 10% allocation. European T1 is becoming a more institutional market, and I think that’s a trend going forward.
To continue reading this roundtable, click the relevant section. Foreword - Participants - Part 1 - Part 2 - Part 3
