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IFR: Is that because people are trying to cap private bank allocations now, or just because of demand?
Ben Sy, JP Morgan Private Bank: No, the order sizes are much smaller now. In the first deals, such as Rabobank’s T1 in early 2011 at 8.375%, there were large orders from Asia. But in the last 12 months, because of regulatory changes and because of the increasing complexity of the instruments, we’re concerned the clients may not fully understand them, or that they may not match their risk profile. That’s a key issue now.
Bryan Collins, Fidelity:So it sounds like it’s not just to do with reduced investor appetite but also it’s because of your actual ability to sell on these securities.
Ben Sy, JP Morgan Private Bank:I think private banks take a more conservative approach now. At the time of the Rabo deal, the regulatory environments were very different. We now have deals with a complete writedown, and some of the T1 can be worse than equity because it can write down the principal to zero when equity, in theory, is still there, so we have started to become concerned whether the clients understand these kinds of features. The regulators are also looking at that, and we’ve become more conservative this year. Only certain clients can buy – most clients will be out of the risk profile. I believe most private banks are taking a more cautious approach in the selling process, so that affects the demand.
Desmond Lee, Morgan Stanley:How much leverage can the private banks provide on Basel III securities?
Ben Sy, JP Morgan Private Bank:I’ve heard some PBs have reduced the leverage to zero for those with contractual writedown. We are more concerned that the product risk level matches the client’s risk profile and the increasing complexity for loss-absorption features, but some banks take a different approach. Some give zero loan-to-value [LV] to the new CoCos; some banks give the LV based on the rating – both of those are happening. Asian clients have historically tended to be the big buyers for the more risky, higher-yielding instruments, but now we go for more corporate hybrids or insurance hybrids that tend to be simpler, come without triggers and tend to have cumulative coupons.
Valuing the new CoCos is like valuing a piece of art, changing all the time. If the rating agency changes equity treatment or regulatory par call events occur, a bond price may drop from 110 to 103 That increases the complexity and can cap the upside in the future. The bond may never trade at 120 because there will be a regulatory call at par before that. The sector is so complicated and is getting increasingly complicated, so now we’re moving more towards those simpler T2 or corporate hybrids.
Desmond Lee, Morgan Stanley:In terms of selling these new securities, do you look at pricing to the maturity date now or do you even talk about the call date anymore? Obviously under Basel III you’re not supposed to give the impression you are committed to a call, but that will be cheaper from the issuer’s point of view.
Sean McNelis, HSBC:With the T2s we’re able to include the rate reset and if a 10 non-call five, for example, is not called it loses 20% of the capital credit per annum in the last five years. There have been a few examples of non-calls – including Deutsche Bank back in 2009 – but, in general, banks have been calling callable Tier 2s. That amortisation continues under the new regime. Certainly the issuers can make no representation that they will call the bond, that’s not permitted, but they do tend to trade to the first call date.
With the new T1s, there are no step-ups anymore and there is no amortisation, so that muddies the water in terms of whether they will get called. What UOB elected to do was to include rate resets rather than a fixed coupon for life as was previously more common in the Sing dollar market, and that choice reflected feedback from investors that interest rate risk is at the forefront right now. A structure where the coupon resets, say, every five years to the new SOR [swap offer rate] plus the initial credit spread removes the rate risk for investors to a large degree. You can argue about whether they or not trade to the call date – in reality they tend to trade on a yield basis rather than to the first call.
If you look at Basel language it says a bank may replace these securities at the call date but only on terms that are not prejudicial to the issuer. So, if a bank was looking to refinance, say, in five years time, and a new issue would be substantially more expensive, then they may not get approval to do so. That could be more of an issue in those fixed-for-life structures rather than with rate resets, but as an investor you have to be aware of the rules on replacements.
Dominique Jooris, Goldman Sachs:The first perpetual securities we are talking about were issued in 1998. We always bullet-proof these securities with features that should make them resist the test of regulatory and rating agency changes, but the truth is most of these securities are being called at their first call date – barring catastrophic events – because they don’t meet the new regulatory requirements. We’re all relatively young around this table but trust me, there is a Basel IV coming.
In other words, investors can get perpetual credit spreads for what, in practice, is never going to be perpetual, if they can avoid the interest rate risk through reset structures. I can’t think of any instrument issued 15 years ago that is still compliant with rating or regulatory criteria. If you think of 15 years as your cap for perpetuity, that gives you a decent arbitrage in spreads.
Bryan Collins, Fidelity:That’s a very fair point. All of those instruments, however, have been through hell and high water between then and now, and we’re also in an environment where – regardless of rate resets – the cost of capital has come down in that time for pretty much all instruments, corporate and financials. That may not be the case in years to come. It’s not just interest rate resets, there needs to be some provision for credit as well, as the credit quality of an institution may change whether the five-year Treasury moves or not.
Dominique Jooris, Goldman Sachs:We can’t lose track of the fact that this is close to a zero-sum game. As we put more credit onus on these T1 and T2 instruments, over time we make the senior materially safer. So if you have a fixed volume of money to invest into banks, it’s a zero sum: we are making the senior a bit safer – and Jonathan you were about to upgrade some of the senior ratings due to the new capitalisation rules – and certain investors can take a more credit-intensive exposure to some of the capital instruments. Ultimately, the risk in the system is spread differently, but is still intact.
Sean McNelis, HSBC:Just to allude to Dominique’s point on Basel IV, I fundamentally agree. I think Basel IV is probably already starting, and where it appears to be going is that the whole concept of bail-in becomes a lot wider than just capital. The crisis management directive in Europe does involve senior debt – on Cyprus, we saw even depositors involved – and provides for a write-off all the way up to senior. I think what we’re going to see in Europe over the next three to five years is the concept of bail-in senior or sub, but it won’t simply be regulatory capital. Similar to the Tier 3 of the past, you could have a two-year or three-year security, whether it’s senior or subordinated is largely irrelevant – it’ll have a trigger element where it’ll be written off at the point of non-viability. Regulators are starting to push the idea that banks might hold 3%–5% of RWAs in this form of bail-in senior debt that would get hit before other senior bondholders. This would obviously enhance the senior bond rating and also depositor protection.
Bryan Collins, Fidelity:On that point of making the senior stronger, I completely agree. It makes the system stronger. At the end of the day the investors that are at the forefront of regulators’ mind are the governments, the taxpayers and also the depositors. So, for any kind of investors below a depositor, we know it is going to involve risk.
Dominique Jooris, Goldman Sachs:My point was a positive one for investors without being a negative one for regulators. As they try to adjust the system to reflect the real risks, they will have to progressively discount some securities. I’m referring to the notion of perpetual risk.
Bryan Collins, Fidelity:And from an investors’ perspective, if your perspective is simply that XYZ bank is never going to get in trouble, so I’ll just buy whatever, the changing nature of those riskier instruments adds complexity – they are becoming incrementally more risky. That is an issue that can really only be addressed through investor education.
Dominique Jooris, Goldman Sachs:The current funnel approach to how old Basel II instruments are grandfathered, but effectively phased out, is an incentive for a bank on a portfolio basis to manage that down. Some features will be a disadvantage to new issues and others will be a disadvantage to existing holders, and I’m sure you can find a number of combinations there.
IFR: There’s also some restriction here in Asia on the kind of investors who can get involved in these kinds of securities.
Sean McNelis, HSBC: Absolutely. The Thai SEC, for one, is very focused on it. They have historically limited who can sell to insurance companies – one of the issues with these securities is that, if a banking regulator makes a determination of non-viability on a bank, it could create a solvency crisis elsewhere. I think they are also worried about mis-selling to retail, as a non-viability determination could cause problems with the general public, so regulators in general prefer these instruments to be distributed internationally, not just to their local investor base.
Bryan Collins, Fidelity:Even little things, such as letting these sorts of instruments trade on the stock exchange, send an amazing signal to an investor that this is not a bank deposit, this is an equity-like investment. In the case of Australia a lot of those instruments are executed only on the ASX, and I think that goes a long way to changing people’s perspective about risk. Whether or not they read the documents, of course, is another matter.
Jonathan Cornish, Fitch Ratings:In Australia if they’re going to be issued to a retail investor base they’re going to be unrated because none of the agencies are licensed to rate for retail.
Desmond Lee, Morgan Stanley:It’s just a bit worrying. If you’re talking about most of this bank capital being issued in local currency, then how is that risk going to be dispersed outside of the borders?
Sean McNelis, HSBC: I don’t think most of it will be raised domestically, certainly over time. If you look at the Malaysian and Indian transactions that have gone through, they’re quite small. Beyond Singapore dollars – and, to some extent, the ringgit market – those markets are not as deep. For banks that want size they’ve always historically gone to the dollar market. Some of the Chinese banks have been using the offshore renminbi market – CNH – as they have a quota from the PBOC to do so. Those are the themes you could see in the future. Our view is that the local markets may offer the most attractive pricing, yes, but not the ability to issue in size.
IFR: One thing I’ve noticed is, even though regulators might be hesitating to give more clarity on the non-viability rules, the more active pipeline is in south-east asia. What’s driving that?
Sumit Bhandari, BlackRock: I think Hong Kong and Singapore, just given their status as financial hubs, are likely to give less clarity, not more, so I don’t think it’s that. We haven’t been playing in these deals at all just because we feel like the price discovery mechanism is still at a very early stage.
Sean McNelis, HSBC:OCBC did a Singapore dollar T1 last year and then there was the UOB T1 in July this year. Both were actually for refinancing. UOB had issued a perp non-call five in 2008 and basically they’ve now announced the redemption of that. For the Malaysian banks, they have T2 redemptions coming up, so I think in the short-term you can expect a lot of the issuance for refinancing.
Bryan Collins, Fidelity:I think for Australia it’s been getting the capital structure up to be Basel III-compliant well in advance, as well as quite a lot of refis of old-style dollar bonds.
David Lai, Eastspring:Could that be because of the private bank community in Singapore? The yields in Singapore dollar and Malaysian ringgit are very low so these kinds of instruments may be appealing even at discount pricing. In Hong Kong they can buy all kinds of things, Chinese property high-yield for example.
Bryan Collins, Fidelity:It’s a function of years of effort by the regulators to promote and develop the Singapore dollar market as well. The same probably could happen in the Hong Kong dollar market if it was a very specific one but I wouldn’t consider them equals.
Sean McNelis, HSBC:There is an institutional Hong Kong dollar market but in terms of PBs – and we’ve done a lot of work on this around perpetual and corporate hybrids – the thing you’ll hear is that high-net-worth people tend to hold their money in US dollars, and, because the exchange rate is basically fixed, there isn’t the same kind of currency play that you have in Sing dollars.
Ben Sy, JP Morgan Private Bank:I expect there is demand for CNH bonds but not Hong Kong dollars, because people hold most of their money in US dollars now. The Singapore dollar market is very technical, so we cannot use that as a benchmark. Most of the bonds in Singapore look very expensive relative to US dollars, and a lot are unrated. It’s the nature of the market. Everything is tighter because there is strong liquidity and nothing to buy.
One thing that we haven’t touched on is the US banks issuing preferred stock. Now the banks are issuing preferred stock, which is simple, non-cumulative, and has no writedown. They have issued quite a lot this year, but in Europe and Asia we don’t get that kind of product. Does anyone have any comment on that?
Sean McNelis, HSBC:Just to be clear the US Fed has ruled out the trust preferred instrument, which they were able to use in the past. Why aren’t Asian banks using preferred stock? Basel III fully allows subordinated debt as opposed to a preference share, so where the legal framework allows it you’re likely to see that. Tax deductibility is the biggest point but other considerations, like corporate approvals, are among the secondary concerns, since a preference share is legally a share.
Jonathan Cornish, Fitch Ratings:I think one of the markets where prefs have been more popular is Japan. The government subscribed to prefs when they bailed out the megabanks quite some time ago. That might be a market, but we’ve not really heard much anywhere else.
Sumit Bhandari, BlackRock:Sean, correct me if I’m wrong but I thought part of the reason why in T1 there is this predefined capital trigger of 5.125% for equity treatment originally comes from this belief that in the US crisis the preferreds basically acted as a pretty decent level of absorptive capital and effectively did their job.
Dominique Jooris, Goldman Sachs:I think it’s a little different. At the start of the crisis in Europe, there was misunderstanding as to what capital was loss-absorbing, and regulators took the better part of a year to come to grips with the fact that you could have liability-accounted perpetual bonds with some writedown features that were more efficient than preferred shares with equity-accounting. We’ve reached a point where a number of regulators have become more agnostic regarding the legal form of the instrument and are more focused on characteristics such as whether or not to allow for loss-absorption.
Sean McNelis, HSBC:I think that’s right. The Basel committee in late 2009 started focusing on the accounting position, and their view was that these hybrids needed to convert into equity or get written down to create equity in the balance sheet of the bank. They were largely agnostic as to whether it’s a writedown or a conversion that creates equity for a bank, saying that if the instrument is equity-accounted then it is already equity on the balance sheet so you don’t need to create new equity with a numeric writedown trigger.
In terms of structuring these instruments we can create something that is accounted as equity fairly easily. Some jurisdictions require more than accounting equity: the US is insisting on non-cumulative preference stock, and the EU is insisting that you need the 5.125% trigger in T1 regardless of whether it is debt or equity-accounted. Other jurisdictions in Asia Pacific have followed Basel but even within Asia the RBI in India and Bank Negara in Malaysia have looked at what the Europeans did and said, regardless of accounting form, we need this trigger that creates equity at a specific point in time.
Desmond Lee, Morgan Stanley:Just one last question from me in terms of rating and pricing. Do you foresee a case, maybe two or three years down the road, when people start to see that governments are still supportive of banks, that notching for government-supported banks in Asia should be lower than in Europe, where clearly regulators are a lot more harsh. And from a pricing perspective can Asian banks price tighter than everyone else in the world?
Jonathan Cornish, Fitch Ratings:Notching from a loss severity perspective won’t differ. As for performance, our starting point is our viability rating – that really is the best indication of viability and therefore non-performance – but, where we see the prospect for early intervention by the government we would expect to be notching from the support-driven rating. So in some jurisdictions you’re talking about a difference of multiple notches. But, regardless of whether you are in developing Asia or developed Europe, notching for performance won’t differ at all.
Dominique Jooris, Goldman Sachs:In terms of pricing, we need to remember that while European investors have gone through an immense amount of pain, investors in Asia were virtually unscathed during the crisis. If you combine that fact with the great domestic following, the natural buyer base here will keep spreads lower than it would on a relative basis in Europe. It’s a reflection of supply and demand. Think of the Chinese investor base, for instance, which has been starved of access to anything other than deposits. For a product like the AT1 that offers a significant step up in yield, the risk perception is that it is relatively safe but offers a significant amount of additional yield for the same umbrella exposure. This is the type of reaction we would have seen in Europe in 2006–07, but I think this will be the mindset until it is proven wrong.
Bryan Collins, Fidelity:I think, generally, you’re right on pricing. It may also help senior pricing relative to more developed markets more than it might in the sub space, in its various forms. Generally speaking there is a big domestic bid, and Asian institutions are seen as very well capitalised. Plus we haven’t had a major financial crisis for some time in Asia – in theory we’re probably the next one due, which might change things slightly. Asian institutions were very well capitalised compared to banks in Europe and the US, but after the latest round of adjustments they are now looking like the poorer cousins.
IFR: I think that brings us to a natural conclusion, but I’d like to end if I may with a prediction. Until we get to a point when we have benchmark deals out of Asia that trade at the right price, we are talking in a lot of hypotheticals. My question is how long will it take to get there?
Dominique Jooris, Goldman Sachs: I think within nine months.
Jonathan Cornish, Fitch Ratings: Maybe a little longer but that’s not far off the mark.
Desmond Lee, Morgan Stanley:Two years, maybe three until you get back to institutional investors being 50% or more of the allocations. Issuers are in no rush.
Sumit Bhandari, BlackRock:Perhaps in countries like Japan where there are a lot of refinancing needs, this price discovery could happen a little sooner, but otherwise 24 months or so.
David Lai, Eastspring:I won’t disagree. It will take some time for institutional investors to warm up to this new asset class.
Bryan Collins, Fidelity:To me this is more of an iterative process, and the European market is still constantly evolving. But as long as we’ve got a reasonable universe of securities from reasonably comparable institutions within the next 12 months, the market should be reasonably efficient at pricing them.
Sean McNelis, HSBC:I would differentiate between T1 and T2. I think the T2 market may take off more in even the next six months. We struggle with not having the right comparables, but as we see more and more issues we should have more clarity in terms of advising issuers by, say, April next year. For T1 I think it will be more like 18 months to two years.
Ben Sy, JP Morgan Private Bank:Two to three years for T1, probably one to two for T2. I think we’re more ready for T2.
IFR: Gentlemen, thank you all very much for your time.
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