The European Banking Authority has said that it discourages banks from issuing so-called Risk Adjusted Capital (RAC) Tier 2s, likely spelling the end of issuance of the rare instrument tailored to derive rating agency equity credit.
Few RAC Tier 2s remain outstanding after a spate of deals issued between 2012 and 2014 have mostly redeemed. That left French issuer BPCE as the most prominent - and most recent - issuer in the space, with the bank having raised €1.75bn of RAC Tier 2 capital in a two-part transaction in October 2021. Fellow French lender My Money Group was the first to revive the format earlier in 2021, printing a €100m 20.25 non-call 5.25 transaction in July of that year.
While traditional bank Tier 2 instruments are aimed at meeting issuers' regulatory requirements, RAC Tier 2s are designed to also receive intermediate equity credit from S&P until their first call date and improve the issuer's RAC ratio, a measure specifically used by the rating agency.
Such instruments have - unlike standard Tier 2s and more like Additional Tier 1 bonds - generally been structured with principal write-downs triggered if the issuer's Common Equity Tier 1 ratio falls below 7%, in order to qualify as contingent capital under S&P's criteria. The bonds have also featured "rating methodology events", leading to a step-down in the coupon if the bond loses equity credit ahead of the first call.
In a report published last Friday, the EBA spelled out its opposition to RAC Tier 2s - also referred to as Tier 2 CoCos. The EBA stated that issuers should avoid links between a credit rating and payments in the terms of conditions of their capital instruments.
The regulatory agency said that "rating methodology events, which are triggered by an instrument no longer being recognised under a specific rating methodology due to a change applied by the rating agency, causing a subsequent trigger event and a reduction of the interest to be paid, need to be carefully assessed on a case-by-case basis as these events could conflict with various eligibility criteria", including by creating a potential incentive to redeem.
The EBA also said that call options linked to rating events conflict with various eligibility criteria under the EU's Capital Requirements Regulation.
It concludes that such features "pose risks in terms of the eligibility of the instruments and, therefore, the EBA discourages the use of these instruments".
Bankers said the recommendations likely spell the end of European banks' RAC Tier 2 issuance. They said the EBA had been expected to take such a stance, particularly after the rescue of Credit Suisse by UBS drew attention to the product's treatment when a bank runs into trouble. Credit Suisse's US$2.5bn Tier 2 CoCo - which will mature on August 8 - was not written down as part of the bank's rescue, unlike its AT1s, despite featuring a 7% write-down trigger and similar viability event language.
"After the CS situation, the whole argument about low trigger Tier 2 instruments was brought to the fore, and that gave the EBA more ammunition to come out against this structure," said a capital solutions banker.
The banker said the EBA had taken a pragmatic stance by discouraging further issuance while not disqualifying existing bonds as Tier 2 capital.
Eligibility unchanged
As for bonds outstanding, BPCE's RAC Tier 2s do not feature a call option linked to a rating event. They do, however, feature a 25bp coupon step-down, triggered if a change to S&P's methodology results in a material reduction of the bonds' equity content ahead of the first reset date.
Francois Courtois, global head of financial communication, investor relations, rating agencies & short-term treasury sales at BPCE, said the EBA's recommendations are a "non-event" for the issuer as it already had no plans to issue further RAC Tier 2s.
He said the instruments were issued specifically to boost BPCE's RAC ratio, which had fallen below 10% at the end of 2020, as BPCE carried out a public tender offer on shares of Natixis, its subsidiary. He noted the RAC ratio is now above 10% and the bank is confident it will stay above that threshold.
Courtois said the EBA's recommendations do not affect the bonds' subordination or Tier 2 eligibility and said BPCE does not have any information regarding potential changes to S&P's methodology that would affect their equity content.
The EBA's recommendations prompted some market participants to speculate that BPCE is now more likely to call its RAC Tier 2s at their first call dates - albeit while noting the instruments would have lost RAC eligibility after the call date regardless.
Courtois said BPCE could not comment on the likelihood that it will call the bonds, except to say that its policy on call decisions will be unchanged.
The bank's €900m 1.5% January 2042 non-call 2026 note was trading at a cash price of 85.50 on Monday, up from 84.90 on Friday, while its €850m 2.125% October 2046 non-call 2031 note was trading at 72.10, up from 71.70.