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The Future of Bank Capital | June 2013 | EUROWEEK 1

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02 overview A brave new world: bank capital redesigned

05 Keynote address, andrea enria, eBa The implications of the Single Supervisory Mechanism on European financial supervision

07 issuer roundtaBle Regulatory fog begins to clear but new challenges emerge

17 CaPital instruMents Choose your instruments

21 investor roundtaBle Cocos pose bank capital a trillion dollar question

30 the investor Base Demand goes global as Europe comes on stream

34 legal, regulatory and tax overview Beware of regulator discretion

38 MarKet outlooK Avant le déluge: looking forward to liquidity

41 Bail-in Bail-in: how does it affect bank capital?

Contents: the Future oF Bank Capital

Overview

2 EUROWEEK | June 2013 | The Future of Bank Capital

A new dAy has dawned in euro-pean banking. After years of wait-ing, banks are on the cusp of finally being able to issue a new breed of capital securities that are intend-ed to protect them — and society at large — from the catastrophes that befell not just individual lenders but entire countries during the finan-cial crisis.

The main missing pieces of the puzzle are the first pan-european Capital Requirements Regulation and the fourth Capital Requirements directive, which effectively transpose Basel III into european Union law.

They will be backed up by a raft of technical standards from the european Banking Authority (eBA), and form a solid foundation for the eU’s grand plan for banking union.

Under CRd IV, banks will be required to hold common equity tier one capital equal to 4.5% of their risk-weighted assets, supplemented by a 2.5% capital conservation buffer and another 2.5% for systemically important financial institutions.

That will take them to a 9.5% common equity tier one ratio. Sitting on top of that will be 1.5% of additional tier one capital —

replacing old-style hybrid tier one debt — and 2% of tier two capital, which will be similar to old-style tier two but subject to being bailed in under the incoming Crisis Management directive (CMd), often referred to as the Recovery and Resolution directive.

This amounts to a lot of new issuance. But the pieces are slowly coming together, and issuers and capital structurers are ready to usher in a new generation of capital instruments.

“we are basically just waiting for regulators,” says Khalid Krim, head of european capital solutions at Morgan Stanley. “The markets are supportive to a certain extent, and almost all the stars are now aligned. It’s time to move to the next stage.

“we have CRd IV, the CRR, and we also have the CMd coming in, which includes bail-in. So we have connectivity between the capital side and the funding side.”

Over the past couple of years, most european banks have focused on bolstering their core tier one capital ratios, through a mix of equity issuance, liability management exercises, asset disposals and retention of earnings.

now that most are comfortably

above the eBA’s 9% minimum core tier one ratios, and CRd IV has been finalised, issuers are turning their attention to total capital ratios — which includes additional tier one securities, tier two debt, and in some jurisdictions, contingent capital, otherwise known as Cocos.

Assuring functionalityAdditional tier one capital will incorporate triggers for loss-absorb-ing features such as temporary or permanent write-down, or conver-sion into equity, as well as coupon deferral.

estimates of potential supply of AT1 vary, but the consensus figure is around €250bn, based on assessments of the RwAs of europe’s 40 largest institutions. That could rise if banks use AT1 to satisfy leverage ratio requirements, which national regulators are still wrangling over. Cocos will also be seen in some jurisdictions, such as the UK, the nordic area and Switzerland.

early indications would suggest that there is enough demand to meet that supply. The depth of the market may be exaggerated by the low yield environment at the moment, which has forced investors

The financial crisis exposed significant flaws in banks’ capital structures, not least the fact that many supposedly loss-absorbing instruments proved surprisingly unfit for purpose. But over the past few years, bank capital has been transformed. Will Caiger-Smith reports on a market reborn.

A brave new world: bank capital redesigned

CRD4 Additional Tier 1 and Tier 2 Requirements

Total Capital Debate

1.52

4.5

2.5

0 to 3

0 to 2.58% Min Total Capital

6% Min Total Tier 1

11.513.5

0

5

10

15

RCT1T1TEC

Min CET1 CCB Syst. risk bu�er CCCB AT1 Tier two

CET1

bu�

ers

Min

CET1

4.5% Min. CET1

Operating Target

10.0

CRD4 FinishMinimum and bu�ers

% • Total Capital CRD IV (1) : ~13.5%

– CET1: 10%

– AT1: 1.5%

– Tier two: 2%

• Expected EU average/ operating levels:

– CET1: 9%-10%

– TCR: 13%-15% (including 1.5% AT1, 2.5%-

3.5% tier two)Note1. Assuming full systemic risk bu�er

Total capital debate

Source: Morgan Stanley

overview


towards riskier instruments as they search for yield. But with more and more european and US institutional investors building dedicated platforms to invest in this new class of securities, the buyer base is looking far more permanent today than it was in 2011, when most deals were built around a strong bid from high net worth individuals in Hong Kong and Singapore.

“This is now truly a global investor base, spanning the US, europe and Asia,” says Alex Menounos, head of european IG debt syndicate at Morgan Stanley. “demand was initially driven by high net worth investors, but as yields continued to fall, institutional investors were compelled to allocate more time and resources to investing in this developing asset class given the relatively attractive returns on offer.”

No more bail-outAfter the financial crisis laid bare

the faults of the previous generation of capital instruments and the lack of a coherent — and swift — framework for recapitalising banks without opening the public purse, regulators are determined to redesign the european banking sector to make it possible for banks to fail without threatening the economies of the countries in which they operate.

The CRd package was agreed in late March 2013, after numerous delays. It is expected to be officially published by June 30, and if it is, it will take effect from January 1, 2014.

The eBA’s technical standards for own funds, which flesh out the finer details of how CRd-compliant additional tier one and tier two deals are to be structured, will be officially published alongside the CRd package. However, the eBA published a near-final draft in early June.

The reforms don’t stop at new-style capital. The bank Recovery

and Resolution directive is being thrashed out at eU level and will feature a raft of measures intended to nurse failing banks back to health or swiftly resolve those that are already past saving.

One of these tools is bail-in, which will apply on a statutory basis to tier two debt and, controversially, to senior unsecured, forcing losses on those creditors when a bank fails, to avoid taxpayers footing the bill.

The much grander plan overarching these new regulations, however, is european banking union. This project features three pillars: central supervision by the european Central Bank; a europe-wide resolution fund; and an eU-wide deposit insurance scheme.

The march towards this goal is a slow one, and it throws up many potential issues for banks. But the finalisation of new capital rules is a solid foundation for the new face of european banking. The door is open — let the money flow. s

European Regulatory WorkstreamsCRD IV/CRR1, CMD/BRR, Banking union

[May/Jun]EBA �nal

‘own funds’ RTS

Feb 27CRD IV political

agreement

Mar 5CRD IV ECOFIN

endorsement

Apr 16CRD IV EP adoption

[Jun/Jul]CRD IV publication in

EU o�cial journal

Mar 27CRD IV EP-

Council agreement

[1 Jan 2018]Bail-in/

debt write-downapplication

Q2 2013EC/EP

negotiating positions

[Q3 2013]CMD political

agreement 1 Jan 2015CMD

entry into force

1 Jan 2014CRR1/CRD IV

entry into force

2013 2014 2015

CMD/BRR& bail-in introduction

CRD IV/CRR1

2018

Banking union

GlossaryCRD (Capital Requirement Directive), CRR (Capital Requirement Regulation), CMD (Crisis Management Directive), BRR (Bank Recovery and Resolution). EC (European Commission, EP (European Parliament), SSM (Single Supervisory Mechanism),RTS (Regulatory Technical Standards), DGS (Deposit Guarantee Scheme)

,

Mar 19SSM agreement

[Q2 2014]ECB taking over

supervision of 150-200 institutions

[Q1/Q2 2014]EBA stress tests

under ECB

[Q3/Q4 2013]EBA publication ofbanks’ exposures

[2014-2015]SRM negotiations

on CMD template

[TBD]EU resolution

fund/DGS

H2 2013Lithuanianpresidency

European regulatory workstreams



Overview: The deals sO far

THe CRd package was agreed in March this year, after numerous delays. Most banks are expected to wait for the rules to be officially pub-lished before they start printing addi-tional tier one deals. That does not mean the market is unfamiliar with new-style loss absorbing capital issu-ance, however.

non-european issuers such VTB and Banco do Brasil have issued their own versions of Basel III-compliant additional tier one paper, and there have been several contingent capital deals from european banks, such as Rabobank, Credit Suisse and UBS.

Most of those Cocos have used a tier two host instrument, however. The only CRd-compliant additional tier one trade from a european borrower so far is BBVA’s $1.5bn perpetual non-call five year trade, which was printed on April 30.

That deal was well received by the

market, attracting over $9bn of orders, and performed well in the secondary market.

But it was conservatively structured, effectively incorporating six different triggers for conversion, in order to sat-isfy BBVA’s home regulator, comply with the CRd package, and be counted as additional tier one capital in the stress tests the eBA will conduct next year.

Dangerous precedent?This displeased some market par-ticipants, who felt it was a danger-ous precedent to set. “If you solve for every single consideration, every trade would be awfully complex,” said a cap-ital structurer away from the deal at the time. “It means you are structuring deals for every possible eventuality. This type of ‘all-in-one’ deal is not fair to investors. we have so many great precedents out of Switzerland in terms

of simple, Basel III-compliant trades, and this one is just a massive outlier.”

Permanent write down tier two host Cocos, such as those issued by Barclays and KBC Bank, have also attracted criticism, particularly from investors, who see them as the least attractive option compared with equity conversion or temporary write down.

Evening outHowever, as the market develops, issu-ers, investors and bankers hope these securities will become less idiosyncrat-ic and more homogeneous.

Most new-style capital issues so far have been structured out of necessity, says Alex Menounos, head of europe-an IG debt syndicate at Morgan Stan-ley, playing down concerns that these aggressive precedents could make issuers opt for less investor-friendly options going forward.

“Several issuers clearly capitalised on very conducive markets and man-aged to place some ground-breaking structures.” he says. “There were no real alternatives to per-manent write down available to issuers at the time when Barclays and KBC came to the market. Setting a precedent will be a significant stepping stone for many issuers, to bring further deals and to explore dif-ferent currency alternatives. The market has dem-onstrated appetite for high trigger LT2-host Cocos and for AT1.” s

Recent Bank Capital TransactionsAdditional Tier 1, Ti er 2 and Tier 2 CoCos

50

150

250

350

450

550

650

750

Jan Feb Mar Apr May Jun2012 2013

Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May

�ve-year dollar mid-swap (USSW5) iBoxx dollar Eurodollar lower tier two

Spreads and Reference Rate Development - Since Beginning 2012

Select Asia private bank-targeted trades

Tier twoSize: $1.5bnCoupon: 6.25%

Spread: 521bp

Tier twoSize: $1.0bnCoupon: 5.7%Spread: 390bp

Tier two CocoSize: $2.0bn/$1.5bnCoupon: 7.625%/ 4.75%

Tier two ‘RAC’Size: $1.0bnCoupon: 7.125%Spread: 632bp

Asian retail (Reg S)

Tier two ‘dual tranche’Size: $500m/€500mCpn: 6.375%/7.125% Spread: 547bp/540bp

Tier one Size: $1.0bnCoupon: 6.375%Spread: 539bp

Tier twoSize: $1.0bnCoupon: 6%Spread: 418bp

Upper tier twoSize: $1.0bnCoupon: 7.875%Spread: 710bp


Tier two CocoSize: $3.0bn/$1.0bnCoupon: 7.625%/ 7.75%


Tier two ‘RAC’Size: $1.5bnCoupon: 6.525%Spread: 575bp

Tier two CocoSize: $1.0bnCoupon: 8.0%Spread: 719.7bp

Tier twoSize: $1.0bnCoupon: 5.50%Spread: 418bp


1.02%

1.21%€ institutional

Tier twoSize: €1.25bnCoupon: 4.125%Spread: 330bp


Global Distribution (144A/ Reg S/ 3(a)(2))

Recent bank capital transactions


The deluge may be yet to come, but some banks have already bitten the bullet. Banks have already printed Cocos, additional tier one and tier two capital that they expect to comply with the final CRD and EBA guidelines. But it hasn’t always been an easy ride. Will Caiger-Smith reports.

Controversial beginnings to a crucial market

keynote address, andrea enria, eBa


The consTrucTion of the single supervisory Mechanism (ssM) and the whole project of the Banking union are usually justified on the basis of the shortcomings of the institutional framework for the single currency, which have been so clearly exposed during the sovereign debt crisis.

however, i would like to start from a different observation point, that of the single Market. During the last three years we have witnessed a dramatic process of renationalisation of banking business, which has deeply damaged the functioning of the single Market.

As a result of the political decision to rely exclusively on the national safety nets to provide solvency support to the banks, both market participants and national authorities have taken actions that have segmented the single Market along national lines. Bank capital and liquidity are now allocated on a country basis and cross-border groups have achieved a much closer matching of assets and liabilities in each jurisdiction. The strong reduction in cross-border banking has been driven in particular by the collapse in exposures to banks in other jurisdictions. This partly reflects the reluctance of banks to lend to each other and the emergence of sovereign risk as a main element in banks’ behaviour. But although i lack robust empirical evidence, i am fairly sure that an important driver is also a sharp contraction in the transfers of capital and liquidity within cross-border groups, from the parent company to subsidiaries in other Member states and the other way round.

We are witnessing what i would call a “soft break-up” of cross border groups along national lines. This means that cross-border groups are not functioning anymore as channels for integrating the retail banking market, recycling savings from countries in surplus to meet the financing needs of small and medium enterprises and households in other Member states. The single Market is failing to fulfill its main function.

The ssM is providing a prompt and strong institutional response, and the right one. if properly completed with effective and integrated mechanisms for resolution — the so-called single resolution Mechanism — the new institutional framework could go a long way in establishing a european safety net and cutting the link between banks and their sovereigns. i do not think that the europeanisation of deposit guarantee schemes in their paybox

function is essential to move forward, although some mechanism for the integration of national schemes is essential in a longer term perspective, also via reinsurance obligations for local schemes, as recently suggested by Daniel Gros. But we surely need a european authority which can mobilise pooled private resources contributed by the banks themselves and rely on the liquidity support and the fiscal backstop of the european stability Mechanism (esM), to ensure that effective restructuring and resolution can occur at the european level.

however effective this response, though, it will only cover the banking business within the Member states that will join the ssM. The responsibility for supervision and resolution, and the connected mechanism for support, will not cover all the Member states. repairing the single Market, and avoiding a rift between Member states that will join the ssM and those that will not, requires that a number of additional steps are taken, all strengthening other components of the european system of Financial supervision (esFs), for which at the moment i do not see the necessary political commitment.

Single RulebookFirst, we need a renewed and enhanced effort for the single rulebook. Truly unified rules are the necessary conditions to restore trust amongst competent authorities and allow joint execution of supervision on cross-border groups. A wide degree of discretion left to national authorities could open the room for the use of rule-making to de facto ring fence national markets.

A lot of progress is being made in establishing a single rulebook in banking, and the eBA is close to finalising a significant number of standards linked to the new legislation on capital requirements (the so-called crD iV-crr). But there are still important areas of flexibility that need further action.

There is the flexibility granted for the exercise of macroprudential responsibilities. This is huge — up to 500bp in the capital ratio, with further room allowed in defining the liquidity buffers — but warranted, to tackle bubbles that could develop in national markets. here it is essential that eu-wide mechanisms are devised to constrain the exercise of this discretion and make sure that it is effectively employed to contrast macroprudential risks, and not aimed at trapping capital and liquidity in domestic jurisdictions.

Andrea Enria, chairman of the European Banking Authority, made the following speech at the European Commission’s public hearing on EU financial supervision in Brussels on May 24 this year.

The implications of the Single Supervisory Mechanism on European financial supervision

keynote address, andrea enria, eBa


Moreover, there is the flexibility granted to address smaller institutions operating on a local basis, especially savings and co-operative banks. Also this type of flexibility is warranted, as the rules should abide to the principle of proportionality and reflect the specificities of different business models. But the principle of proportionality should be applied on an eu-wide scale and in no case should simply offer carve-outs to common rules for certain categories of intermediaries, in order to avoid generating de facto barriers to entry in local markets.

There are the elements of flexibility granted just to reflect different policy stances of Member states. For instance, i am particularly concerned of the discussion of the draft Directive on Bank recovery and resolution, where the request for flexibility could have two very detrimental effects: (i) it could put at risk the level playing field in the treatment of different classes of creditors, thus allowing for the use of the regulatory lever to reduce the cost of funding for domestic players; and (ii) it could maintain differences that could turn out to be an obstacle in interconnecting national resolution regimes and ensure a smooth and joined-up approach to cross-border groups.

in all these areas the introduction of the ssM should be a positive force, pushing for greater uniformity of the regulatory framework. The eBA has already developed its advisory role, identifying areas where truly common rules are warranted. Perhaps this role should be further codified, to provide a stronger underpinning to the eBA as the guardian of the single rulebook.

Single Supervisory HandbookThe second area in which the ssM calls for further action at the single Market level is the convergence in supervisory practices and cooperation between authorities.

steven Maijoor [chairman of the european securi-ties and Markets Authority] has already mentioned the need to step up the efforts for supervisory convergence in the previous session. The urgency is even higher in banking, where the staff of the ecB and all the national authorities joining the ssM will have to conduct their supervisory tasks according to a common manual. The task to develop a single su-pervisory handbook for the whole eu, attributed to the eBA, recognises the importance that key chapters of the manual are truly common across the single Market. The eBA has already started to work to some of these chapters of the handbook, in the area of supervision of business models, and will soon move to the methodologies to conduct risk assessments, asset quality reviews and attribute scores to recovery plans. The discussion on the handbook has focused mainly on the legal nature, and the draft legislative provisions point out clearly that it will not be legally binding. however this misses the point, which is the

actual commitment of all competent authorities to define jointly the methodologies and apply them in their day-to-day practice.

having common rules and common supervisory practices will not rule out the possibility for tensions between home and host supervisors. The introduction of the ssM will simplify home-host relations, but we have to remind ourselves that almost all large cross-border groups have establishments both inside and outside the euro area. The eBA has so far conducted a major effort, within supervisory colleges, through formal and informal mediation, and also via investigations on breaches of eu law, to push forward stronger co-operation and joint decisions. This strand of the eBA work is somewhat obscure, but essential for the repair of the single Market.

Finally, the greatest challenge will be in the construction of a comprehensive and credible framework for cross-border bank resolution. if the srM covers only the countries joining the ssM, as it is likely, the challenge will be to avoid that some degree of segmentation remains in the single Market, as a consequence of the divergent underlying safety nets on which european cross-border groups will rely. once completed, the Banking union should thus contrast this trend of national segmentation and provide a robust underpinning for an integrated european banking market. To this end, the srM should be accompanied not only by a common resolution toolkit for the whole union but also by clear and binding criteria, agreed among the parties involved, for smoothly manage the crisis and resolution of cross-border groups. recent experience shows that voluntary agreements are not enough: when a crisis materializes the strong incentives to diverge from the original agreements need to be set-off by credible, binding arrangements. For this purpose, a european Authority should ensure that these agreements are put in place under a common umbrella and are effectively enforced in a crisis, for the whole single Market. s

Andrea Enria: recent experience shows that voluntary agreements are not enough

The EBA authorised euroWeek to reproduce Andrea Enria’s speech for this report. The EBA retains the copyright.

The Future of Bank Capital EuroWeek 7

Bank Capital Issuer Roundtable

EUROWEEK: Let’s start off with a question around regulation. There are many moving parts — the CRR, CRD IV and the CMD. What’s still missing, and what are the most important issues that need to be resolved, from a bank capital point of view?

Anne Reinhold, Nykredit: When we are discussing the possibility of issuing capital additional to tier one, we find it difficult at the moment because, with the draft EBA guidelines, writedown is a possibility, but not a very favourable one. Since we are mutual, having a conversion to ordinary shares is not possible for us. So additional tier one is a difficult issue. We want to have a very strong capital position, so we want to be able to issue different kinds of instruments, but especially

core tier one. We hope eventually to have some form of core tier one instrument, like Rabobank’s. That will allow us to issue AT1, which can be converted into this kind of instrument.

Otherwise your only option is temporary, rather than permanent, writedown. Temporary writedown is not very beneficial for us. So what we need is a good tier one instrument, and we are trying to work around that by having a CT1 instrument instead, and then afterwards it will be easier for us to also issue tier one capital.

At the same time, we are also interested in boosting our capital base through increased earnings. Since we have quite low prices in our markets, that’s also a possibility.

Participants in the roundtable were:

James Macdonald, credit analyst, Bluebay Asset Management

Juan Cebrián Torallas, head of capital management and planning, CaixaBank

Anne Reinhold, chief analyst, regulatory affairs and rating, Nykredit

Vishal Savadia, capital issuance and structuring, Lloyds Banking Group

Georgina Aspden, executive director, global fixed income and currency investment management division, Goldman Sachs Asset Management

Norbert Dörr, managing director, group treasury, Commerzbank

Khalid Krim, head of capital solutions EMEA, Morgan Stanley

Alex Menounos, head of European IG debt syndicate, Morgan Stanley

Rogier Everwijn, director, long term funding, Rabobank

Stephen Roith, partner, Sidley Austin

Will Caiger-Smith, moderator, EuroWeek

Regulatory fog begins to clear but new challenges emerge

Over the past two years, banks have focused on building up their core capital ratios, through a combination of equity issuance, asset disposals, RWA reduction, and liability management.But the regulatory blocks to new capital issuance are clearing and new-style loss absorbing instruments are almost ready to hit the market. BBVA has already brought the first.But plenty of challenges remain for this remodelled bank capital market. New regulation does not stop at minimum standards for bank capital instruments — it goes further, turning senior unsecured funding into another form of capital, and laying the ground for an integrated European bank resolution framework and banking union.The overall picture is still confusing, and issuers are constantly having to adapt to this changing environment. To discuss how they are meeting these challenges, a number of issuers and several investors gathered to compare notes at the Morgan Stanley Bank Capital Issuer Roundtable in late May.

8 EuroWeek The Future of Bank Capital

Issuer Roundtable

Khalid Krim, Morgan Stanley: What Anne has been describing is exactly what a number of issuers and also investors are waiting for, which is regulatory clarity. It took us some time to get clarity in Europe and to get implementation of Basel III. We are getting there. So we have pillar one — the definition of capital that the European Commission and the Parliament adopted, with CRR I. On the liquidity side there is some fine-tuning to be done. A couple of points are missing, which are technical standards on tier one capital, but they will be published very soon.

And we are missing some clarity on how regulators will look at capital across Europe. We need more guid-ance from regulators on that. But on the structure, I think we’re getting there, and we will have a European version of Basel III, whether it’s harmonised or not. Hopefully it will be harmonised and we’ll have the same instruments, the same definition of capital instructions across Europe.

The question that people will have is how Europe compares with banks in the US and in Asia, and I think that’s step two. Over the last 18 months, there has prob-ably been some concern and frustration on the issuer side, on the intermediary side, on the investor side, about the lack of clarity. That is behind us, and we are moving to a stage where this new regulation is forth-coming on January 1, 2014. Then we will have clarity.

Rogier Everwijn, Rabobank: Clarity is there, that’s true, but what we are missing is an agreement between all the European countries, and maybe also a global view. In Europe, the national finishes are really impor-tant. Some of the non-euro countries are looking at other possibilities, like here in the UK where you have primary loss absorbing capital, while other countries are not using it. And then in the crisis management direc-tive, there is even more national discretion around these national finishes. We need harmonisation in Europe and maybe on a global basis.

Norbert Dörr, Commerzbank: I believe we are enter-ing an important second phase. The first phase was the CRR and CRD IV. This is now being approved by the parliament, while there are still technical aspects to be finalised around gold-plating, common equity tier one, G-Sifis and D-Sifis. Attention now turns to things like bail-in, and that will really drive the focus on total capi-tal. Other aspects of that debate, like depositor prefer-ence, will drive the focus on senior unsecured, which sits above tier two. All of regulators’ initiatives, like the

asset quality review, or the delayed EBA stress tests, will play an important role in sorting out that area. That is the focus now.

Vishal Savadia, Lloyds: I agree. But what I’m slightly cautious about is that, while we’re taking a big stride forward, there’s still a lot more to be done, be that around technical standards and getting full clarity around treatment of some instruments across different jurisdictions, or work around bail-in.

The key point is around national implementation, or the transposition of this new regulation into a frame-work for open issues. That affects everyone around the table, for example on issues like tax. That will ultimately drive issuers’ appetite to access these markets. We have made massive strides forward, but there is more work to be done before issuers have the full picture around regulation and treatment of capital instruments.

Reinhold, Nykredit: Even though we are approaching clarity on capital, liquidity and how the LCR will be implemented is still a big issue for us. There are some very important issues coming up in the next couple of years where the EBA will play a very important role, and they have lots of technical standards to implement.

Stephen Roith, Sidley Austin: I think there are possibly 50 separate sets of technical standards required from the EBA in connection with CRR and CRD IV.

Juan Cebrián Torallas, CaixaBank: I heard that, from now until the end of the year, there are 153, adding up the guidelines and technical standards. We now have a single rulebook, but if you read it thoroughly, you find out there are little details which could lead to big differ-ences in the way you apply it. That’s why discretion is critical, and how the EBA supervises that process is very important.

The other critical thing is the resolution regime and bail-in, particularly how it’s going to be applied in different countries. That will define the risks on different capital instruments or even senior debt. So what is the optimal capital structure for a bank?

Krim, Morgan Stanley: We are talking about a two-phase transition process. But people are now trying to navigate within banking union, and I think this means that different sets of rules should be harmonised by the EBA, with one rule-making authority.

During this push for harmonisation, we need to continue to issue, and regulators will continue to give us time to manage that. We also need to proofread for the future of regulation, to see as much as we can of what is coming. But the EBA has a huge task in terms of putting together a harmonised framework at a time when we have issuers across the EU with different issues, different priorities, and investors trying to understand what it means for them when they buy a piece of paper. They are not buying that piece of paper for one or two years — they are buying it for at least five or 10 years, or even a perpetual basis. They want to know what will happen to the securities on an ongoing basis.

Dörr, Commerzbank: What worries me is that while we are seeking transparency and clarity, the number of different structures and the variety of trigger points in recent issues were all done for very idiosyncratic rea-sons and they create less transparency. It worries me,

Rogier Everwijn, Rabobank


Issuer Roundtable

because in the next downturn, these instruments could react dramatically in different market environments.

EUROWEEK: On that note, is there a danger that you get a very confusing market, with lots of banks issuing different structures with multiple objectives — say ratings agency credit or EBA stress test credit? Could we end up with a capital arms race, where everyone’s trying to do everything at once?

James Macdonald, Bluebay Asset Management: That actually offers us great opportunities to find value. But it’s key to understand the transition phase that we’re in now and the rationale for different structures. Investors are just starting to understand how point of non-viability and bail-in are going to interact with different parts of the capital structure but we’re a long way away from real clarity on precisely how these instruments will work in practice across jurisdictions. We may not really get clarity until there’s another crisis and we see how the different instruments react, and how regulators react to the situations they find themselves in.

Georgina Aspden, Goldman Sachs Asset Management: From the investor point of view, it’s still not clear to me who’s really driving the idiosyncratic issuance we’ve seen to date. But if you’re thinking about the future and what you’re trying to create, which is a market, you’ve got to think about what you want that market to look like and who you want to invest in it. Because currently, the securities we have and the opportunities they provide mean that maybe you’re not getting the bulk of investors that you really want — pre-cisely because the structures are so idiosyncratic.

Krim, Morgan Stanley: I think that is high on the regu-lators’ agendas. When we interact with regulators, they ask us questions — who are the buyers, compared with the previous generation of bank capital securities? And how do we move on from legacy sub debt in a way that allows the investors of yesterday to be there in tomor-row’s market?

Alex Menounos, Morgan Stanley: I think there’s a natural evolution to the process. Some regulators and issuers are perhaps a little bit more forthcoming with new structures, and some instruments were designed with legacy rules in mind. We expect this to evolve over time but ultimately to result in a core structure and amount of supply in the product, because regulators,

issuers and investors alike would like to see a deep and liquid market, with multiple issuers from multiple juris-dictions, of varying quality.

My biggest concern is around national finishes and gold plating. Ultimately we may end up with a large variance between what is acceptable in one country versus another in terms of basic structure, like for exam-ple where you set the contractual trigger. Investors are becoming quite technical in their analysis of triggers — but still, is a bank that is able to issue with a low trig-ger going to have an advantage over another bank that cannot issue with a low trigger, even if they have a com-parable buffer to trigger? Despite the CRD IV blueprint for AT1, we may not end up with something uniform across Europe.

EUROWEEK: Let’s talk about total capital. Norbert, does Commerzbank have a specific target for total capital?

Dörr, Commerzbank: It’s very difficult to come up with a target number for total capital at this moment in time. I expect that, depending on the jurisdiction and the approach of the regulator on recovery or resolu-tion, each individual institution will require a different target in terms of total capital ratio. It is not one size fits all. Investors can’t price a senior bond based only on a rating any longer. They need to look at the indi-vidual bank and the environment in which it operates, and consider the regulator’s approach. So yes, there will be at least a minimum level of total capital. You can say you want to be about 4% higher than common equity tier one. But that might not be the end of the story.

For the CRR and CRD IV, for common equity tier one, we want to be well above 9% on a fully phased-in basis. I expect we will have 3% or 4% in other forms of capital.

Everwijn, Rabobank: We always have been target-ing a total tier one ratio, but with the incoming bail-in regime, we also think it is important to provide inves-tors more comfort, to mitigate risk, at the lowest pos-sible price.

So, the focus is on tier two going forward as well. Our core tier one ratio will be 14%, and our total tier one ratio will be 17.5%. And then our total capital ratio is floating. It partly depends on what the competition is doing. But we want to operate at a minimum total capi-tal ratio of 20%.

Georgina Aspden, Goldman SachS aSSet manaGement (GSam)

Alex Menounos, moRGan Stanley


Issuer Roundtable

Cebrián, Caixabank: I agree that there is no magic number. There are a lot of things to consider — your funding structure, your depositor base, your senior debt, your risks. You have to plug it all into the formula to work out the optimal capital structure. We’re plan-ning to run above 10% on common equity tier one. Obviously, the phasing-in period is going to affect this number, and we’ll see it differently in different juris-dictions. And obviously with the three, four, or five extra percent of tier one, additional tier one and tier two instruments, it should be a minimum total capital target of 14% or 15%. And depending on your pillar two issues, or your different aspects of risk, you could always run with higher levels.

But we have to transfer from the old style to the new style at the same time, and we need a market that can support this level of polarity. So even though these are rough numbers that we have in mind, the targets are not yet set in stone until we move towards the new framework and things start to stabilise.

Aspden, GSAM: Can I just ask, in relation to all your answers, are you answering with respect to total capital as a proportion of risk weighted assets?

Cebrián, CaixaBank: Yes.

Aspden, GSAM: Do you think that’s the best way to measure total capital?

Cebrián, CaixaBank: No. But it’s a reasonable metric that we’re all using. From the beginning, I said there was no magic number. Obviously, you just have to look at your risk-weighted assets and come up with a percentage. That is easy to transmit, but you also have to take into account your total assets, and other risks that might be arising from other businesses, which are not clearly reflected in your risk-weighted assets. In terms of funding, you need to consider how many depositors you have, and how well they have to be covered. The regulator, whether your national one or even the ECB, is going to be very aware of that — how much senior debt you have and how much pressure you have on senior debt spreads — because the capital you hold as a cushion for senior debt could eventually not be enough to prevent it from being hit in a resolu-tion scenario. So it’s a lot more complex. But we look at RWAs because it what’s we’re used to. To offer an analogy, you’re either used to measuring in Celsius or Fahrenheit.

EUROWEEK: Let’s carry on with that debate shortly. I’m just going to give Vishal and Anne a chance to explain their positions on capital.

Savadia, Lloyds: Our position is slightly different by virtue of the Independent Commission on Banking pro-posals. As a large UK retail bank we have a target core tier one ratio, but through the ICB framework it could be 10% or possibly slightly higher, and we have a tran-sition timeline to get there.

Then we also have a total capital requirement, which we see as potentially part of what the ICB calls the Primary Loss Absorbing Capital (Plac) requirement. That suggests holding 17% in loss absorbing capital instru-ments, so we’re running that alongside a total capital ratio at the moment.

But when you incorporate items like bail-in, are you

looking at total capital, are you looking at subordinated debt, or bail-in-able liabilities? And what is the scope of those bail-inable liabilities? You’ve got to work through all of that, but our position is that it doesn’t matter what measure you look at — it is simply that the broad-er the bail-inable scope, the better for the market.

Reinhold, Nykredit: We always have had a very high core tier one capital ratio and of course we want to continue being very well capitalised. We already had a high voluntary buffer, but now that’s being replaced by the buffers in the CRR and also the proposed Danish national finish, which adds 2%. They also had the idea of having an extra crisis management buffer, but we can discuss that later. All in all, we would like to have at least 15.5% core tier one capital and around 19% total capital. That is also partly due to our structure.

Krim, Morgan Stanley: It’s interesting that total capital was less a focus both for issuers and investors before the crisis, and I think it’s only becoming a focus because of bail-in. It comes down to the loss of sover-eignty that we will see in the European banking sector.

Once we have full clarity on bail-in, the next step is for the fixed income market to tell us about the direc-tion for total capital, and what they expect from banks — because they will have to look at banks versus one another. We are currently probably above 18%, and we need to adjust the number based on what competitors are doing. So there will need to be a benchmarking exercise, where you face the other layer of the market, which is not the capital itself but the people that pro-vide you with liquidity and that worry about bail-in risk and loss absorbing capacity.

Menounos, Morgan Stanley: Can I ask a question for Georgina or James? What do these very different tar-gets for CET1 and total capital mean for you, can you make sense of it? Is there an easy way of benchmark-ing one jurisdiction against another? Does it throw up investment opportunities, like you were saying James?

Macdonald, Bluebay: I think we’re definitely just still in a state of flux with regards to how you can view it, because you don’t know how regulators are treating different parts of the capital structure. A lot of investors are not just buyers of bank capital, but also buyers of senior debt, which is a liquidity instrument. And inves-tors who are buying senior debt don’t expect to be the capital providers. They don’t expect to be taking losses,

Khalid Krim, moRGan Stanley


Issuer Roundtable

especially for banks that are going concerns. To get a better sort of benchmark across jurisdictions is still really difficult, until we get more certainty on how the capital stacks will look in different countries, and how different regulators are going to treat them.

Aspden, GSAM: I agree. I think the point James makes about being in flux is related to the transition stage and not only determining what kind of instruments banks issue, but also what investors want or need. We look across the capital structure, including senior unsecured and covered bonds, so what we get concerned about depends on what part of that structure we are look-ing at. But ultimately this is still in transition and as a result, bail-in will be taken more into account in some jurisdictions where there’s clearly a high risk of losses.

Banks in those regions will also obviously seek high-er capitalisation levels at the moment because of the conservatism of the community. The only thing I would add, though, is that as an investor we are not just look-ing at target percentage figures. We are stress testing banks’ balance sheets in all the ways you describe, and we’re looking at nominal amounts of capital to work out where we think the different types of capital should be applied for senior relative to the potential offer.

Menounos, Morgan Stanley: Can I ask one more question in case we move off bail-in? Increasingly, investors looking at senior unsecured debt are focusing on the risks of bail-in, one being encumbrance, two being depositor preference, and three being the amount of capital that can absorb losses. Is there one of those three that concerns you more than others? Is there a difference across jurisdictions?

Macdonald, Bluebay: I think it varies by jurisdic-tion. It can vary across the board but at the end of the day you need to believe in the bank’s business model and understand its capacity to absorb losses so I would say those are the most important fac-tors. The way we invest now we’d expect that most national regulators would enact depositor preference. Questions may arise still around uninsured deposits but we certainly wouldn’t be counting on them being parri passu with unsecured debt within our analysis for the time being.

Krim, Morgan Stanley: What we’re hearing from Brussels is that we are moving towards depositor pref-erence, which will probably be part of the European

version of bail-in. What is interesting is that in Europe it took us some time to get used to the idea of bail-in and whether it was positive or negative. How many people think bail-in is a good thing? Or do you think that bail-in is going to create more issues than it solves?

The reason I am asking is because if I look back at the initial proposal from 2011, when the European Commission was testing the water, it took a number of months to confirm that bail-in would feature in the CMD. A number of times we discussed with issuers and investors what was the alternative to bail-in. And the answer was always that it’s either liquidation or bail-out. Bail-out is no longer on the table, so that leaves us with liquidation. If we were to have, as part of the framework, a tool that guarantees more stability and something that is equivalent to liquidation but done in a different way, is that really that bad?

Dörr, Commerzbank: When this topic came up for the first time we were still in a situation where you had banks that couldn’t go insolvent because they were too big to fail. And you can’t liquidate them either. Bail-in was never a real possibility. But those times are over. People now accept that there needs to be an equivalent to insolvency for banks, and that is bail-in.

Krim, Morgan Stanley: Well, it’s more that there is a resolution package and bail-in is one of the tools that may be used.

Dörr, Commerzbank: Of course. I think later we will probably also touch on the aspect of contractual versus statutory loss absorption. And if you put that all togeth-er, bail-in can only be part of a bigger framework, which is the equivalent of insolvency for a bank.

Savadia, Lloyds: Bail-in is definitely the direction of travel for regulators. There was a point at which we were trying to achieve too many things at once. We had CRD IV on the table, the CRR, as well as a general ongoing focus on regulation and the notion of bail-in. Bail-in is now very much entrenched.

We’ve touched on what I think are the most impor-tant things around bail-in, such as harmonisation of the framework across jurisdictions, just to give everyone a level playing field. I think it’s also important that, as the bail-in framework is introduced, we and the regu-lators continue to stress the importance of the capital hierarchy. Then investors are made comfortable that

James Macdonald, bluebay aSSet manaGement

Norbert Dörr, commeRzbank


Issuer Roundtable

this hierarchy will be preserved in a bail-in scenario. Then you can base the amount of bail-inable debt you have on a very clear waterfall of instruments.

Everwijn, Rabobank: And regulators and politicians should refrain from adding everything up together. So we have CRD IV, we have the CRR, and that gives you a new capital requirement. Then you have bail-in on top of that. And what they are now also suggesting is to add an extra layer to protect investors in a bail-in sce-nario. It is just adding up and adding up, and it will not stop. At some point you have to pause for a moment and ask if banks really are safer than they were in the past.

EUROWEEK: We seem to have got on to the subject of bail-in so we might as well carry on with that topic. Arguably, there’s a quasi-political risk to investing in banks now, because who will pull the trigger when it comes to bail-in? How close are we to having an EU resolution authority? How do you model for bail-in risk?

Everwijn, Rabobank: A resolution authority in itself isn’t a bigger risk. The risk is who will be the resolution authority and at what point they will be in charge, and what is the interaction with the national central bank or the ECB. Are you forced to have a double report-ing line? Is there any communication between the two entities? Or is it that initially you deal with the national central bank, and once you get into trouble the file is handed over to the resolution authority, where there is no proper relationship with the issuer? That is the scari-est part of it.

Dörr, Commerzbank: One very important aspect is the boundary between a recovery and a resolution sce-nario. For me, a recovery is where the regulator calls the shots, asking for more capital within an early inter-vention. At that point the bank is still a going concern. When you enter into the resolution scenario, in my opinion, some really hard-wired things start to happen, and it’s closer to insolvency.

The regulator cannot do that — it’s down to the people who usually deal with insolvency in that juris-diction or an adequate resolution authority. That is the defining connection point of these different aspects of dealing with bank failure. That gives me some con-fidence that if that process is respected, the capital hierarchy will be respected as well as possible and that there are clearer rules and the current arbitrary feeling around resolution will be mitigated.

Krim, Morgan Stanley: One problem is that in Europe, we’re lacking a track record in resolving banks quickly. They have closed 500 banks in the US. We have closed 10 or 11 in Europe. We are missing expertise in resolu-tion. That’s not a criticism — the philosophy in Europe is different to the US, and we need to learn from that and understand how to resolve banks and give the mar-ket confidence things are under control. We will have the tools and the ability to do it quickly, to keep the market stable.

Dörr, Commerzbank: That is true — bail-in is pretty much a non-issue in the US market.

Krim, Morgan Stanley: Correct. We will have it even-

tually. But they don’t call it bail-in in the US. It’s not something people have focused on, because they know that the FDIC is around the corner and can act quickly if there is an issue with a bank.

Reinhold, Nykredit: One of the reasons they can react quickly is that they already have their recovery and resolution plans. They have had a resolution frame-work for many years so they very much know where they stand and what to do. That is one of the benefits of the new directive. However, you also have to take into account the differences between banks and their

varying business models when it comes to working out these issues.

Of course you want harmonisation, but at the same time you cannot have one clear overall procedure because we all have very different business models. If you were to look just at deposits, you would say it is very good to have deposits, and banks could stick to that to be safe. But if your business model is to fund all your loans by covered bonds, as we do, it’s not a problem if you don’t have deposits. In fact, it could be an advantage because you don’t have to protect them if you run into problems. So it’s difficult to have a one size fits all approach, because you also have to look into very specific models. That can make it very com-plicated.

Cebrián, CaixaBank: The question is not actually who is going to take the decision to go into resolution — it’s how the framework is going to be set up for a true banking union within Europe. Legally it could be very complicated. That leads to a lot more uncertainty about our capability to resolve a situation like this even over a weekend. If we can’t sort out the framework of bank-ing union, investors are not going to be so confident on the EU’s ability to run a sound financial system. The question is not so much about who is going to make the call as much as it is around the framework. If we can do it legally, we need to sort out banking union.

EUROWEEK: There’s one specific legal aspect of the CMD that I want to touch on, which is Article 50 of the CMD. Stephen, maybe you could just outline that for us?

Roith, Sidley Austin: Sure. It remains to be seen whether it will be an obstacle, but it’s certainly an issue at the moment. In the draft CMD we have this provi-sion that is without any historic counterpart, which

Anne Reinhold, nykRedit


Issuer Roundtable

says that if you are issuing an instrument — not just capital but also senior debt (in fact, any ‘eligible liabil-ity’) — that will be governed by the law of a non-EU member state, which in practice is most likely to be New York, then you have to essentially incorporate the future bail-in regime into the contractual terms of the instrument by having a specific contractual term that you wouldn’t otherwise have.

Without Article 50, you would probably disclose the outline of the future bail-in regime through the risk fac-tors, rather than through the contractual terms. But in this situation, if the security is to be governed by New York law, or Japanese law, or Swiss law, then under the current draft of the CMD an additional term would have to be included.

Dörr, Commerzbank: I want to comment on that, and I also have a question. Situation A is you have a European entity issuing out of the European entity but through a programme that is under US law. Situation B is that you have a US subsidiary of a European bank that is issuing locally.

In my opinion, under situation A, this entity is clearly regulated by the European regulator, which is different to situation B, where the host regulator also enters the game. In all of the instances we have seen so far, with European issuers issuing under European law, you have risk factor language pointing to the bail-in regime. But we also have a blueprint, which is the US tier two bond issued by Deutsche Bank. That deal was registered by the SEC, and Deutsche also took the risk factor approach.

Krim, Morgan Stanley: I think what we’re touch-ing upon here is exactly what the EU will face when dealing with cross-border issues. Not just cross-border issues within groups, but also cross-border offerings by European banks, when they issue abroad.

We need New York law to access the market in SEC-registered format, and that is unlikely to change. Some adjustments are probably required to make sure that European banks are not penalised when they go to US investors and present accounts with a security that car-ries an identical risk to the one they are selling in the European market. It’s a disclosure promise — making sure that we are explicitly telling investors around the world that when we raise capital, the bail-in risk is gov-erned by the issuer’s jurisdiction.

Norbert alluded to that being used by Deutsche Bank recently in its tier two deal, and also by Barclays in their Coco transaction. You should always be aware that if there is a bail-in or resolution scenario, the entity that deals with that is the FSA for Barclays and the German regulator for Deutsche Bank.

Once we’ve established that, attaching a cost or pre-mium to it is debatable. It isn’t a contractual point. It’s an area where you’re taking more risk, but it’s just put-ting you on a level playing field with European inves-tors. We want to make sure European regulators are comfortable with foreign issuance, and that’s something which in the last couple of months has actually become quite blurry. We should try to keep it simple if we can.

A question for the investors: does this make you nervous? Does it make you demand a premium when you’re looking at tier one and tier two?

Aspden, GSAM: There’s one answer, which is the theo-retical and logical one, which is, yes, we would require

some sort of additional premium for it. Because this is all untested, so you want as much protection as pos-sible, and if it’s written in contractually, you have less protection than if it was in the risk factors. Until that’s tested we have no proof one way or the other, so we should get compensated for that to an extent.

However, because it’s untested, I do have sympathy with the issuer’s point of view that ‘when push comes to shove’ the logical conclusion is that the home regula-tor is the ultimate one to decide, and issuing your capi-tal through a foreign entity shouldn’t change that.

But during this uncertain time, while we’re in a state of flux, we need as much protection as we can get, and that’s understandable, considering what investors have experienced over the last few years.

Roith, Sidley Austin: I think there are going to be a lot of variations. But just look at this year’s issue from Barclays. They went all the way. That instrument is gov-erned by New York law, but in the documents, there is a note saying the PRA has requested them to include a contractual term regarding the UK authority’s bail-in power.

That probably has the effect of accelerating or pre-implementing the inception of the bail-in regime. ‘UK bail-in power’ is very broadly defined for this purpose and, of course, the UK authorities already have broad and expanding powers under the UK Banking Act 2009 so, hypothetically, by virtue of this specific term, the exercise of those powers would arguably be recognised as a matter of New York law for the purposes of this Barclays issue even if the CRD were never passed and implemented.

Krim, Morgan Stanley: For me, it’s nothing more than explicitly saying the FSA has authority. It doesn’t accelerate or pre-implement bail-in in the UK. If there is an issue, and a problem with Barclays as an entity, then the bail-in powers used would be the ones that exist with the UK FSA, and not any US institution. Even if the deals are contracted with New York law, the UK FSA is still competent.

Savadia, Lloyds: I completely agree. It is a disclosure point. It is to be transparent, and specify how you expect these instruments to work in a bail-in scenario. I take some comfort that investors appreciate that there should not be a distinction between instruments with contractual or statutory point of non-viability features. They should be treated in exactly the same way.

Stephen Roith, Sidley auStin


Issuer Roundtable

We get ourselves into tangles if we expect instru-ments to be treated differently, even in a single juris-diction, because one has a contractual non-viability clause and one is caught under statutory framework.

That is not the intention of the regulation. We are caught in this window where it is not entirely clear, or has not been entirely clear, how that legislative frame-work needs to be applied, and so we’ve seen a host of different instruments transpire. But I think the ultimate goal is to simplify the capital structure and make sure these instruments are treated equally.

Roith, Sidley Austin: It’s also not clear from when the bail-in regime may first be applied. The ECON commit-tee of the European Parliament has asked for the bail-in regime to be in force no later than January 2016, where-as the original Commission proposal specified no later than January 2018. That’s quite a big difference. But if it were to be 2016, we will still have this interim situation.

On the other hand, the regime is slowly taking shape. The issues about depositor preference and pref-erence of deposit protection schemes are slowly being resolved. Some regulators, like in the UK and Spain, are at the forefront of wanting the shape of the regime to be foreshadowed clearly in disclosure documents now, whereas I understand the Italian regulator is tak-ing a completely different view. But if it is to come into force in 2016, the interim period will obviously be a lot shorter which should help to bring about greater con-sistency of approach more quickly.

Dörr, Commerzbank: Yes, but what if right now you have a big bank, and they start to issue, and the regu-lator asks for contractual clause, because he says the whole framework is not yet in shape and he wants something now. Firstly, such an issue won’t provide enough capital in a resolution scenario, unless you have it applying to the whole stack of instruments, and sec-ondly, investors may ask for a higher premium because of the contractual clause.

Once the framework is in place, that investor is definitely worse off, because he’s first in line. And then there is the statutory bail-in framework. So when we’re talking about the terms of a deal, in my opinion the best option is to wait for a statutory scenario, and include that in the risk factors. In Germany, our law-yers say you can’t really do more than that.

Roith, Sidley Austin: That’s not what happens here in the UK.

Savadia, Lloyds: Is it not the case that both in the CMD and also in the CRR you are not required to insert a contractual non-viability clause if there is a cross-bor-der agreement between regulatory authorities around how the resolution framework may be applied? So you can override the need for a contractual clause if there a regulatory agreement in place.

I think what we’re saying is we hope that there’s a point at which there is a cross-border agreement in place between regulatory authorities, but we don’t want to be caught in the interim and be unable to issue. That’s why issuers are being pushed to put in additional contractual features to access, for example, the SEC market.

Roith, Sidley Austin: I’m sure you’re right. The regula-tors wouldn’t want or expect there to be a significant pricing difference, but I think the broad regime will presumably come to pass within the EU. Article 50 is specifically about whether that regime would ultimately be respected in the US by the FDIC and the US courts.

EUROWEEK: Can I get a sense from people around the table about the different capital instruments that we’re looking at under CRD IV? What instru-ments are you going to focus on, and why?

Everwijn, Rabobank: We have a clear strategy to issue tier two, old-style tier two in terms of the language. That’s purely because our core and total tier one ratios are already high enough, and because of the bail-in regime we want to add an extra layer of protection for senior debtholders.

Dörr, Commerzbank: We’re similar. We’re focusing on common equity tier one. We want to fulfil the regulatory requirements, which includes tier one, and then we will focus on tier two. Keep it simple.Cocos, for us, are a non-issue as long as there is not any regulatory benefit for it, and to be honest, I only see them working in very specific situations. It will be very interesting to see what happens when the first Coco is triggered.

Reinhold, Nykredit: We have a difficult situation, because our authorities have put forward proposals for the Danish finish. That complicates things because they are suggesting an additional buffer. So right now we are finding it difficult to issue. But our focus is also on tier one. We also want to strengthen that through increased earnings.

Cebrián, CaixaBank: In this new environment every-one’s started building up a more robust common equity base, and the commitment is to fill up with more capi-tal. In that sense additional tier one could be our initial focus, because it allows you to boost common equity tier one during the phasing-in period. But that will be an individual decision and it might not be the case for everyone.

As for Cocos, I guess there’s one issue with the ECB taking over supervision from next year.

We don’t know how they are going to focus on pil-lar two, and what their requirements would be on that front.

We’ll end up with more homogeneous types of Cocos, as we’re going to have a lot of large banks under the same supervisor.

Vishal Savadia, lloydS bankinG GRoup


Issuer Roundtable

Savadia, Lloyds: Like everyone around the table, we are focusing on organic build-out of our core capital and our CEO has clearly stated a fully loaded core tier one target for both 2013 and 2014.

In terms of contingent instruments, we’ve all pointed to the additional work that needs to be done, and clearly the specifics will drive whether that contingent instru-ment is in AT1 format, which is clearly defined under that regulatory framework. But in the near term it’s about get-ting up to speed: building up core capital, getting through the regulations and understanding what the instruments will need to look on the additional tier one side.

Krim, Morgan Stanley: There’s a semantic point here that we need to address. We talk about Cocos a lot, and we talk about AT1, but Cocos are specific to some coun-tries. Switzerland, for example. We’ve had a focus on Cocos in the UK, because the PRA is giving clear direc-tion to UK banks about their utility value on the regula-tory side, but I think if we export it into CRD IV and CRR I, that makes it gone concern capital that is tier two capital, and there is no capital ratio-based trigger.

The only alternative left is additional tier one, and that’s where we will have a Coco feature, or a capital ratio based trigger. Then when we extend it, additional tier one can be in conversion format or in a writedown and write-up format.

For the conversion format you have to consider national law, because it affects how quickly you can get approvals in place for share issuance, whether you can dilute shareholders, and generally, how quickly you can execute tier one with a conversion feature. We’ve seen it from the Swiss, so we’ve had a precedent there. What we’ve seen recently, at corporates and banks, is them building in the option and the ability to issue convertible AT1 and Cocos if there is a need to.

In the UK, for instance, we’ve seen Lloyds, Royal Bank of Scotland and Barclays going to shareholders to make sure they are equipped to issue convertible structures. It doesn’t mean that they will issue a tier one convertible, or a tier two convertible, but at least they have the capacity. AT1 is what European banks would be looking at, in terms of going concern capital, rather than Cocos.

EUROWEEK: So how do you go about choosing which structure you use in additional tier one? Is it going to be a function of timing? Is it going to be pricing? Or is it going to be a matter of satisfying your investors? What are your priorities?

Everwijn, Rabobank: In the absence of shareholders, conversion into shares is not a possibility. So for us the option is quite simple. It will either be permanent or temporary writedown, so we have to wait for the final technical standards to be released by the EBA. But you have to work out how high the coupon should be ver-sus the return on equity the company is making. The higher the coupon, and the lower the return on equity, the longer it will take to be written back up. The prefer-ence will be for temporary writedown. But they will take a very long time to recover before being written back up, so there’s still the possibility of losing some principal.

Cebrián, CaixaBank: I would like to hear about inves-tor’s preferences. The level of discretion the issue has over temporary writedown actually means it could be

very, very similar to permanent writedown. Conversion seems to be the cleanest option, and the most likely. But it has a lot to do with how the current shareholders feel. Some might take a position, and say they refuse to be diluted. It’s not just about the process of conver-sion or the process of writedown, but also about the management and the sort of reactions you will get well before the trigger is being pulled. You will always try to avoid hitting the trigger.

So from our point of view, it will have to be a cost-benefit analysis. But I guess the preference, and the best price, will be for equity conversion, rather than permanent or even temporary writedown.

Macdonald, Bluebay: I guess the first thing that I would mention is that whether you’re looking at equity conversion or permanent writedown, there’s probably still a question in my mind of whether you ever get to the 5.125% trigger or whether you hit point of non-viability before that.

That being said, I think between the three structures we would definitely have a preference for equity con-version. That’s the best way to respect the hierarchy of subordination.

The way writedown and write-up are structured right now doesn’t really do that and permanent writedown has the least respect for the hierarchy of subordination, effectively subordinating credit investors to the equity investors, which is not reflective of how a fixed income investment should work.

Dörr, Commerzbank: Are you more nervous about the issuer breaching the trigger, or about the issuer defer-ring your coupon?

Macdonald, Bluebay: I’d be a lot more nervous about coupon deferral.

Dörr, Commerzbank: That’s what I would have expected.

Reinhold, Nykredit: But you already get coupon defer-ral when you hit one of the buffers, don’t you?

Dörr, Commerzbank: Well, technically, CRD IV says that if you are within the combined capital buffers within the different quarters you can pay a dividend or AT1 coupons. In practice, I expect that as soon as you hit the 7% buffer, or whatever the top buffer level is, you don’t pay. You will want to get out of that buffer as soon as possible.

Juan Cebrián Torallas, caixabank


Issuer Roundtable

That’s the easiest way the management of the bank can treat all investors equally. We don’t have dividend stoppers or dividend pushers, so you either are in a position to pay everyone, or you don’t pay anyone.

Reinhold, Nykredit: Yes, that’s where the regulators will also probably have a say. I’m not sure that issuers will be making that decision for themselves.

Menounos, Morgan Stanley: When it comes to inves-tors evaluating loss-absorption mechanisms, is there a technical consideration around how mandates are struc-tured, whether you are able to take equity conversion, for example? Is there also a theoretical evaluation of some of the structural features, like for example struc-tural subordination? Have mandates evolved far enough for you to be equally capable of buying a conversion and a write-off structure, leaving the decision down to valuation?

Macdonald, Bluebay: Our mandates vary across the board. For the majority of the money we manage, we can invest in either. I think that’s a really important point that you raise though. What’s really important is that managers are investing their clients’ money in the way that their clients expect it to be invested. Even if some investments are technically allowed within the mandate, managers should only be investing within the spirit of what they’re supposed to be doing.

If we take our investment grade credit mandates and consider an instrument that we would see as subordi-nated to equity as an example, even if the mandate says we can buy that instrument, it wouldn’t be within the spirit of what we’re supposed to be doing for our cli-ents and so its difficult how to see how we could justify investing in it.

Any managers that focus purely on what they can or can’t do within the wording of the mandate, rather than what they should be doing are not doing a just job for their clients.

Aspden, GSAM: I would agree. From a theoretical point of view we have the ability to invest in all types of structures, but the reality is that our mandate is to get a good return on a risk-adjusted basis. If that risk is too high, it’s not good value for clients, especially when their mandates are quite specific sometimes about what you can and can’t invest in. Not only with things like equity conversions, but also ratings, and whether these things are investment grade, which then begs the ques-

tion of to what extent are these instruments actually investment grade assets.

Krim, Morgan Stanley: How important is rating? Banks are starting to focus on supporting their rating with capital.

Also, we’ve seen a lot of liability management activ-ity, with everyone around the table having different experiences about how they have handled liability it. Until now that has been about generating core tier one. How do the issuers see liability management as means of generating total capital?

Dörr, Commerzbank: Having been quite active in lia-bility management, because of generating core tier one, I don’t think there will be any liability management on tier two, because that is taken care of by the statutory bail-in regime.

With many of the grandfathered additional tier one instruments, when they lose AT1 recognition, they’re simply tier two. Many of them are perpetual tier two, I think, so you just have to look at the economics to work out whether it’s worth doing a liability manage-ment exercise.

It really depends on the situation, but what I mean is that the grandfathering rules of CRD IV give you a lot of options.

Krim, Morgan Stanley: Doing an exchange from old to new tier one is what remains to be tested. But we still don’t know whether investors will be comfortable flipping from the existing tier one. It will be grandfa-thered. Some of those deals already have writedown features, and some of them already have non-cumu-lative coupons, but in the UK, for instance, we didn’t have any write down or write up deals.

So to go from current UK tier one to CRD IV-compliant tier one is a big step, compared to the hybrid tier one paper that we’ve seen issued around Europe, like in Italy and France.

Cebrián, CaixaBank: I totally agree with Norbert. I think the picture’s going to change, because of the sovereign support aspect that used to affect ratings. Your level of capital is defined by a far more complex equation than the one that is used to calculate your S&P risk-adjusted capital (RAC). But we can’t complain about that — the only thing we can do is show a larger RAC.

Savadia, Lloyds: Liability management has proved to provide one effective way issuers can optimise capital structure, and it can work both for issuers and investors. I agree that the rationale for such exercises may well be different now than they have been previously, but we’ve seen that liability management does provide an effective solution for specific needs, and it can be structured in a way that works for the relevant stakeholders.

As for rating, we need transparency from the rating agencies, as methodologies have changed. This must have affected their relevance from an investor stand-point. I suspect investors are doing a lot more of their own work now, and will additionally assign securities with internal ratings.

However, I suspect mandate restrictions around the ratings will continue, so it’s really for investors to determine how important ratings are when determining their investment criteria. s

Will Caiger-Smith, euRoWeek

CApitAl instruments


While european policymak-ers have been dithering over bank capital rules, regulators have been busy telling banks to raise more of it. Most have done so via cash-genera-tive 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 puz-zle, however. There are other buff-ers to fill to comply with CrD iV, the accompanying Capital requirements regulation (Crr) and europe’s vari-ous 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 dedi-cated to the product and investors allocating money,” says Claus Skrum-sager, co-head of global capital mar-kets eMea at Morgan Stanley.

“Three years ago people were scep-tical. obviously we have been helped by a very constructive fixed income market, where low yields have incen-tivised investors to look at higher yielding products such as hybrid debt.”

Focus on AT1Several jurisdictions still need to give clarity on tax deductibility for addi-tional 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 jurisdic-tions which have been active in pur-suing 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 deduct-ibility.

“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 mak-ing coupons tax deductible is part of that.”

after a long hiatus, tier two supply

resumed with a vengeance last sum-mer, with even banks in peripheral jurisdictions like uniCredit and Bank of ireland printing deals.

But now, with the official publica-tion of CrD and the eBa’s techni-cal standards just around the corner, banks are expected to focus on build-ing 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, addition-al tier one instruments must have a perpetual maturity, discretionary and non-cumulative coupons, and incor-porate a loss absorbing feature which is triggered when the issuer breach-es a 5.125% common equity tier one capital ratio.

Loss absorption trinityissuers have three options for that loss absorbing feature: equity con-version; 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-via-bility — 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 con-version 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 conver-sion 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

For a market that disappeared during the financial crisis, contingent capital has made a startlingly quick recovery. It probably would have been quicker without political wrangling over last minute additions to the European Union’s CRD package, such as a cap on bankers’ bonuses. But now that it’s back, what are an issuer’s options? Will Caiger-Smith reports.

Choose your instruments

“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”

Khalid Krim, Morgan Stanley

capital instruments


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, sharehold-ers are very suspicious about these instruments — because of the poten-tial 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.”

Total wipe-outat 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. per-manent write down is unpalatable to some fixed income investors — many argue that it subordinates bondhold-ers to equity investors.

There is no denying that perma-nent write down structures — or “wipe-out bonds” as they have been called — are at the more aggres-sive end of the loss absorbing capi-

tal 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 inves-tor friendly structures — and that because they are searching for yield, investors may continue to bite on the riskier permanent write down struc-tures.

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 domi-nating 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 invest-ing 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 instanc-es, where breach may be viewed as a less extreme probability event, equity conversion structures may be more appropriate,” he adds.

The third wayThere is a middle ground — of sorts. The market has had to wait a long time for the eBa’s technical stand-ards to detail exactly how temporary write down will work, and the indus-try’s massive lobbying effort has paid off. The near-final draft, published

%5.4%5.4%5.4%5.4%5.4

2.5%

5.0%3.5% 3.0%

5.5%

2.5%

2.5%

1.5%

1.5%2.0%

2.0%

Up to 2.5%2.5%

.

9.0%

7.0%

5.0%

0%

5%

10%

15%

20%

Risk-based MinimumCapital Ratios

Requirements for SIFIsunder

Basel III

Swedish Finish Danish Finish ICB Risk-based MinimumCapital Ratios

Requirements for Large Swiss BanksCommon equity tier one

SIFI bu�er

Capital conservation bu�er

Additional tier one

Tier two

Bu�er capital

Pillar two

Comparative overview

REGULATORY CONSIDERATIONS

Basel III/CRD IV SIFI

SwissSIFI

UK ICB

Source BCBS, Swiss Expert Commission, ICB Report, Danish SIFI Commission

Swedish SIFI

CET1 requirement

TCR requirement

Danish SIFI

2.0%

1.5% 10.5%

6.0% High trigger

3.0% Low trigger

Cocos

10%

19%

15.5%15.5%

12%

13%

9.5%

Cocos

2.0%

1.5% 10%

17%

PLAC

European National FinishesBasel 3/CRD4, Sweden, Denmark, UK and Switzerland

Cocos

Cocos?

European national finishes


CApitAl instruments


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 cou-pons 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 deci-sions to the issuer’s discretion. it is expected that the market will impose its own discipline, says rob Kendrick, senior credit analyst at legal & Gen-eral investment Management.

“Management will have a lot of explaining to do if they choose divi-dends and not coupons,” he says. “This at least gives issuers the capa-bility to act in bondholders’ inter-ests.”

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 regu-lators 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 con-version is not an option. Temporary write down and write-up is funda-mental to the europe construct.

“even banks that can issue equity conversion trades may opt for a non-dilutive instrument to keep share-holders 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 instru-ments.”

another consideration for addition-al 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 share-holders,” 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.”

New-style tier twoadditional 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 subordi-nated debt.

rather than incorporating contrac-tual write down or conversion lan-guage, tier two debt will be subject to point of non-viability loss absorp-tion 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 cou-

pons.The CrD package also discour-

ages banks from issuing callable tier two debt with a step-up cou-pon 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.

Semanticsin the precise use of the term, Coco stands for contingent convertible. if it is convertible to equity, CrD-com-pliant additional tier one capital is also a form of contingent convert-ible — it converts once the issuer breaches a 5.125% capital ratio trig-ger.

But the term “Coco” has become a catch-all for any form of loss-absorbing capital that incorporates

What Type Of Capital Should Be Considered?Review of instruments’ characteristics

CAPITAL STRUCTURING CONSIDERATIONS

two reiTytiuqE (2)Tier two

Coco

Regulatory classification (pillar one) CET1 T2

Pillar two CET1 (stress test capital) ü (ü)

(country-specific)

S&P RAC capital ü (ü)

Leverage ratio ü Ñ

Bail-inbu�er/total capital ü ü

EBA CT1

ü Ñ

Tax-deductibility Ñ ü

(1)

Note

1. If issued with 20 year final maturity (e.g. 20NC5 or 30NC5), subject to outcome of S&P consultation

2. Following the release of the S&P RAC criteria consultation, RAC-eligible instruments in tier two format seem to be o� the table

T2

Ñ

Ñ

Ñ

ü

Ñ

ü

Dilution risk

ü

Additional tier one

AT1

(ü)(country-specific)

ü

ü

ü

Ñ


Ñ(for write-down)

Ñ(for write-o�)

Ñ

N/A

Ñ

Ñ

Ñ

ü

Ñ

ü

“Tier three”

Ñ

All(RWA reduction)

Ñ

(ü)(RWA reduction)

Ñ

Ñ

(ü)

N/A

RWAreduction

Ñ

EBACoco

AT1


ü

ü

ü

ü


ü

What type of capital should be considered?


capital instruments


a loss absorbing feature based on a certain trigger. But Cocos are general-ly 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 mar-ket 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 trig-ger, 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 short-fall 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 — pub-licly 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 prepar-ing themselves. lloyds, rBS and Bar-clays 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 dia-logue with uK issuers around Cocos,” says the head of FiG DCM at one lon-don-based investment bank. “Given that the uK has really adopted con-tingent 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 look-ing into how Cocos could feature in banks’ capital structures.

Enlarge your RACBanks can also use loss absorbing capital to improve their ratings. Spe-cifically, Standard & poor’s counts some types of capital as risk-adjust-ed capital (raC), counting a portion of such deals as equity when it con-siders a bank’s capital for its rating methodology.

Before March 2013, S&p was count-ing tier two debt — subject to certain

minimum criteria — as raC compli-ant. Danske Bank and Société Géné-rale 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 grand-father deals it had previously given that credit to.

now only additional tier one capi-tal 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 struc-ture 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 Géné-rale and Danske Bank found when tapping the reg S dollar market for their deals.

“or you make the bond raC-com-pliant, 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 addition-al 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 regu-latory reasons, not for rating agen-cies; and in the raC context it is one agency out of the three that usually rate these institutions.” s

Overview of Bank CoCo ActivityIssuance Activity and Applicability

Switzerland UK Belgium Spain Denmark (2)

Context Format dictated by regulatory requirements for SIFIs

Format offers Pillar two stress test benefits

Not a CRD IV regulatory requirement

Company-specific, in context of repayment of government capital


Format dictated by EBA Coco and capital principal requirements


Format dictated by regulatory requirements for local SIFIs

Trigger High and low High High High (EBA) and low (1) High

Lossabsorption

Write-off or conversion

Write-off or conversion

Write-off Conversion Write-off or conversion

Additional benefits

None Pillar two stress test None EBA CT1 and capital principal recognition

TBD

Precedents UBS/CS Barclays KBC BBVA N/A

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●

●

●

●

●

●

●

●

●

Overview of Coco rationale and regulatory benefits



Bank Capital Investor Roundtable

EUROWEEK: It has been estimated that by 2018 the market for Cocos and AT1 will be worth $1tr. Is this realistic?

Alex Menounos, Morgan Stanley: The $1tr number sounds too high, but it is clear that this has to be much more than just a niche market. A couple of years back, we saw the emergence of Coco and Basel III opportu-nity funds. But if the market is to grow to anything like what 1.5% of bank RWA suggests, it’s going to have to be a mainstream product for flagship funds — not just a niche investment.

It’s likely to be a product with multiple types of inves-tors, ranging from real money to hedge funds and high yield or distressed debt investors. In order for this to happen, a few technical issues need to be addressed, one of which is the need for mandates to be sufficiently flex-ible to accommodate new structural features, including

conversion to equity.There is also a ratings issue. Given that a large amount

of Cocos and AT1s will be sub-investment grade, some funds may not be able to adapt. High yield and dis-tressed funds may step in and make up the difference.

Then there is the question of index eligibility, which is obviously not an issue for all investors around the table. Even for those where it is a factor, most investors are able to make significant off-index investments.

From a fundamental perspective, there are other chal-lenges that need to be addressed. Investibility for one, given there are still structural features that some inves-tors have not got comfortable with, like subordination to equity.

Finally, there needs to be a common basis from which to approach relative value and pricing. The market will find a way of comparing instruments across different jurisdictions, looking at the size of the buffer to trigger

Participants in the roundtable were:

Georgina Aspden, executive director, global fixed income and currency, Goldman Sachs Asset Management (GSAM)

Dierk Brandenburg, senior credit analyst, fixed income, Fidelity Worlwide Investments

Vincent Cooper, BlueMountain Capital Partners

Dr Norbert Dörr, managing director, group treasury, head of capital management and planning, Commerzbank

Bruno Duarte, analyst, Claren Road Asset Management

Rogier Everwijn, managing director, head of capital issuance and structuring, Rabobank

Andrew Fraser, investment director, Standard Life Investments

Khalid Krim, head of capital solutions EMEA, Morgan Stanley

James Macdonald, credit analyst, BlueBay Asset Management

Alex Menounos, head of European IG debt syndicate, Morgan Stanley

Simon Morgan, Moore Europe Capital Management

Phil Moore, moderator, EuroWeek

Cocos pose bank capital a trillion dollar question

An increasingly diverse and liquid asset class in instruments across the capital structure is taking shape. But there are plenty of unresolved questions facing investors in instruments such as Cocos and additional tier 1 (AT1). To discuss how they are meeting these challenges, a number of investors and several issuers gathered to compare notes at the Morgan Stanley Bank Capital Investor Roundtable in late May.



and the capital flexibility of the issuer, as well as the spe-cifics of the structure.

EUROWEEK: How do mainstream investors address the technical challenges arising from mandates, for example, that Alex mentioned?

Andrew Fraser, Standard Life: With difficulty. Most of these instruments are non-benchmark dollar issues, while most of our funds are either euro or sterling denomi-nated. So as Alex said, for us most of them are off-index positions.

That is also true of our high yield funds, which are ex-financials, so when our high yield fund managers are looking at these instruments they are competing with other high yield instruments. We like the asset class as a concept, but our ability to invest is relatively limited.

Because these are new instruments, their loss-absorb-ing characteristics need to be explained to our clients, some of whom don’t want to take the risk of having these in their portfolio. So a number of mandates will exclude them completely.

Dierk Brandenburg, Fidelity: For long-only managers the index question is always going to be an issue, particularly with regard to secondary market liquidity.

Andrew mentioned that a lot of these issues are dollar-denominated, so we have to ask how yield-driven the current investor base is, and how their appetite may change in an environment of rising dollar rates.

Broadly speaking, we have now reached a point where CRD IV is coming in, and a lot of headline regulatory ini-tiatives are coming to an end. So we are moving towards regulatory consensus, which may include a number of features that neither investors, nor banks, nor even regu-lators themselves like. But the key challenge is to make it work, and to price instruments correctly.

Our view is that contractual contingent capital bonds are particularly cheap at the moment. They are being issued at big premiums, and given that we are headed for more stringent bail-in regimes anyway, I would question how much cheaper traditional instruments are. So overall we see it as an attractive asset class.

Simon Morgan, Moore: Firstly, my comments throughout this forum reflect my own personal views.

It’s a question of creating value across structures. I believe you have to return to basics, which means doing your credit work, knowing the issuer and understanding

the buffer to the trigger. After that, the various write-down mechanisms work in different ways for different investors. They work for some mandates and not for others.

Over time I think that the market will evolve and con-verge towards a core set of structures across euros and dollars, and with some sterling issuance. That will make it a lot easier to invest in.

I’ve seen some research pieces that look at valuation based on a breakdown of the sum of the parts — host pricing, subordination risk, distance to buffer, conver-sion optionality, and so on. I’m not sure how helpful that is, because it’s very difficult to ascribe a point estimate of value for any of these factors and, from a hedging perspective, it’s not possible to monetise many of these options. It’s all theoretical — which takes me back to the notion of employing fundamental credit work and not being distracted by structural tweaks whose real purpose is to navigate through mandate limitations and expand the buyer base.

This is clearly a nascent market. If you think back to interest rate swaps, investors tried to quietly extract value by taking advantage of compounding or day-count nuances, because the market wasn’t fully developed, fully standardised or fully understood. I suspect we’re at a similar stage today in the Coco bank capital market.

I question the $1tr figure you mentioned at the begin-ning, which seems quite high. I recently saw one piece of sell-side research that said there was $260bn of tier two securities outstanding and $160bn of tier one. If Cocos can develop to a similar scale, and currently there is a question mark over that in my own mind at least, it will clearly become a very meaningful market.

Bruno Duarte, Claren Road: We find the $1tr number a bit sensationalist. When the first ECNs were issued, the consensus was that the market was going to open up and that the majority of the banks were going to issue ECNs. Only last week we had Lloyds and RBS both saying they no longer need to issue ECNs.

With margins under pressure, the current fundamental operating environment for banks makes it very difficult for the vast majority of them to print these instruments. Besides, some banks don’t even have a full capital struc-ture curve out there. So to think that all of a sudden the floodgates open and we have $1tr of these instruments is perhaps somewhat unrealistic. It may happen in the long term, but for the time being there are perhaps 10 or 12 banks that can print these structures and do so at a

Andrew Fraser, Standard Life inveStmentS

Bruno Duarte, CLaren road aSSet management



level that makes economic sense. The rest of the sector is still in a rehabilitation phase following the financial crisis.

Alex Menounos, Morgan Stanley: Hopefully we are close to getting clarity on CRD IV. But what does that actually mean, given that we have different jurisdictions across Europe, with different national finishes? Although we expect to get a blueprint for what an additional tier one structure looks like, it’s clear that issuers across different jurisdictions will gravitate towards different structures based on these national finishes.

How as an investor do you then assess the investment opportunity and relative value? How do you compare the instrument, the issuer and the jurisdiction, given the diverging views on bail-in, different trigger levels and minimum capital requirements?

Georgina Aspden, GSAM: As an investor the relative value assessment starts with the credit. When you’ve identified which credits you like, you look for where the best value is within the capital structure.

At the moment, because the new instruments are so idiosyncratic, and because there isn’t a full capital struc-ture across all issuers, we have to pick and choose where we see best value. That might be in a new structure or an old structure, because I don’t think the old and the new are necessarily fungible just because bail-in is coming in. The reality is that there is a difference between contrac-tual and statutory, and there is a difference between a trigger that you can flip versus a point of non-viability (PONV) that we are all still uncertain about. All these fac-tors will have an impact on pricing.

James MacDonald, BlueBay: I agree that you have to start with the credit, and beyond that it is more of an art than a science. Given the variety of instruments in the market and the number of moving parts, trying to develop a spe-cific mathematical formula for identifying relative value is next to impossible.

On the question about mandates, one of the messages we’ve been sending to syndicate desks is not whether these instruments can fit into our mandates, but the degree to which they are appropriate for our clients. A lot of people have pointed out that traditional long-only funds can’t buy equity conversion, but they can buy per-manent writedowns. The question that we’d ask is: what makes more sense for your clients?

Vincent Cooper, BlueMountain: We aren’t in any way

restricted as to what we can buy. I care about ratings and indices-eligibility only because of the impact they may have on mainstream investors and on the liquidity and size of the market that is available for these instruments post-issuance. Will there be other buyers out there if we change our view on the credit?

Broadly speaking, we take a barbell approach. We’re open to all types of structure but we prefer to look at secured debt at the higher end of the capital structure, where we can do fundamental, intrinsic assessment of the value of the secured assets we’re buying. And then we’ll look at the higher yielding, higher volatility oppor-tunities offered in the Coco and AT1 space, where you can be better rewarded for taking views on the credit and the fundamentals of that credit.

Fraser, Standard Life: That will definitely be true as we move into a bail-in world.

To come back to an earlier point, I do believe that existing capital instruments probably are fungible with new ones, because if the bank runs into trouble, you’ve lost money across the capital structure, even as far up as senior. That’s the world we’ll be living in from 2015 onwards.

EUROWEEK: Are buffers more important than the triggers themselves?

Brandenburg, Fidelity: We all spend an awfully long time calculating buffers, and in CRD IV there will be a lot of intangibles in these buffers, such as goodwill and DTAs. You can’t really buy these securities based on today’s buffer. If you invest in these securities you’re making a call on the future earnings power and diversification of the issuer, because the leverage in the sector as a whole is still so high that it’s very hard to come up with a model that tells me whether or not a 4% or 5% buffer is enough, because that could get wiped out very quickly.

Intangibles can disappear very quickly if there’s a problem. For example, in a crisis it doesn’t take much to cause a $5bn goodwill writedown, which is why I am always wary of goodwill. The same is true of DTAs, because again, in a crisis the first thing you realise is that your DTAs aren’t worth what they used to be. So it’s important to strip them out.

I think this limits the use of these securities to organ-isations at the larger end which have earnings power and diversification, which can only be delivered by the large cap banks.

Khalid Krim, Morgan Stanley: So what should the mini-mum size of the buffer be? Should it be 1%, 2%, 3%?

Aspden, GSAM: You don’t necessarily look at it as a per-centage. Yes, you look at how close it is to the trigger, but what is more important is to look at the balance sheet and the risk of burning through the buffer. So you can’t just say it should be 1% across all European banks. The risk of getting to the trigger will vary, depending on whether you’re an investment bank or a small, domestic retail bank. That’s where we add value with the credit work we do.

Duarte, Claren Road: Adding to Dierk’s point, we believe that market sometimes gets carried away with looking at just the capital ratio, taking the RWA for granted. The danger there is that if those RWAs start changing, all

Georgina Aspden, goLdman SaChS aSSet management (gSam)



of a sudden you could lose 50bp or 100bp, which cre-ates a different ballgame. You can assume a 2% buffer is fine, and then get blindsided by RWAs going up by 10% because the regulator has decided that it wants to be more conservative on risk weights across the whole sector.

Brandenburg, Fidelity: So accounting changes that may come in over the next couple of years could also influ-ence your capital calculations.

EUROWEEK: So from an investor’s perspective, the credit work is much the same as in the senior unse-cured market?

Brandenburg, Fidelity: Yes. Except that you’re much more leveraged to the issuer’s earnings power. So recur-ring earnings power is quite important for these securi-ties.

Krim, Morgan Stanley: How much and what kind of information do investors expect from issuers in the market? We’ve been hearing a number of investors say-ing that it’s difficult if they have an instrument with a capital-based trigger — a Coco or an AT1 — to moni-tor it, unless they are given more details by the issuers themselves on how their ratios are evolving. What infor-mation can issuers give you that would make you more comfortable with the risk that is linked to AT1 or Cocos?

Duarte, Claren Road: It comes down to doing your home-work and analysing the worst-case scenario. In the case of BBVA, for example, if it decided to sell some stakes in Mexico or in China, would that give a sufficient buffer to move away from the trigger?

Then you have to look at the issuer’s track record. If management has a great track record and has never done anything untoward, as an investor you can get more comfortable and it becomes a more palatable investment.

Overall, we wonder if we’ll eventually go down the US path where you basically have equity and senior. In-between, you might have some plain vanilla tier twos, because in a point of non-viability (PONV) world, why issue a 10% coupon when 5% serves the same pur-pose?

Rogier Everwijn, Rabobank: I can imagine that a tier two investor is looking for more protection than a tier one

investor. So having additional tier one layer on the bal-ance sheet can help provide the cushion you’re looking for.

Norbert Dörr, Commerzbank: If you have an instrument that includes specific triggers or features that are rel-evant to the time of issuance you only get a very specific investor base that is able to price and trade them. It gets even more interesting if you have triggers and features that currently don’t matter but suddenly start to matter in the future.

As a consequence, I think people need to stand back a bit and try to achieve more standardisation. This would also allow for the development of a broader investor base.

Menounos, Morgan Stanley: Standardisation from the per-spective of structure, or in terms of national finishes?

Dörr, Commerzbank: Overall, there needs to be transpar-ency on the capital hierarchy, on when the regulators will intervene in a soft way by asking banks to do some-thing in normal markets or when they will intervene in a recovery scenario. And there should be transparency on the criteria at which they will intervene in a resolu-tion scenario.

There also needs to be standardisation of the instru-ments themselves, so that every investor knows that if he buys an instrument from a given bank in a given jurisdiction, he knows how all the regulators and rel-evant authorities will act.

Krim, Morgan Stanley: CRD II in Europe, before Basel III, was meant to provide a framework for a harmonised structure, especially for hybrids. Frankly, we ended up with structures that weren’t harmonised across Europe. So the challenge for CRD IV and CRR I is to reach a level of standardisation where investors can benchmark and compare structures across the EU.

Fraser, Standard Life: Banking union across Europe should deliver this standardisation, with the EC decid-ing when a bank is non-viable rather than having the Germans, the French and the Dutch regulators making the decision on an individual basis.

Krim, Morgan Stanley: It is important that banks in dif-ferent European jurisdictions come to you as investors with comparable instruments and help you to become

Dierk Brandenburg, fideLity WorLWide inveStmentS

Dr Norbert Dörr, Commerzbank



comfortable with how their various capital securities fit into the capital structure. That would also make it easier to have a discussion about pricing and relative value.

We haven’t yet seen a harmonisation of structures, because we’re still in a transition phase.

In talking about the size of the market, we already have a pool of legacy subordinated debt that banks have, during the last decade, sold to investors around the table in tier one and tier two format.

Today, issuers are looking to transition, and to recycle these securities into the next generation of tier one and tier two instruments.

Cooper, BlueMountain: It’s interesting that all the inves-tors here have talked about the importance of knowing the credit, or being comfortable with the credit quality. But we still spend an enormous amount of time — argu-ably wasted time — talking about the technicals of bond structures, which ultimately leads to poorer fundamental analysis of credits and poor asset allocation across the whole credit space. So the quicker we can move to a harmonised, homogenous-type product, the better for fundamental credit analysis.

RWAs and core tier one calculations also need greater clarity. Core tier one as a trigger metric is clearly flawed, but in our opinion it’s the best of a bad bunch as a trig-ger for a Coco conversion security.

It would be very helpful to have more clarity around RWA calculations. Most of us probably look at things like average RWAs to asset ratios across the banks in Europe and try to dig down where we can into specifics.

It would be helpful if issuers could provide a lot more colour about what their RWA calculations entail, because there are some enormous differences in the size of RWAs to size of assets that are difficult to explain.

EUROWEEK: Are other investors spending more time looking at RWAs?

Duarte, Claren Road: Definitely. It has been an important issue across the European banking sector for some time. If you look at where RWAs were two or three years ago compared with today, capital ratios are indeed higher, but RWAs are lower despite greater asset bases.

The absolute amount of capital has been raised in the last two or three years but the sector’s recapitalisation has come also from the optimisation methodology that banks have used. If we’re looking at RWA metrics of a second tier issuer, what assurances do we have that the national regulator does not decide mortgage risk weights should be 25% rather than 15%?

As an investor, do we have the information to do the calculation accurately ourselves? The answer is no. We think that as this market develops the issuer will have to provide more of this information so that investors can do their own homework.

Dörr, Commerzbank: Regulators are addressing this issue in various ways by introducing risk weight floors for certain asset classes, for example, or counter-cyclical buf-fers on the capital requirement side.

Brandenburg, Fidelity: Some more initiatives on leverage ratios would be helpful for Coco investors. Right now banks have various different ways of computing their leverage ratios and there is very little regulatory push towards uniformity.

Fraser, Standard Life: More balance sheet disclosure on a quarterly basis would be appreciated. I’m not talk-ing about issuers like Rabobank or Bank of Ireland, but about the French banks, which don’t publish quarterly balance sheets, which for major global banks is incred-ible. They publish their core tier one ratios but they don’t give any breakdown, and they hardly ever provide you with a total assets number.

Krim, Morgan Stanley: We have the EBA now tasked to draft the regulation and the ECB which will supervise the European banking sector. How much comfort do you take from that in terms of having an entity that oversees national regulators and can help to promote transparency and comparison of banks across Europe?

Cooper, BlueMountain: I place very little reliance on regu-lators, based on the experience of multiple stress tests in recent years which were unable to pick up on banks which subsequently failed. Even in 2013 we’ve had two effective failures in the UK and the Netherlands, and it’s clear that in those instances the regulator was not in any way on top of the situation.

My guess is that the regulators have limited manpow-er. So I wouldn’t expect that when we move towards a pan-European supervisor things will improve much.

Brandenburg, Fidelity: I think the only country which has defined a PONV is Canada. There seem to be sched-ules out there between regulators and banks that say if the capital ratio drops you do x, y and z. But what we don’t know right now is where dividends stand relative to alternative tier one coupons. Will the coupons be suspended at the same time as the dividends, or will the dividends be suspended first, then the coupons? And at what levels does this kick in? Particularly in the case of AT1, this is clearly an unresolved issue, which was not answered in the BBVA issue.

And then, what is really the difference between a 7% and a 5.125% trigger? And how does this relate to PONV? What happens right now is everybody puts the PONV very high — at about 10% — which is clearly not in the interest of the banks.

But my hunch is that PONV could actually be quite low. On systemic banks it will still be difficult for any regulator to put them through any of the existing bail-in and resolution regimes. So at the moment there is something of a stand-off, whereby the regulators like to talk tough but it’s not clear how realistic all this is.

Khalid Krim, morgan StanLey



What needs to be cleared up is: is the PONV a last resort or a first resort? And where do all these triggers in the middle fit in?

Menounos, Morgan Stanley: So, in a high trigger instru-ment, do investors think regulators will allow this to be breached before triggering PONV, and conversely for a low trigger instrument, will PONV come before the con-tractual trigger?

Fraser, Standard Life: Before you even get to the trigger or the PONV, you have the regulatory discretion to go in and tell the bank to switch off its coupons, and by doing that you signal to debt investors that there’s a problem. That language will start to worry AT1 investors long before you get to the PONV or the trigger.

Menounos, Morgan Stanley: Some may even go as far as suggesting that a low-trigger AT1 instrument — where market perception may be that PONV comes before the contractual trigger is reached — would leave investors more focused on coupon and extension risk, rather than going-concern loss absorption, and may therefore not be a huge departure from what we had in the past. Cooper, BlueMountain: Maybe we should be thinking about these additional tier one coupons much more like dividends. I think the investor base is still coming round to this, or hasn’t quite grasped the risk of this being a dividend rather than a coupon.

We as a firm have an issue with the fact that the new AT1 is not going to have any kind of dividend stopper language, because we typically like to have very good, clear legal recourse and hierarchy. It feels as though we’re investing on the basis of reputational risk, which as we’ve seen in the past can change quite quickly. I don’t think it’s a great investment thesis to assume that an issuer is OK and is going to keep paying the coupon.

The only argument I would have against this is that previously, under the old tier one structure, you could in theory have had a situation where a bank decided that for every five or 10 years, say, they wouldn’t pay any dividends or any tier one coupons. Instead, every five or 10 years they would pay a massive extraordinary dividend alongside a single tier one coupon. And you wouldn’t have been in that much better a position, as an old-style tier one investor with your dividend stopper, than you are now.

So while I don’t like the structure as it is, it’s not a million miles away from what we already had anyway.

Everwijn, Rabobank: There are ways for an issuer to at least provide comfort to an investor that it won’t have a preference for paying dividends over tier one coupons. What we did in our latest tier one structure was to align the coupon dates with the dividend dates of our CET1 instrument, so at least the investor knows that the issu-er’s decision to stop paying your dividends or on your tier one securities occurs at the same time.

Fraser, Standard Life: Do you think the Dutch regulator would allow you to pay an equity dividend and not pay a coupon?

Everwijn, Rabobank: I don’t think so. I think once you are forced to stop paying dividends the question also arises of whether or not you should stop or will be required to stop paying on your AT1 coupons.

Macdonald, BlueBay: The first point Vincent made is key, which is that previously when people looked at tier one instruments they were seen very much as fixed income products which were expected to pay a coupon every year. Given the way people look at AT1 instruments and their subordination features, the coupon looks much more like a dividend now.

So I think people’s expectations are that it is optional rather than mandatory. That optionality raises the ques-tion of whether we should look at these as pure fixed income instruments.

EUROWEEK: Does this mean that AT1 is as close to equity as you can get?

Brandenburg, Fidelity: There’s the obvious difference that there’s a call date which you don’t get with equity, but apart from that I’d agree that it’s as close to equity as you can get.

Cooper, BlueMountain: One other aspect which credit investors may still be gaining awareness of, is that with the new buffers we have now, and particularly with the capital conservation buffer, in the future we will poten-tially be reaching situations where the regulators are going to be forcing banks to stop paying the coupon. So there are going to be threats to the coupon much earlier than investors appreciate right now.

Menounos, Morgan Stanley: Does that mean that you would prefer a high-trigger, tier two host instrument

Alex Menounos, morgan StanLey

James Macdonald, bLuebay aSSet management



with certainty on coupons and no extension risk versus a low-trigger tier one instrument? In other words are you prepared to take the write-off risk as opposed to taking the lower trigger, but with the extension risk and the potential coupon risk?

Cooper, BlueMountain: I tend to prefer not having the extension risk. I typically don’t like the callable-type structures because I don’t feel I’m getting sufficiently well paid for the credit risk I’m taking. But it’s a tough question, because it will vary from issuer to issuer. It’s almost impossible to give a generic answer, particularly without any kind of prices.

Everwijn, Rabobank: What’s your definition of a high trigger?

Menounos, Morgan Stanley: That’s a good question, but let’s call it 7%.

Everwijn, Rabobank: In that case I think the risk of non-viability is always there and that under the new bail-in regime PONV risk probably occurs above 7%. That makes it an attractive instrument for an investor; one can argue that they get compensated for a risk that is unlikely to be triggered.

Duarte, Claren Road: We agree that if the issuer is going to stop your coupon it becomes more like equity. However, we believe that reputation still plays a part for most issuers that will be in the market constantly refinancing securities. Management should be willing to pull all possible levers to ensure that the bank stays comfortably away from the trigger.

However, with a one-off issuer that plans to rely more on equity, then clearly there are higher risks. But for a global Systemically Important Financial Institution, irre-spective of how unfriendly the structure may appear to be, there is a vested reputational interest on the part of the issuer to honour those coupon payments.

On the question of the PONV, what is very important is that this has historically been determined by whether or not there is a run on deposits. What we saw with certain banks in Europe is that the moment regulators start to get nervous, the first thing they have to do is to intervene in order to safeguard the system. So it doesn’t matter if your core tier one ratio had been 10% or 12% the previous quarter, the reality is that you could have a PONV of 5-1/8th but if there’s a run on deposits that

PONV will be invoked.So as an investor you have to go back to asking your-

self how stable the franchise is, how comfortable you are with the assets on the balance sheet, and do you feel fundamentally secure that in a worst-case scenario this won’t happen?

Menounos, Morgan Stanley: Therefore the jurisdiction must come into play in terms of your analysis, as well as buffers, earnings power, RWA and capital flexibility?

Duarte, Claren Road: Absolutely. We think investors are very cognisant of issuers across the different regimes. A Sifi in southern Europe is probably going to get more forbearance from the local regulator than a bank in the UK where there is more clarity about what will happen in a bail-in scenario.

Menounos, Morgan Stanley: On the question of relative value, we find that most investors will try to find some-where to anchor the pricing. Most take a fundamental view that they will buy a deal because they don’t expect it to ever get triggered. But once you go beyond that decision, relative value has to come into the analysis.

If you take something as crude as the premium to host instrument, among the issuers that have already come to market such as Barclays, KBC and even the Lloyds ECNs, there is a pattern in how these trade. Do investors assign a weight to the size of the buffer, the capital ratio, RWA complexity and jurisdiction and come out with a fair value over host, comparing it to existing deals?

Morgan, Moore: I’ll answer that by asking you a ques-tion. I haven’t had a single bank come to me with a pric-ing construct that begins with equity and works down from there. It’s always bottom up. Why don’t the banks come to us with a construct which begins with the cost of equity?

Menounos, Morgan Stanley: It’s a good question. Do people look at the relative value question fundamentally, and adopt a bottoms-up pricing approach? Or do they look at value in the context of what is already out there?

Cooper, BlueMountain: We try to place value in the context of what is already out there. We don’t just say, ‘the structure is brilliant and we love the credit so let’s buy it regardless of the fact that it trades 300bp through its peers’. This is why Coco relative value analysis is quite difficult right now, because there aren’t that many instruments out there for comparative purposes.

We do think about the cost of equity, and the extent to which we would rather own additional tier one than equity. But one of the difficulties I have personally with the callable structures — particularly when you have a short call with a potentially long extension — is that it’s very difficult to price the option that you’re selling the issuer for a long period of time in these instruments. I think investors are undervaluing the option they’re sell-ing to issuers.

Krim, Morgan Stanley: But if you compare these instru-ments to the previous generation of tier one and tier two that banks used to issue, there has been a repricing post-crisis. We used to price these instruments at a very different level to what banks are paying today and will be paying going forward.

Rogier Everwijn, rabobank



Morgan, Moore: Things have changed as well in the sense that sub debt used to be ‘faux’ sub debt — there was the contractual possibility of loss absorption but with a very low perceived probability. Now, as a func-tion of tightened regulatory focus on account of instanc-es where sub debt has not performed as advertised or designed, there is a very realistic risk of loss, which is why there has been an element of repricing. There has to be a repricing to reflect the new risk paradigm.

BBVA is a very good example. It came well inside where people thought it should have priced, which,

according to some banks who weren’t involved in the deal, should have been at least 10%. That tells me that we’re in a market place where we’re not pricing credit. We’re pricing vast pools of liquidity that are competing for limited yield opportunities.

In 12-24 months’ time there may not be the same easy liquidity out there. But at the moment, everything is being priced relative to other issues, rather than with an eye to the actual fundamentals and risks. The lead managers force that on you. If you try to price an issue according to a rational, fundamental view, and you go to the syndicate desk at a bank that’s running the deal, they laugh at you.

The demand-supply equation forces you to either pass or acquiesce to the false consensus, because, as I said, there is a strong element of pricing liquidity rather than real risk.

I don’t feel that people are currently able to ade-quately price in the equity exposure that has been graft-ed on to what is primarily a fixed income instrument.

Menounos, Morgan Stanley: So do you believe that given bail-in and PONV, a Coco or AT1 is closer to equity than it is to sub debt?

Morgan, Moore: Yes. I also think the nature of the sub-ordinated debt discussion has changed in line with the change in the regulatory environment.

EUROWEEK: Would others agree that pricing is being driven by the rates environment rather than by fun-damentals?

Brandenburg, Fidelity: Yes. There is definitely a strong rates component to current Coco pricing.

Fraser, Standard Life: One of the problems is that BBVA priced the first AT1 structure at a 9% coupon, which in

a normal environment is fantastic for the issuer but for me as an investor is the wrong level.

EUROWEEK: What would be the right level?

Fraser, Standard Life: Double figures.

EUROWEEK: How has the evolution of the investor base influenced pricing?

Menounos, Morgan Stanley: We have seen a signifi-cant evolution in the investor base over the last 12-18 months. Historically, we would have expected demand for dollar-denominated Reg S transactions to be led pre-dominantly by Asian high net worth investors. We’ve seen the emergence of a US institutional bid, and over the last few months, Reg S have achieved a larger pro-portionate distribution into European institutional inves-tors versus Asia or high net worth.

So do issuers have a preference around the composi-tion of the investor base, and do investors buy Reg S dollars because they perceive that market to be broader and deeper with Asian high net worth? And are we ready for the first euro-denominated transaction?

Dörr, Commerzbank: I agree that there has been a shift in the investor base. The real objective should be to find the right balance between Asia and elsewhere. It is important to get clear signals from the institutional side about what they do and don’t expect from a deal. For example, they don’t want you to move too much into Asia and create flowback as a result, which might dam-age the secondary market for the deal.

I think for issuers it will be vital to ensure they have a functioning secondary market that is accommodative of multiple issuance.

Everwijn, Rabobank: It’s also important not to design instruments that are targeted just at retail. You need to focus on the Asian private banks and on the institutional base in Europe and the US.

Krim, Morgan Stanley: Having spent quite a lot of time with regulators I would caveat that. There is a big focus in Europe on MiFid, and on ensuring that products aren’t mis-sold to retail clients and this is right. I would not go as far as stating that regulators prefer or are keen to see bank capital raised outside Europe.

For instance, we’ve had the EBA and other European regulators and policymakers asking us why we haven’t seen more European investors playing in this space, and why recent deals have been denominated in US dollars rather than euros. Is it because of the regulatory frame-work or because investors still have concerns about banks in the Eurozone?

MacDonald, BlueBay: I’m not sure the currency is a big issue. My feeling is that far from dumb money it is probably smart money that is leading demand for these investments. These investors are getting coupons of 9% when rates are at zero, but in normal circumstances I doubt that demand would come from the same inves-tors. These are investors whose mandates allow them to buy dollars, euros and sterling, and to invest across the whole of the capital structure. So the currency is a different argument to whether it’s going to be a purely institutional deal that will go to long-only investors who

Simon Morgan, moore europe CapitaL management



will be regular participants in these products on a long-term basis.

Krim, Morgan Stanley: For issuers, currency does matter, and euro in particular, for two reasons. First, it gives them confidence if they know they have strong domestic demand and are not dependent only on the dollar mar-ket. Second, for accounting reasons, if AT1 is accounted for as equity, issuers don’t have to worry about how they should hedge their currency and/or interest rate exposure.

MacDonald, BlueBay: I agree that it is beneficial for the issuers. But for the type of investors who are buying the product I’m not sure it makes much difference.

Brandenburg, Fidelity: I like transacting in the US dollar market, although maybe not in Reg S format. I think the structures we saw in the dollar market last year were positive because I suspect they will help generate broader interest in these securities and potentially sup-port index inclusion.

On the European side, what concerns me is that there still seems to be a high degree of non-participation because the insurance sector which was a big buyer in the past seems to have checked out of this market alto-gether. So there doesn’t seem to be the depth of investor base which is a concern.

The good thing about the US market is that liquidity is such that issuers can always transact. The risk in Europe is that it’s a one-way street which will be driven by a handful of investors while the others stand back. I think a lot will depend on whether or not insurance compa-nies are going to participate in the market because they control a large part of the long-dated pools of capital out there.

Fraser, Standard Life: Solvency II is a big issue for insur-ance companies, given the amount of capital they have to hold against these low-rated instruments.

Dörr, Commerzbank: I think that a sufficiently strong bank could do a European deal. We may not see order books of the same size that we see in the dollar market for the reasons Dierk mentioned, but a deal could cer-tainly be placed. The question is: do you need to place a deal in Europe right now, or are you better off waiting until the recovery in the banking sector is reflected in spread compression.

EUROWEEK: Alex, do you think an issuer like BBVA would be able to issue AT1 in euros today?

Menounos, Morgan Stanley: The type of investors we’re seeing participate in Reg S deals today are far from being Asian only. There is definitely a skew towards institu-tional investors, and there is a good balance between real money and other investors.

That gives me a good basis to be constructive on the buyer base for a euro-denominated institutionally-target-ed transaction.

EUROWEEK: Going back to the discussion about resolution, would anybody like to comment on the two recent precedents we’ve seen, namely SNS and Cyprus? What lessons can investors draw from those events?

Cooper, BlueMountain: As a credit investor, I have some issues with what happened with SNS. I understand equity investors were given a lot of time to try and find some capital for that institution going back to the middle of 2012.

Because they couldn’t find enough, the regulator decided that not only the equity investors but also the credit investors all the way up to but not including senior would be written down to zero. It seems wrong to me that the credit investor community wasn’t given those same opportunities to find the necessary capital. A far more optimal solution to me would have been for the regulator to have put out a statement that said investors were going to get expropriated over the next two weeks unless they could find some kind of solution, with a senior or liquidity guarantee also provided.

The bonds would have dropped in response, but prob-ably not to zero. Investors would then have been able to make a decision on whether or not to inject the capital based on whether they saw some franchise value. That would have been a better way of tackling the situation than assuming that credit investors were meaningless.

Cyprus highlighted policymaker risk in Europe. The silver lining I take from Cyprus is that it did ultimately raise awareness of the importance of capital hierarchy, which Draghi spoke about afterwards at the ECB press conference.

Brandenburg, Fidelity: What Cyprus and SNS both point to is that banks will have to run higher levels of total capital. So far, I think the whole capital debate has been focused too much on core tier one. The fall-out from Cyprus is that we’re going to get depositor prefer-ence which means senior will be squeezed from above, whereas SNS tells us we’re going to get squeezed from below because the capital will be wiped out more easily. The answer in both cases is that there needs to be a big-ger buffer in the middle.

Krim, Morgan Stanley: In conclusion, a lot of work has been done but we are still in a transition phase. I’m pleasantly surprised at how much information on the developments that are happening on the regulatory side is already flowing to the investor community. As a result, investors are much more sophisticated and aware about where we stand. But there is still plenty to be done in terms of giving investors confidence that European banks are investable across the capital struc-ture — not just the national champions. s

Vincent Cooper, bLuemountain CapitaL partnerS

The InvesTor Base


“I’m astonIshed by the sup-port for this trade among euro-pean institutional investors,” was the response of one banker to the distribution of the $1.5bn addition-al tier one (at1) transaction from spain’s BBVa at the start of may, which generated demand of about $10bn from 400 accounts.

almost two-thirds of the BBVa issue was placed with asset manag-ers, with only 22% sold into hong Kong and singapore, which is a far cry from the early 2000s, when asian private banks provided a bed-rock of demand for european bank capital instruments.

some might suggest, provocative-ly, that there was nothing remote-ly surprising about the strength of european institutional demand for BBVa’s at1 deal. Where else, after all, could investors expect to be offered a coupon of 9% for a national champion in the european banking sector — albeit a champi-on from troubled spain?

true, the structure of the BBVa CRd IV-compliant deal was new, and, on the face of it, mightily com-plex, with four conversion trig-gers. But in today’s low-yielding environment, it is probable that some of the demand for the BBVa deal came from investors who were prepared to overlook some of the structural detail in exchange for an irresistible coupon. more, however, will have been driven by sophis-ticated accounts recognising the value of the 420bp buffer between BBVa’s core equity tier one ratio and the highest of the four equity conversion triggers.

While the strength of european institutional demand for the BBVa transaction may have been surpris-ing in its historical context, it built on a trend that has become increas-ingly visible over the last 12-18 months. as morgan stanley com-

ments in its latest Coco Compen-dium (published six weeks or so before the BBVa transaction), the buyer base for recent transactions has been “somewhat surprising in its breadth and depth”.

specifically, says the compendi-um, only 6% of UBs’s $2bn 7.625% Coco went into asia, and “a full 52%” of Barclays’ $3bn contin-gent capital notes (CCns), issued in november, was placed in the Us. the Barclays CCns generat-ed demand of some $17bn from 600 accounts, with 28% taken up in europe and a modest 16% in asia.

Asia remains crucial several important conclusions can be drawn from the recent distribu-tion of Cocos (loosely defined by morgan stanley as anything with an explicit trigger in addition to point of non-viability language). the first, however, is that although the participation of asian investors may be declining in relative terms, rumours of their wholesale with-drawal from the market are much exaggerated. that much is imme-diately apparent from the distri-bution data for a number of recent european bank capital issues.

In the case of société Générale’s $1.5bn perpetual risk adjusted cap-ital (RaC) tier two in november 2012, for example, asia account-ed for 40% of placement, while danske sold 58% of its $1bn RaC tier two into asia last september. Rabobank, meanwhile, placed 66% of its $2bn 8.4% issue in asia in november 2011, with 64% of the transaction absorbed by asian pri-vate banks.

“It’s a little early to say that asian private bank demand has withered in any way,” says Ronan mcCullough, managing director at morgan stanley in hong Kong. “I certainly wouldn’t downplay the

very encouraging way in which the european institutional investor base for this product has expand-ed. But name recognition is still very important in asia, and one reason why issuers like BBVa and KBC generated more demand in europe than in asia is that they are not household names among asian retail investors.”

mcCullough adds: “more gener-ally, asian demand remains strong. For example, the asian bid for the emirates nBd perpetual tier one at the end of may was exceptionally healthy.”

the $1bn emirates issue was unfortunately timed to coincide with heightened concerns about Qe in the Us and the mini-meltdown in the Japanese equity market. nevertheless, it built an order book of $4.25bn.

mcCullough says that robust asian demand for european bank capital first came to prominence in the early 2000s. In particular, he points to standard Chartered’s $1bn perpetual non-call five tier one issue in 2001, which was priced at a coupon of 8.9%, as a notable land-mark in the evolution of demand for subordinated debt into asia.

“the standard Chartered transaction was a huge success, underpinned by its tremendous name recognition in asia,” says mcCullough. “that deal was fol-

A year ago, to call the investor base for new-style bank capital instruments truly global would have been pushing it. Nowadays, the boast is not such a stretch, with Europe finally beginning to take a bigger role, most evident in the recent BBVA AT1 trade, US retail firmly behind the product, the US institutional bid gaining strength and Asian private banks as hungry as ever. Philip Moore reports.

Demand goes global as Europe comes on stream

“The idea that Asian investors will buy

bank capital on the basis of the name

and the bank’s rating alone has fallen by

the wayside”

Ronan McCullough,

Morgan Stanley

The InvesTor Base


lowed by others from a number of borrowers such as BnP Paribas, Lloyds, RBs, axa and allianz, all of which were sold predominantly to asian private banks.”

this demand, says mcCullough, was driven by a combination of powerful name recognition and alluring yields. “the higher interest rate environment and the relatively wide spreads on these new-fangled subordinated instruments meant that the absolute yield on offer was sufficiently attractive to the asian private bank investor base,” says mcCullough. at the time, he says, many asian retail investors were licking their wounds after the bursting of the dotcom bubble and were looking to recycle funds out of equities into fixed income.

today, yields continue to be as important to the asian buyer base. “one of the underlying realities of the asian market for european subordinated bank capital is that it remains dominated by private banks and is still very yield-driv-en,” says mcCullough. “We are see-ing more institutional demand. But the distribution power of pri-vate banks in asia, the scale of their assets under management and the fact that many retail inves-tors increase their leverage by buy-ing on margin, means the private banking investor community will remain bigger than the hedge fund or real money investor base for this asset class.”

that means that demand and pricing dynamics in asia are dif-ferent from those in the european institutional market. For one thing, says mcCullough, the asian bid tends to be determined more by absolute yield than Libor spreads or relative value analysis. For another, asian demand can also be more momentum-driven than it is in europe. “this means that demand can be less price sensitive than in europe where some institu-tional orders may fall away at a cer-tain pricing point,” he says.

mcCullough emphasises, how-ever, that it is wholly inaccurate to stereotype asian private bank sup-port as unsophisticated money. as he says, the client base of asian private banks is a wide spectrum that can range from individuals with $500,000 to invest in a lim-

ited portfolio of bonds, through to accounts capable of booking orders in single bond issues of as much as $100m.

the majority of the demand from private banks, says mcCullough, comes from inves-tors who are increasingly asking the right questions about com-plex instruments. “What has fall-en by the wayside is the idea that asian investors will buy bank capital on the basis of the name and the bank’s rating alone,” he says. “Investors are asking about the difference between statutory and contractual triggers, point of non-viability and temporary versus permanent write-downs.”

US comes onstreamBankers say that Us retail inves-tors, which are another important component of the global investor base for european bank capital, are also channelling more resourc-es into analysing the structures of Cocos and Coco-like instruments. “the Us investor base has long played an important role in buy-ing capital instruments from large european financial institutions,” says Kevin Ryan, managing direc-tor at morgan stanley in new York.

much of the recent demand from Us retail has been yield-driven, with european bank capital look-ing increasingly attractive relative to Us bank perpetuals, many of which, says Ryan, have been priced at coupons of 5.5% and below.

“In the domestic market, spreads have come in dramatically in both senior and subordinated debt as Us banks have become better capital-ised,” says nathan Wallentin, exec-utive director of the Global Wealth management Group at morgan stanley in new York. “But although there is no longer much in the way of a spread differential between Us and european banks in the senior debt market, the spread differential between subordinated securities, including Cocos, now stands out like a sore thumb.”

the reasons for this differen-tial, twinned with the sometimes mystifying evolution of the euro-pean regulatory framework, are variables that the Us investor base believes are worth dedicating time and resources to understanding.

“as an investment banker based in new York each morning I wake up to four or five emails that have come in overnight advising of some new regulatory announcement in europe,” says Ryan. as long as there were no more than two or three deals coming out of europe each year, he adds, it scarcely seemed worthwhile for investors to try to keep on top of the european regulatory agenda. “at least there are enough deals now to make the credit work worthwhile,” says Ryan.

Beyond retail participation, evi-dence is emerging to suggest that the Us institutional investor base is becoming more comfortable with Coco-style products. “the second UBs low-trigger permanent write-down Coco, which came in august 2012, was a significant milestone for Us institutional involvement in the market,” says alex menou-nos, managing director and head of european IG debt syndicate at mor-gan stanley in London. “that was the first Coco specifically anchored with Us institutional investors. Barclays subsequently placed more than half of its high-trigger write-off Coco in the Us, confirm-ing demand for both low and high trigger structures.” august’s 10 year bullet Coco from UBs attract-ed an order book of close to $9bn from about 400 accounts, with 58% placed in the Us, switzerland tak-ing 18%, the UK, 12%, and asia just 6%.

to date, participation by Us insurance companies has been minimal. In the second UBs $2bn issue last year, for example, only 4% of the notes went to insur-ance companies, with managed funds buying almost half the issue. Granted, insurers played a bigger role in the CCns issued by Barclays last november, accounting for 11%.

“I wake up to four or five emails that have

come in overnight advising of some

new regulatory announcement in

Europe”

Kevin Ryan, Morgan Stanley

The InvesTor Base


nevertheless, their overall partici-pation remains low, which con-trasts with their decisive influence in the market for private place-ments by overseas borrowers in the Us market, where insurers have historically been happy to use their credit skills to identify value, espe-cially at the long end of the matu-rity spectrum.

the role played by Us insur-ance companies in the market for european subordinated debt may change if and when they are able to pigeonhole bank capital securi-ties with conversion features more effectively than they can today. “smaller insurance companies in particular are still trying to decon-struct instruments such as Cocos to determine whether they should be booked as preferred, as equity or as debt,” says Ryan. “When we have greater clarity from the naIC [national association of Insurance Commissioners] on this, insurance companies may be an investor base to watch because more will want to participate in the market.”

Bankers say that european issu-ers are of course eager to culti-vate a deeper and broader domes-tic institutional investor base, not least to demonstrate to regulators and rating agencies that there is a diversified reservoir of demand for contingent capital throughout the cycle.

But that does not mean cutting off international retail demand, which bankers say is a deep and sophisticated investor base. as menounos says, high and ultra-high net worth investors, often with significant investment resources, represent an important source of established and sophisti-cated demand for deeply subordi-nated hybrid capital.

Europe catching upthe retail or hnW investor base also offers the appeal of being free from many of the constraints that may have held back the europe-an institutional bid until recent-ly. Foremost among these are the often asphyxiating mandates that dictate asset allocation decisions across large sections of the insti-tutional community. most of these mandates cling to the notion that debt is debt and equity is equity

and never the twain shall meet, which makes it impossible for many institutions to accommo-date structures with equity con-version features. “Placing these new generation instruments into traditional fixed income man-dates has been a key challenge for many real money investors,” says menounos.

there are other complications for institutions attracted by the structure and yield of Cocos. the first is that these instruments are generally rated non-investment grade, with their transition from gone concern to going concern products having prompted a fall in their credit ratings.

sub-investment grade ratings will continue to present a chal-lenge for institutional investors in europe. most obviously, punitive capital charges under solvency II will make the asset class a no-go area for insurance companies.

a second, related complication is the ineligibility of Cocos and at1 instruments for mainstream indi-ces, which again may be a reason for many institutional investors to give them a wide berth.

despite these constraints, menounos says that there are a number of encouraging signals to suggest that european institutions are finding ways around them. “several of the recent Reg s Us dol-lar Coco and at1 transactions have achieved two-thirds placement in europe, predominantly with insti-tutional investors,” he says. “the enduring low-yield environment has acted as a catalyst in the evolu-tion of the real money investor atti-tude towards going concern loss-absorbing instruments.”

menounos adds: “some con-cerns around structural subordina-tion remain. But the relative yield on offer versus other asset class-es seems to have compelled many to assign significant investment resources to this developing asset class. While initially we saw the development of a niche investor base driven by dedicated Coco and hybrid funds, many institutional investors have now adapted main-stream and flagship funds to cope with features like loss-absorption, the point of non-viability and equi-ty conversion.”

menounos says that while some mainstream european institu-tions have been relying on off-benchmark allocations to accom-modate these new generation and sub-investment grade-rated bank capital instruments, high yield funds have also been pivotal play-ers, accounting for more than half of the internal allocation for some investors. these funds’ antennae will have been aroused by Cocos and at1 instruments offering high-single digit (and in some cases dou-ble digit) coupons.

“Pre-crisis, tier one was typical-ly single-a rated and most deals would clear between 50bp and 100bp over swaps, levels which would not have attracted the atten-tion of high yield investors,” says menounos. “now that deeply sub-ordinated transactions are notched further away from senior debt rat-ings, which in turn are also lower, much of the Coco and at1 deal universe would be rated double-B, with a yield to compensate — and hence much more appealing to high yield funds.”

many of these funds will also have taken note of the spellbind-ing performance of some of the funds that were set up specifical-ly to invest in Cocos. one of the most striking of these has been the algebris Financials Coco Fund, which was set up in march 2011 and returned 56.4% in 2012 — mak-ing it the fourth best performing hedge fund in a Bloomberg ranking of funds with assets under manage-ment of $100m or more.

Euro Cocos a matter of timenevertheless, a euro or sterling denominated new generation Coco or at1 transaction remains con-spicuous by its absence, with issu-ers like UBs and Barclays having

“The spread differential between

subordinated securities of

European and US banks, including

Cocos, now stands out like a sore thumb”

Nathan Wallentin, Morgan Stanley

The InvesTor Base


strategically prioritised Us dollar investors with their recent Cocos. menounos, however, believes that a new generation Coco or at1 denominated in euros or sterling is only a matter of time. “I believe Reg s dollars was the most appro-priate market for BBVa to launch the first at1,” he says. “But I also believe that the euro market would already support an at1 transaction in euros for many of the national champions across europe. Beyond the perception that dollars may currently offer a broader and deep-er market, most european institu-tional investors are either indiffer-ent between the core currencies or have a mandate-driven preference for euros.”

that may be. But analysts are doubtful that there will be a dra-matic increase in supply in the immediate future, which is one reason why there is likely to be continued downward pressure on

yields. Indeed, in its compendi-um published in march, morgan stanley draws attention to “the (in our view, valid) expectation that there is not a deluge of Coco issuance in the pipeline.”

this view is strengthened by the general belief that the poten-tial universe of issuers remains restricted to national champi-ons. as menounos says, to date institutional investors in Cocos, in particular for write-off struc-tures, have drawn comfort from the belief that a breach of the trig-ger is a remote tail event.

this suggests that expecta-tions of an asset class worth $1tr by 2018 — which has been pre-dicted by davide serra, Ceo and founder of algebris — may still be premature. Perhaps more impor-tant, in the absence of a deep and highly diversified range of instru-ments in europe, is that the scope for relative value analysis of Cocos

remains limited. as one partici-pant puts it in the investor round-table discussion in this report, for the time being the market is still pricing liquidity, rather than credit risk.

that, say investors, means that pricing Cocos remains more of an art than a science, although a num-ber of reference points are availa-ble to those looking to unlock rela-tive value. “many investors use a building block approach to pric-

ing, where rela-tive value is expressed as a premium to the host instrument pricing,” says menounos. “For most investors, valuation starts with an analy-sis of the buffer to trigger in the context of the magnitude and rate of poten-tial losses in stress scenar-ios. a bank’s perceived abil-ity to raise fresh capital if under stress, either in the market, through dis-posals or other strategies is another key var-iable. Consid-eration is also given to specific jurisdictions and the likeli-hood of local regulators step-ping ahead of a trigger event.” s

“Placing these new generation

instruments into traditional fixed

income mandates has been a key

challenge for many real money investors”

Alex Menounos, Morgan Stanley

Allocation of precedent tier one securities and Cocos


Allocation of precedent T1 and CoCos


By Investor Type

Asia40%Europe

53%

Other7%

Private banks50%

Asset managers44%

Banks3%

Insurance 2% Other1%

US52%Europe

28%

Asia16%

Other4%

Europe74%

Asia24%

Other, 2%

Hedge funds24%

Banks2%

Private banks41%

Asset managers33%

Asset managers43%

Private banks 27%

Insurance11%

Hedge funds10%

Banks6%

Other3%

Barclays 7.625% CocoNov 2012

• Final pricing: 7.625%

• Book size: $17bn

• Final size: $3bn (5.2 times covered)

• Number of accounts: 650+

SocGen6.625% tier two Nov 2012


• Book size: $10bn

• Final size: $1.5bn (6.6 times covered)

• Number of accounts: ~325

KBC 8% CocoJan 2013

• Final pricing: 8%

• Book size: $8.5bn

• Final size: $1bn (8.5 times covered)

• Number of accounts: 300+

Barclays 7.75% CocoApr 2013



• Final Size: $1bn (3.5 times covered)


Asset managers46%

Private banks 11%

9%Insurance

Hedge funds23%

Banks3%

Other8%

US58%

Europe34%

Asia8%

Rabobank8.375% tier one Jan 2011



• Final size: $2.0bn


Asia51%Europe

32%

Other17%

Retail79%

Institutional21%

Asset managers60%

Private banks20%

Hedge funds20%

UK57%

Asia22%

France8%

Switzerland7%

Other6%

BBVA 9% AT1 Apr 2013

• Final pricing: 9%

• Book size: $9bn+

• Final size: $1.5bn

By Geography

LegaL, ReguLatoRy and tax oveRview


Investors can’t say they haven’t been warned. stephen roith, a partner at sidley austin in London, says that it is impossi-ble to predict what will cause the next financial crisis and, therefore, which triggers on new-style hybrid capital securities will be pulled. But one thing is certain: “the next time banks get into trouble, these are the securities that will be on the front line,” he says.

although their methods can sometimes appear circuitous and poorly co-ordinated, what govern-ments and regulators are aiming to achieve is clear enough. “Inves-tors should work on the assump-tion that regulators will be doing everything they possibly can to ensure that taxpayers aren’t forced to put their hands into their pockets before bondholders and even possi-bly before shareholders,” says David Howe at sidley austin.

that, as he says, is precisely what loss-absorbing securities are designed to ensure. It was their abject failure to do their job dur-ing the financial crisis, however, that has led to wholesale changes in regulation and to the wave of prod-uct innovation that has given rise to the development of cocos and other new generation bank capital instru-ments.

It is easy to see why policymakers are so single-minded about making sure that loss-absorbing instruments do what they’re supposed to do. according to the european commis-sion, the total amount of aid offered to banks during the financial crisis amounted to 30% of GDP. although the amount actually used was less than half of this, at about 13%, this remains an eye-watering total.

small wonder that governments and regulators have left no room for doubt in their approach to creditor subordination. “there is no question

that governments, regulators and, as a result, issuers are all going out of their way to communicate their message to investors,” says roith. “Investors should be under no illu-sion that politicians across europe want banks to be smaller, de-risked and more boring.”

the consequence is that although regulation governing subordinat-ed debt may appear to be punitive for investors, it is seldom opaque. Indeed, bankers say that where structures of new generation cocos and additional tier one securities look complicated, this is not the product of deliberate over-elabora-tion, but an inevitable reflection of a regulatory regime in a state of flux.

take the example of the $1.5bn additional tier one (at1) transac-tion from BBva at the start of May. the first of its kind to comply with the new capital requirements direc-tive (crD Iv), the BBva structure was regarded by many as complex because of its multiple conversion triggers.

“the structure of the BBva at1 has been described as complex, but frankly it wasn’t that complicated,” says Khalid Krim, head of capital solutions eMea at Morgan stanley in London. “there are multiple trig-gers in the structure, but with good reason. It is the eBa coco instru-ment combined with an addition-al tier one. this means it is effec-

tively two instruments rolled into one, which is necessary because we are still in a regulatory transition phase.” the apparently cumbersome structure, Krim adds, is a function of the issuer covering all bases by ensuring that the securities comply with both current and future eBa and Bank of spain requirements.

“For as long we remain in this transition phase, we will continue to see structural differences across jurisdictions,” says Krim. “that said, we are clearly moving towards greater regulatory harmonisation in europe, with crD Iv and crr ensuring that there will be reduced scope for discrepancies and differ-ences across the eU. For the first time in the history of the european bank capital space, we will have reg-ulation that applies in the same way in each eU state.”

others agree. “the key point is that crr is a regulation, and with eBa technical standards imposed on top, there will be very little scope for arbitrary or varying interpretations,” says roith. “that is distinct from the recovery and resolution Direc-tive (rrD), which as a directive will be interpreted and implemented on a country-by-country basis, which will still leave room for differences in interpretation as we have seen in the past.”

none of this is to suggest that investors are completely comfort-able with some of the legal detail associated with trigger-based con-tingent capital instruments. Jackie Ineke, managing director at Mor-gan stanley covering european financials credit, says that the con-cern most often expressed to her by investors about additional tier one securities is on lack of dividend stoppers. “Investors’ greatest con-cern is the fact that coupons can be cancelled whereas equity dividends can continue to be paid,” she says.

Regulatory harmonisation is on its way. Thanks to CRD IV and CRR, for the first time in the history of the European bank capital space, there will soon be regulation that applies in the same way in each EU state. However, as Philip Moore reports, investors will still need to make a judgement on the likely response of national regulators to banks judged to be failing or likely to fail.

Beware of regulator discretion

“The Recovery and Resolution

Directive will still leave room for

differences in interpretation”

Stephen Roith, Sidley Austin



“rabobank has tried to address this issue by harmonising the date they pay dividends to holders of member certificates with pay-ments on their tier one coupons. However, this doesn’t remove the possibility that still, sharehold-ers can be paid and tier one hold-ers not.”

Senior most vulnerable?Perhaps ironically, however, inves-tors most at risk from regulatory change are more likely to be senior bondholders than those buying into cocos and coco-like securities. this is because, as consultant Pricewater-housecoopers (Pwc) explained in a recent briefing: “the only real dis-tinction [between bail-in capital and cocos] is that the conversion trigger for bail-in capital is at the discretion of the regulator, whereas for cocos it is a fixed trigger.”

this implies that predefined trig-gers can’t be subject to revision. “the issuer can’t usually change unilaterally the terms of the issue,” says sidley austin’s Howe. “In other words, if an issue is structured with a low trigger it wouldn’t usually be capable of being revised to a high trigger without noteholder approv-al.”

the distinction is important,

because it suggests that while for coco and at1 holders conversion triggers are clearly defined, sen-ior bondholders will continue to be hostage to regulator discretion. It is this regulatory discretion that will determine the point of non-viabili-ty (Ponv), the definition of which is vague. In a recent Bank of eng-land speech, for example, Ponv was described as being reached “when the supervisory authority identifies that the institution was failing, or likely to fail, and that no other solu-tion, absent the use of resolution tools, would restore the institution to viability.”

It added that “resolution powers would only be used if it was nec-essary to employ them in order to meet clearly defined public interest objectives, for example the mainte-nance of financial stability and the protection of depositors.”

“If your product exposes you to what

the bail-in regime happens to be in

the future, then it is much more difficult

for investors”

David Howe Sidley Austin

Capital structuring considerations: European overview of tax deductibility of additional tier one instruments


Capital structuring considerations: European overview of tax deductibility of additional tier 1 instrum


• Uncertain given lack of specific tax rules and limited Swedish case law guidance

• Hybrid instruments generally accepted as debt for tax purposes, provided there is formal obligation to repay/ strong incentive to redeem (eg through dividend stoppers/coupon pushers)

Sweden

Italy

• Potential issues with tax deductibility as full discretion for non-cumulative interest payments could be viewed as not compliant with the definition of “interest” for German tax purposes

• No change yet but discussions between German banks and Ministry of Finance

Germany

• HMRC’s Finance Bill 13 draft legislation published in December 2012 confirms tier two coupons are tax-deductible and not treated as distributions for tax purposes

• AT1 uncertainty remains, tax-deductibility of tier two Cocoinstruments confirmed

UK

France

Netherlands

• Uncertain given lack of specific tax rules and limited Dutch case law guidance

• No change yet but discussions between Dutch banks and Ministry of Finance

Spain

• Preference shares issued under Law 19/2003 (tax safe harbour) enable tax deductibility and exemption from any withholding tax

• Current tax law exempts deeply subordinated securities (titres super subordonnes; used for AT1 purposes) from withholding tax and explicitly provides for tax deductibility

• Tier one issued by French banks under CRD I and CRD II already combined perpetuity, non cumulative coupons and loss absorption via principal write-down

• Law approved end 2011 specifies that “atypical securities” issued by Italian banks and listed companies will be subject to the withholding tax exemption also applicable to “bonds” issued by such issuers



the problem with these defini-tions, for senior bondholders, is self-evident. this is that the point at which bail-in can be triggered is based purely on interpretation of highly subjective terms such as “likely to fail” and “public interest”. “the swiss have published more detail on Ponv, but we have noth-ing that investors can truly analyse,” says Ineke. “From the perspective of investors, no progress has been made on pinning down a definition of Ponv.”

“In the case of products that have been structured to have objective-ly determinable capital triggers, you have a reasonably clear picture of where you stand as an investor,” says Howe at sidley austen. “But if your product exposes you to what the bail-in regime happens to be in the future, then it is much more dif-ficult for investors. You are then exposed to the more nebulous and subjective concept of Ponv — and the thing to remember about that is that it looks like bail-in risk is going to apply to all bank debt.”

Precedents are little guidealthough it may be difficult — and possibly dangerous — to draw deci-sive conclusions from the two major credit events of this year, bankers say that both have sent out reason-ably conclusive, and ominous, mes-sages to senior bondholders. Grant-ed, investors in senior debt were spared a bail-in when sns Bank of the netherlands was nationalised in February, while equity holders and subordinated bondholders (up to tier two) were wiped out in what Fitch described as “the harshest burden-sharing at a rated bank since the onset of the eurozone crisis.”

But as Morgan stanley’s Ineke says, it would be a mistake for senior bondholders to take sns as a blue-

print. “there were a number of oper-ational difficulties with bailing-in senior sns bondholders,” she says. “But Dutch finance minister Dijs-selbloem made it very clear that in the future, when rrD is in place, senior debt will be fair game.”

the cyprus bail-out, meanwhile, involved a sizeable bail-in dimen-sion, with large contributions from bank debt holders at all levels and senior lenders, as well as wealthy depositors.

sidley austin’s roith says that the cyprus event was probably not a useful precedent for bondholders, because the catalyst was a sover-eign debt crisis which was dealt with by the troika rather than a banking regulator, but it did produce a seis-mic shock for depositors.

nevertheless, roith says that cyprus was another reminder of the value of the clarity that will be enshrined in the rrD. “cyprus shows how important it is that eve-rybody knows at the outset of a cri-sis which liabilities are going to be bailed in and which will be left untouched,” he says. “and it is to be hoped that the rrD will set out the bail-in hierarchy very clearly.”

No room for complacencyDespite these precedents, Ineke says that many investors remain surpris-ingly complacent about the pros-pects for senior debt being subject to bail-in. “I think investors may be in for a shock when the rating agen-cies start downgrading senior debt in response to rrD,” she says.

the probability of senior debt being bailed in has significant impli-cations for pricing and liquidity in the market for subordinated debt. Ineke says that Morgan stanley advised investors to take an under-weight position in senior debt last october, for several reasons. “We went underweight based on valu-ations and because senior debt is more vulnerable to downgrades than sub debt,” she says. “We also expect depositor preference to be included in rrD, which means that as a sen-ior bondholder you may be subordi-nated to 40% of the balance sheet.”

While rrD may bring more clar-ity, for the time being, investors in senior debt will need to make a judgement on the likely response of national regulators to banks judged

to be failing or likely to fail. as that response will differ from country to country, and will be based on a range of economic, political and social influences, it is likely to be translated into differences in trad-ing levels.

In the subordinated debt mar-ket, many of these pricing differen-tials have already been ironed out. “two or three years ago, the tier one spreads of UK banks traded wider than the rest of the market, and especially relative to the French, Dutch and German banks,” says Krim. “that was based on the mar-ket’s perception that the Fsa had stronger bail-in powers under the UK’s Banking act than many of its peers elsewhere in europe. those differences in spreads have disap-peared as investors have recognised that legislation elsewhere in europe is being brought into line with the UK’s.”

Shareholders’ pre-emptive rightsanother complication arising from heterogeneity of legal regimes across europe is the theoretical conversion of debt to equity, which could again lead to differences in pricing levels of bail-inable debt.

“Issuing subordinated debt that converts into equity is relatively straightforward for a spanish bank like BBva, where corporate law is accommodative to companies ask-ing for shareholder approval to issue convertibles on a non pre-emptive basis,” says Krim. “In the UK it has been more difficult for banks to set a conversion price and issue on a pre-emptive basis. Industrial corporates have blanket approval to issue con-vertible bonds, but banks don’t yet have the same freedom.”

Barclays, Lloyds and rBs have all secured approval from their share-holders at recent annual general meetings to allow for non pre-emp-tive share issuance, which is valid for a year and needs to be renewed on an annual basis.

While UK issuers appear to have addressed the issue of sharehold-er approval for conversion, in some other european jurisdictions the process may not be so straightfor-ward. sidley austin’s vivian root points out that French corporate law on pre-emptive rights, for example,

“From the perspective of

investors, no progress has been

made on pinning down a definition of

the point of non-viability”

Jackie Ineke, Morgan Stanley



may make conversions unwieldy or even impractical. that, she says, may have significant market impli-cations if it leads French issuers to adopt write-down rather than equity conversion structures, when inves-tors’ preference is generally for con-version.

Article 50cross-border issuance of cocos also creates at least one notable legisla-tive complication for issuers and investors, given that Us market practice and underwriter risk man-agement policies have meant that, traditionally, virtually all sec-regis-tered issuance has been governed by new York law. article 50 of the rrD, however, rules that an additional contractual term is required stipu-lating that the bonds are potentially subject to bail-in under the powers in the rrD.

“Governing law on Us deals will be a big question,” says sidley’s Walsh. “Historically, it has been the prac-tice on Us sec-registered and 144a deals for local law — let’s say, Dutch law — to govern subordination and new York law to govern everything else. the recent Barclays deal fol-lowed this approach by using new York law to govern everything apart from subordination.”

“But due to article 50,” Walsh adds, “some european issuers may now push to have their Us deals gov-erned exclusively by local law.” that, he says, may give rise to serious con-cerns among Us investors about the

choice of a civil law such as those that govern subordination in many european countries.

to date, this does not seem to have had an impact on distribu-tion or pricing in the Us. “We would be dealing with a liquida-tion scenario, and historically only a court in the issuer’s country of incorporation has the competence to deal with matters related to insolvency,” says Krim. “so from a marketing and pricing standpoint, we see no objection in having the issuer’s governing law covering loss absorption at the point of non-via-bility.”

the question of subordination law, Krim adds, should be regarded chiefly as a disclosure issue. “From a marketing perspective, the key point is to ensure that investors are warned in advance that this would be governed by the issuer’s law.” to date, he adds, investors have not demanded a premium for deals from issuers such as Barclays, UBs and Deutsche Bank in which any litiga-tion arising from losses borne by bondholders recognises the author-ity of a UK, swiss or German court.

nor, thinks Krim, is it any longer likely that investors will require dif-ferent premiums for different euro-pean laws governing subordina-tion. “18 to 24 months ago this may have been a valid concern,” he says. “today, if you believe that europe is moving towards banking union, you should not be differentiating between Italian or spanish and UK

or German law.”Perhaps. But at sidley austin,

Walsh says that one solution might be for english law, a common law system — as distinct from europe-an civil law — to be applied to the instrument other than the subordi-nation provisions. “there will con-tinue to be a strong preference for new York governing law, but english law could be a sensible compromise to the extent that concerns arise about article 50,” he says.

RWAs: the next regulatory challenge?the temptation may be to assume that most if not all of these legal and regulatory complications have to date been largely theoretical con-siderations, given that issuers in the nascent coco market have general-ly been national champions which nobody seriously believes will be in danger of breaching their conver-sion or write-down triggers.

But as Ineke cautions, that may also be a dangerous assumption that makes the mistake of looking just at the capital that defines the trigger. “Investors are looking at the gap to the trigger,” she says. “But we think they will need to pay increased attention to the denominator of the ratio, which is risk-weighted assets (rWas).”

Ineke cautions that the size of the buffer could itself become vulner-able to regulatory discretion. “We’ve just seen the introduction of a floor on the risk weightings of residential mortgages in sweden, which is the sort of thing that could ultimately cut into core tier one, if introduced as a Pillar 1 measure,” she says. “so while as an investor you might be feeling very comfortable with a 9.5% cet1, regulator discretion on rWas could easily drop this by 100bp, or more, in short order.” s

“French corporate law on pre-

emptive rights, for example, may

make conversions unwieldy or even

impractical”

Vivian Root, Sidley Austin

The principal uncertainty associated with cocos from a tax perspective has been whether they would be regarded by local authorities as debt or equity for tax purposes.

This is a critical distinction for issuers, because while the coupons on debt are tax-deductible, as they have generally been for holders of innovative tier one and tier two instruments, dividend payments on equity instruments are generally not. and while France, Spain and italy have all confirmed tax deductibility for crD4 in-struments, the UK, Germany, Sweden and Belgium have yet to so do — although in all

these cases, tax deductibility is likely, ac-cording to Morgan Stanley.

at Sidley austin, David howe agrees that the tax regime on contingent capital instruments looks to be moving towards a level playing field. “The UK tax authori-ties appear to have reached the conclusion that if these instruments aren’t given tax deductibility, they will effectively be un-issuable. at the same time, the Treasury seems to have recognised that the tax loss it will suffer by allowing tax deductibility for aT1 securities will be sufficiently limit-ed given the restricted size of the crD iV aT1 bucket.” s

Tax deductibility: moving towards a level playing field

MArket outlook


After such a long time waiting for the missing pieces of the regulatory capital puzzle, the questions on everyone’s lips are obvious: how much issuance might we see, and where will it come from?

According to their most recently reported numbers, the largest 30 banks in central europe have a combined additional tier one capital deficit of €31.6bn, and a tier two deficit of €19.3bn.

some bankers have taken a more rudimentary approach to calculating the possible quantum of supply, looking at the rWAs of the top 40 european banks. According to that calculation, for every bank to fill the 1.5% At1 buffer would require €250bn of issuance, they say.

tax is still an issue, but is expected to be resolved soon. Now that the market has seen the near-final draft of the eBA’s technical standards, issuers can make their move, and most expect Nordic banks to be some of the first to bring new deals.

“the Nordic banks are obvious candidates for additional tier one issuance,” says Jochen Mehltretter, head of Benelux and Nordic DcM fIG coverage at Morgan stanley. “It depends on things like the leverage ratio and their ambitions on s&P risk adjusted capital (rAc) credit, but we expect them to take a close look at the market in the second half of this year and next year.

“In the Netherlands and in the Nordic area, most banks are now comfortable on core tier one capital, and they are moving towards building up and maintaining their strong total capital levels.”

Meanwhile, banks in the uK are expected to focus on cocos. But they will structure them with additional tier one host paper, says cecile houlot, head of uK and Ireland fIG DcM at Morgan stanley.

“there will probably be two different structures — additional tier on paper with a 5.125% trigger, complying with crD IV, and At1 with a 7% trigger, similarly to what we have seen recently in a tier two context, and in order to fill the uK regulator’s pillar two capital requirements.”

Banks in the uK are also working towards a 17% primary loss absorbing capital (PLAc) buffer. In all likelihood, that will be filled up with tier two debt, to insulate senior unsecured holders from bail-in, says houlot.

Euros on the horizonuntil now, all contingent capital and additional tier one deals have been denominated in us dollars. But that may be about to change, according to claus Vinge skrumsager, co-head of global capital markets eMeA at Morgan stanley.

“from the first deals being anchored in Asia, with high net worth demand, we have seen the us become a bedrock of liquidity for this market. however, europe is coming online. All of these deals so far have been in dollars, because that was the deepest investor base.

“But look at the KBc transaction — around 60% of that was sold to accounts based in europe. Large institutional investors now have funds dedicated to buying

these products. some of them specifically mention cocos as their favourite trading idea. And what that tells you is that it won’t be long before we see a euro-denominated coco.”

Yields have been plummeting in the fixed income market since Mario Draghi’s now infamous “whatever it takes” statement in the summer of 2012 triggered a bull run on credit. that has greatly helped issuers get new-style capital instruments away at far tighter levels than they might otherwise have anticipated.

BBVA’s At1 deal, for example, was printed with a 9% coupon. Given that some market participants felt that the 9.5% initial pricing talk was tight — and that one of the leads told EuroWeek that fair value for the trade was more like 10% — it is easy to see how investors’ desperation for yield can drive demand even for complex and risky structures.

however, the sell-off in us treasuries that federal reserve chairman Ben Bernanke triggered in May, when he suggested the us could start to taper its quantitative easing programme, showed just how quickly the market can move against issuers.

even if few market participants expect baseline rates to widen sharply any time soon, there is a worry that if they do, new-style capital instruments could become too expensive for issuers.

But the spreads banks offer for these deals will begin to tighten as the market becomes more comfortable with the product, says Philipp Lingnau, head of europe fixed income capital markets at Morgan stanley.

“In a normal and developing market, the more familiar and homogeneous the product becomes, the more spreads come in —

Unless you’ve been living under a rock for the past five years, you will be painfully aware that banks need more capital. But how much of that desperately needed resource is going to come from the new instruments the market has waited so long for? Will Caiger-Smith examines the outlook for the bank capital market.

Avant le déluge: looking forward to liquidity

“In the Netherlands and in the Nordic area, most banks

are moving towards building up and

maintaining their strong total capital

levels”

Jochen Mehltretter, Morgan Stanley

Market outlook


possibly compensating for a possible increase in baseline rates,” he says.

Liability managementOld-style capital issues will be grandfathered under the crD package, progressively losing capital treatment as the new rules are phased in. But issuers will need to replace it eventually, and they may look to the liability management market to do so.

Over the past two years, in order to generate core capital, banks took advantage of depressed prices in their own hybrid and subordinated debt, buying them back at a discount to par so they could book a capital gain.

this led to some investors complaining of being treated roughly by issuers. Now, the motivation of liability management has changed — and banks’ approach towards

investors must change with it.“the dynamic is fundamentally

different,” says Peter Jurdjevic, head of balance sheet solutions at Barclays. “When banks engage in liability management in isolation, to improve the quality of their capital, it’s a more aggressive proposition because you’re buying back securities for less than par.

“the liability management that is going on now is motivated by different objectives. It’s not for the sake of capital generation — it’s to lay the ground for placement of these new securities into the same investor base. If you are not doing that in a way that makes investors happy, you’re working at cross-purposes. You can’t prime the market by upsetting investors — you need to seem thoughtful and careful, taking their interests into account.”

Homogeneous marketAfter concerns about the complex trigger structure of BBVA’s debut At1 trade, market participants hope that products will become less idiosyncratic and more homogeneous as supply increases.

creating a more comparable and easily understandable market is not just down to the issuers and banks structuring these deals — it’s also down to national regulators. crr may be a pan-european regulation, but crD IV is for national implementation, so national supervisors have some wiggle room.

Another issue is that the more complex deals take longer to prepare. And borrowers looking further afield than their domestic markets have some complex legal work to do, says David howe, partner at sidley Austin.

“If you’re talking about a

REGULATORY CONSIDERATIONS

Total Capital Debate

Source Company reporting, Morgan Stanley Equity Research

Notes1. Capital ratios in blue as of Q4 2012. Credit Suisse and UBS capital ratios on Basel III phase-in basis2. Adjusted for €2.5bn capital increase in 20133. Including capital measures April 29, 2013

(2) (3)

Average:

• CT1: 12.4%

• T1: 13.7%

• TCR: 16.2%

17.3 13.2 15.3 13.2 12.1 14.6 11.6 11.0 12.7 10.7 8.5 11.7 11.0 10.7 11.2 10.7 10.6 10.5 10.6

2.4

1.0

4.0 0.0

1.10.8

1.5

2.51.8

2.3

0.90.8

0.5

2.10.4

1.5

1.3

0.5 0.00.2

0.7

1.2

1.8

3.6 3.4

4.7

1.72.3

3.53.9 3.1 2.5

4.4

2.63.9

5.1

1.7

2.82.0 2.3

1.30.8 0.4

15.5

14.7

12.1

7.016.012.118.012.310.213.213.510.210.81

1.80.9

5.0

3.5

2.5

1.40.5

1.9

21.1

19.519.0 18.9 18.8

17.8 17.7 17.4 17.4 17.3 17.3 17.1 17.216.7 16.5

15.6 15.515.1

14.513.8 13.8 13.6 13.5 13.4

11.3

0

5

10

15

20

25

SHBSwed

Rabo

UBSKBC

CBK DB CSABN

SEBIN

GLloy

ds

Barcla

ys

HSBC

Nordea RBI

RBSErst

e

CASABNPP

UniCre

dit

SocGen

Belfius

Intesa

BBVASAN

DNBBES

Caixabank

CT1 T1 T2

11.

European bank capital benchmarking (Q1 2013(1), %)


MArket outlook


european bank doing a reg s tier two deal, the chances are they’ll be able to pull the trigger fairly quickly,” he says.

“they’ll update their eMtN programmes to include basic crD IV compliant provisions. But if they need to go outside the reg s market to tap the us investor base, like an sec-registered or 144A deal, you’re looking at more issues to do with governing law, and that necessitates a longer timeframe.”

On top of that, national regulators have their own demands for bank capital, and as a consequence have a great deal of influence over how these deals are structured. that makes harmonisation difficult, says Morgan stanley’s skrumsager.

“We want liquidity,” he says. “We have no interest in creating illiquid instruments, because illiquid instruments don’t create markets that grow in size and encourage further demand. But the reality is that regulators throughout europe have different views on what this instrument should cater for.”

“then there are different tax treatments, different rules around issuing equity, from country to country. the challenge is getting regulators in each country aligned to a common set of standards — that will lead to more homogeneity.”

Regulatory issuesBut even if individual instruments adhere to a harmonised set of terms, they might still not be comparable across different jurisdictions and issuers. this is partly because triggers for additional tier one and contingent capital are based on rWAs, which can be calculated differently at different institutions, according to complex internal models.

this March, a study by the eBA found that half of the variation between banks’ rWAs could not be explained by differing balance sheet structures and regulation, but were instead down to banks’ own methods for calculating the figure.

that is worrying for investors in new style capital, says Lingnau.

“If you want instruments to be truly comparable you also have to make sure that investors can easily compare the asset side of the respective issuers,” he says.

“Otherwise you might have homogeneous instruments that in reality act differently because the rWAs of the different issuers are calculated based on different models.”

Andrea enria, chairman of the eBA, has said better disclosure could go some way to appeasing investors’ concerns. But this is not enough, and the eBA has committed to deepening its analysis of rWAs to make sure they can be a reliable figure.

Predictably, many banks are resisting this push. A turf war is underway, says skrumsager.

“rWAs are black boxes in many respects, and there is a big drive from regulators to reverse the direction of travel,” he explains. “We moved from a standardised approach to an internal modelling approach. And now we are going back, because investors are saying ‘just tell me what is there and I will decide what it is worth’.

“It is a turf war, over whether we can keep this internal model approach without moving to a fully standardised approach which would maybe produce misleading rWA numbers, but is easier to understand because it is the same across any bank in any region.”

The risks of reformthe move to force losses on investors who consciously decide to lend to banks is mostly based on common sense. It is difficult to argue that taxpayers should foot the bill for banks that lend recklessly or fail to properly manage risk.

As global economies recover from the financial crisis, banks are deleveraging — and, of course, increasing capital. But the rapid pace of change is hurting the economy, says skrumsager.

“regulators have to realise that this process takes time, and if you are very aggressive on asking banks to get to a lower leverage level, that has growth consequences,” he says.

“the big problem right now is the sMe space. there is not enough capital. We need a sMe securitization market — we need it to take up some of the demand that came from the banks pre-crisis. the banks are not providing the sMe sector with as much capital as they were in the past, so

the sMe sector is suffering and that is not good for growth.

“What we learned during the crisis is that banks were operating at too high leverage with too little capital. that is what we are trying to change. What some people will ask is have we gone too far too fast, leading part of the transmission mechanism, like for example the sMe space, to suffer.”

But confidence is critical for the existence of the system as well. With less government support, an under-capitalised bank can lose its deposits quickly and cease to exist, which will also hurt sMes and growth.

Boosting capital is about creating that confidence. But confidence must also come from a fundamental truth of the financial system: that there will always be banks that fail.

the financial crisis has of course become political, and there is no shortage of talking heads willing to endorse reforms that make the banking industry safer. But there will always be accidents — reform is about convincing people that they can be cleaned up quickly, says Lingnau.

“All the things which are going to be put in place will try to avoid something like Lehman happening again,” he says. “this will make bank failures more transparent, easier to digest, and will make it easier to predict what happens if the case arises — but it won’t stop banks from failing in the future.

“We are still banks, we are still there to transfer risk in the economy, and therefore, we must take some risks. By definition, over the next however many years you will see banks fail. It is very important to understand that all the regulation is there to make banks safer, but you can’t take the risk away.” s

“There will probably be two different

structures in order to fill the UK regulator’s

pillar two capital requirements”

Cecile Houlot, Morgan Stanley

Bail-in


The financial markets are by now well versed in what happens to bank capital if a bank is in trouble. losses are taken and the risk of that happen-ing ought to be priced into the instru-ment. But what about the treatment of funding? Just a few years ago, the idea that senior unsecured debt might have to absorb losses was unthinkable.

That has all changed now. The european Union’s crisis Manage-ment Directive set out in 2012 the first europe-wide rules for bailing in bank debt — forcing losses on bondholders when banks are failing, avoiding the taxpayer bail-outs that became such a feature of the financial crisis.

The transformation of funding into capital is revolutionary. Progress has been slow, but since bail-in was first mooted in late 2010, investors have come a long way to accepting it.

Under cMD (now often referred to as the Resolution and Recovery Direc-tive, or RRD), tier two debt will be bail-inable from 2015. Senior debt was supposed to be from 2018, but recent bank failures in the netherlands and cyprus have accelerated the process and the european Parliament is push-ing for implementation in mid-2016.

That tier two debt can be written down to recapitalise a failing bank is no longer an outrage. When SnS Reaal was on the brink of collapse in early 2013, Dutch finance minister Jeroen Dijsselbloem didn’t take long to expro-priate the subordinated bondholders, effectively confiscating their bonds, with zero chance of recovery.

The UK’s cooperative Bank now plans to bail in its subordinated debt-holders, converting their holdings to equity and transforming the institu-tion into a listed bank.

Tricky processBailing in senior debt is trickier and a lot more delicate. Dijsselbloem stopped short of senior bail-in at SnS because he was afraid of the impact on other Dutch banks’ access to funding.

if losses at a bank necessitate senior bail-in, regulators want to get the fig-ure right. Too big a haircut, and bond-holders get spooked; too little, and you might have to go back for more.

“if you impose too much burden-sharing on the investors, they will no longer be willing to be a counterparty, and the bank will not be able to con-tinue to fund itself,” says Khalid Krim,

head of european capital solutions at Morgan Stanley. “Bail-in is part of the toolbox, but regulators will be very careful about how they use it.”

Banks need to continue to fund and refinance themselves, he says. “You cannot go out to the markets that are providing liquidity and impose losses that are over and above the amount of recapitalisation the bank needs, just for the sake of being conservative.”

To protect senior bondholders, banks are expected to load up on tier two debt, possibly even above the ratios required under cRD. a bigger tier two buffer will help to protect sen-ior bondholders from losses. But some capital structurers are going further, working on specialised notes to sit between tier two and senior debt.

These bonds — which have been called senior subordinated notes (SSns) or priority bail-in notes (PBns) — would be designed to be cheaper for issuers than tier two, but absorb losses before senior unsecured. it’s a nice idea, but not everyone is convinced.

“When the early drafts of the RRD were proposed, bail-in was a source of anxiety for the unsecured investors,” says Peter Jurdjevic, head of balance sheet solutions at Barclays. “But mar-kets have moved a lot since then. Yes, they can back up again quite quick-ly, as we’ve seen. But, investors will accept bail-in, and the scarcity of the senior unsecured product will make them pursue it, without issuers hav-ing to create a new tier in the capital structure.”

The development of such a market could depend on whether the regula-tor forced losses on holders of SSns or PBns before other senior holders. The legal niceties could be awkward. The cost benefit is also questioned.

however, it could help an issuers’ ratings, says Jurdjevic. “for banks on the cusp of a ratings band in senior unsecured, like BBB- or BBB+, it could be seen as a kind of enhancement to keep them in the category.” s

Bank capital gets its name from a simple principle — it is designed to form a solid foundation upon which a bank can operate, a buffer against which it can lend. Funding instruments like senior unsecured, meanwhile, are not there to absorb losses. Or are they? Will Caiger-Smith reports.

Bail-in: how does it affect bank capital?

CAPITAL STRUCTURING CONSIDERATIONS

Loss Absorption Mechanisms of CRD4 Instruments

CET1

10%+

7-10%

7%

5.125%

[4.5]%

CCB

G-SIB

MinCT1

7% AT1Write-Down

7% T2 CoCoConversion

7% T2 CoCoWrite-O�

T2

Full Full FullFull Full

DigitalWrite-O�

5.125% AT1Write-Down

CouponCancellation

risk

CouponCancellation

risk

DigitalConversion

Loss Absorption Mechanisms: Full Spectrum from Ordinary Shares to Senior Bonds

Loss Absorption GlossaryCoupon Cancellation Risk: for AT1,on a non-cumulative basis

PONV: full write-o� or conversioninto shares, following statutorywaterfall (CET1, AT1, T2)

Conversion into Shares: for AT1 orTier 2 CoCos, full and permanent conversion into ordinary shares upon trigger breach Progressive Write-Down: partialwrite-down of the AT1 instrument, tothe extent necessary to restoreCET1 ratio to the trigger level

SeniorBonds

Ordinary Shares

Wiped out in Full

ProgressiveWrite-Down

ProgressiveWrite-Down Progressive

Write-Down

CCBDividend

Restrictions

Mechanical restrictions ondistributions and dividendpayments in context of CCB, under 7% CET1

Dilution risk associated with the conversion of AT1 and Tier 2 CoCo instruments

PONVBail-in

Partial if Senior Bail-in needed

Total capital debate


© 2013 Morgan Stanley. All rights reserved. This communication does not constitute an offer to sell or the solicitation of an offer to buy any securities. Morgan Stanley and/or any of its affiliates may hold proprietary interests in any of the securities referred to in this document.

Morgan Stanley & Co. International plc is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and Prudential Regulation Authority. This document is for informational purposes only and is directed only at persons who (i) have professional experience in matters relating to investments falling within article 19(1) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 or (ii) are persons falling within article 49(2)(a) to (d) of that Order (high net worth companies, unincorporated associations, etc.) or (iii) persons outside the United Kingdom (all such persons together being referred to as “relevant persons”). This document must not be acted on or relied on by persons who are not relevant persons. Any investment or investment activity to which this document relates is available only to relevant persons and will be engaged in only with relevant persons.

The global leader in the evolution of bank capital.

Tier 2 CoCo$3 Bn – 7.625% $1 Bn – 7.75%Nov 2012 April 2013

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Tier 2 CoCo$2 Bn – 7.625%Aug 2012

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Morgan Stanley leads the industry in helping banks raise new-generation capital instruments. Along with our experience, innovation, and excellence in structuring, we leverage an unrivalled global distribution platform for our clients.

Tier 2 CoCo$1 Bn – 8%Jan 2013

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Tier 1$1 Bn – 6.375%Nov 2012

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Tier 1$1 Bn – 5.75%May 2013

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Tier 1$2 Bn – 8.4% $2 Bn – 8.375%Nov 2011 Jan 2011

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