Royal Bank of Canada flexed its muscles as a leader and an innovator in the Canadian debt capital markets in 2014, pioneering the development of a new market for non-viability contingent capital for Canadian banks.
After years of consultation with OSFI, the Canadian bank regulator, RBC was the first to crack the code on how to structure an NVCC deal, issuing a C$500m 4% non-call five-year preferred Additional Tier 1 offering.
The RBC structure was so elegant that its competitors decided to adopt the template to issue C$4bn of AT1s, rather than try and work out a structure for themselves.
“It was a bit of an arms race,” said Patrick MacDonald, co-head of RBC’s debt capital markets business in Canada. “Everyone was trying to develop a new instrument, recognising there would be a benefit to being the first.” *
The peculiarities of Canadian bank capital rules mean that being a leader in AT1 structures also results in leading in Tier 2.
Under OSFI rules all Tier 1 and Tier 2 debt has to be non-viability contingent capital that converts to equity, but also respects hierarchy claims of a bank’s capital securities.
OSFI also wanted the conversion to equity to be contractual (rather than at the discretion of regulators), automatic, immediate and resulting in significant dilution of existing shareholders.
Respecting the hierarchy claims meant the conversion formulas for the AT1s and the Tier 2s had to be in sync with one another, because in reality an automatic conversion at the point of non-viability typically sees both securities convert to equity at the same time.
“Basically, we couldn’t create one instrument without also creating the other, because there has to be a symmetry among them,” said MacDonald.
RBC wanted to establish the AT1 structure with its deal in January and then followed up in July with a C$1bn 3.04% Tier 2 subordinated debt trade, cementing a formula that made investors feel they had an investment that was senior to AT1s.*
The formula essentially ensures that each Tier 1 preferred is converted into equity based on a multiplier of one times the note value of the preferreds, while the multiplier on the subordinated Tier 2 notes is 1.5 times the number of shares issued per subordinated note.
The conversion price for both capital instruments would be the greater of C$5 or the 10-day volume weighted average price of the stock.
Adding to the challenge was the relatively small size of the Canadian market, at least compared with euros, where a variety of different CoCo structures exist.
“We wanted something simple and easy to understand,” said Peter Hawkrigg, a senior banker in DCM at RBC. “We had to find a balance between what regulators wanted in a structure but also what investors and issuers wanted so it was repeatable. Then you can look at the underlying credit [when pricing a deal] and not get caught up on the structure.”
* Corrects spelling of Patrick MacDonald and adds terms of Tier 2 issue.
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