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Sunday, 22 October 2017

Coming together

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On 12 September The Basel Committee’s latest recommendations confirmed the amount of Tier 1 capital required from banks by the new regulatory regime. But a number of loose ends remain. Some in the market worry the lack of clarity over grandfathering will lead to the same kind of primary market stagnation seen after the December 2009 recommendations. Matthew Attwood reports.

After many months of anticipation, last Sunday the Basel Committee finally revealed the new capital ratios. Common equity, or core Tier 1, will be increased from 2% to 4.5% while the Tier 1 ratio will be raised from 4% to 6%. The market will have two years from January 2013 to accomplish this – an achievable task for most banks. A 2.5% capital conservation buffer composed entirely of common equity, rather than a proportion of contingent capital as some had hoped, will be introduced between 2016 and 2019. While this is not a mandatory requirement, banks not complying will suffer a curtailment of their rights to pay bonuses and dividends.

The market reaction was broadly positive. More than one banker described the widely anticipated phase-in period as generous, although there were many notes of caution. “It’s not the worst case, but it isn’t all roses,” said Prasad Gollakota, head of capital solutions, EMEA, at UBS. “All they’ve done is spread them out over time, but the banks still need to meet requirements that will transform the sector; they will introduce a leverage ratio, liquidity measures and capital buffers. People now need to be managing towards those targets over time – capital planning is going to be really important over the next three to five years.”

Gollakota is also concerned about the fate of instruments that are not grandfathered or lose such status. “How will they be treated? If they fall out of Tier 1 you can’t necessarily assume they’re compliant as Tier 2 because that in future has to have gone concern loss-absorption features, which past Tier 1 deals do not necessarily include. Also where do the trigger levels need to be set for additional going concern Tier 1? It’s unclear if the Basel Committee is going to leave that to the national regulators or tell them that the triggers have to be a certain level above the minimum.”

Basel’s treatment of non-qualifying assets is a possible area of contention. These will be phased out over 10 years from 2013, losing 10% of their recognition as regulatory capital each year, or all of it in the case of step-up transactions once the first call date is reached. Grandfathering will only apply to deals issued before September 12.

Contraditions

All this contradicts the EU’s capital requirements directive, the current incarnation of which envisages an approach that looks at institutions’ total reserves rather than on a deal-by-deal basis. The current CRD approach is that institutions will be 100% compliant if by 2020 non-qualifying Tier 1 assets are at 20% or below of total reserves, falling to 10% in 2030 and zero by 2040. The EU has said it will clarify the terms of the CRD’s fourth version some time in the first quarter of next year, but as banks look to the EU and national governments for guidance as to the application of new regulations, there is currently an apparent contradiction.

Another key point is the amount of hybrid Tier 1 issuance permissible under the new regime. “There was no further specific guidance on the predominance test itself, IE X% of Tier needs to be common equity and X% can be additional going concern capital,” said Gerald Podobnik, co-head of capital solutions Europe at Deutsche Bank. “We know the common equity minimum ratio will be 4.5% and the Tier 1 minimum ratio 6% and there is of course a 25% gap in between but this does not answer the question as to how much additional hybrid paper you will be able to include, so I would expect greater clarity on this in future publications.”

UBS’s Gollakota is happier to infer a 25% bucket for hybrids from the rules as currently understood, but warns that for the market to reopen, issuers will have to take the plunge without any hand-holding from regulators. “There will need to be a meeting of minds – there will have to be one or two banks that take the lead and put something to the regulators, get a reaction from them and come to the market. The pack might follow – it might not be a case where issuance waits for regulators to spell out the terms completely.”

The criteria outlined last December established the principles on how hybrids should be implemented. They insist that they should be perpetual, deeply subordinated, with full discretionary non-cumulative coupons. They must also contain loss-absorbing features, in the form of either a conversion into equity or a write-down. To that extent, potential issuers know what to expect. But further details are yet to emerge outlining the regulators’ preferences on exactly how those write-downs or conversions should be structured.

Many market participants, including Podobnik at Deutsche Bank, doubt that clarification on this will be made until the new rules are implemented on a more granular level. “At least until the publication of CRD 4, there will not be much clarity. While people may be inclined to issue as closely to the new rules as possible with a regulatory call, they can’t be 100% certain that if they put something together which they believe complies with the spirit of Basel III, it will be fully consistent with the rules when they are applied on the national level.”

Multi-speed regulation

Gollakota points to another, related big unknown: “We don’t know which countries will try to accelerate implementation or set higher standards than the minimum and which will follow the line as it has been written. That will be a big shaper of the market because you could end up with banks being told different things by their local regulators.”

Given the time allowed for banks to comply with the new recommendations, many observers are optimistic. A note from ING published the day after the Basel Committee’s meeting said the majority of banks would have no problem meeting the new requirements. The lengthy implementation period is likely to ensure weaker banks will be able to address any capital shortfalls, possibly through means such as retained earnings. For ING, the industry-wide expectation of significant capital-raising associated with Basel III had abated.

Others see it differently. The new recommendations give banks a concrete means of estimating their liabilities under the new regime: “Bank treasuries will be calculating forthcoming capital shortfalls resulting from the latest paper right now,” said Podobnik. Many may want to issue as soon as possible, but the current lack of clarity on grandfathering might limit their options. Should the current recommendations be implemented, leaving banks with no clue until next year (and CRD 4) as to what future issues should look like and with grandfathering only applying to existing issues, common equity will be the only tool available to financial institutions seeking to build up capital for some months. As happened in December, a document designed to protect banks’ capital bases could have a deleterious effect, albeit temporarily.  

Yet this scenario may not apply if issuers will seek more clarity on grandfathering. “I expect the Basel Committee, or the EU, or national regulators, to offer some additional guidance to issuers as to what instruments they can and should issue running up to 2013,” said Podobnik. “We still don’t have a rule book that answers all the questions but I suspect we will see one, probably next year, once there has been some clarity from the EU about CRD 4.”

Regardless of the Basel Committee, the stress tests earlier in the year exposed many banks which, while not failing under the generous terms of the test, had less than enviable capital positions, said Gollakota. Those banks may have to raise equity before they can begin to consider the hybrid market, simply because of investor reticence where they are concerned. “While Basel is going to set new minimum requirements and institute buffers the market will have its say on what should be the benchmark Tier 1 and Core Tier 1 ratios banks should be targeting,” said Gollakota. “If the larger European champions target ratios at 12% and 10%, any other European bank with 7% and 8% is going to have to make a strong case to the credit market that they are equally investable.”

One thing is clear. Where loss-absorption is concerned – as it must be in all future Tier 1 issuance – investors will need the opportunity to discuss any new deal’s structure at length. One banker not on the recent Unicredit Tier 1 said the number of questions he fielded from concerned investors confused by the innovations it contained made him feel as though he had been intimately involved with its structuring. When new structures emerge, even if they are brought to comply with the latest regulations, issuers and arranging banks must be prepared for a lot of hard work with investors.

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