Hybrid Capital Markets Roundtable 2008: Part 1
IFR: The recent work of CEBS (Committee of European Banking Supervisors) and CEIOPS (Committee of European Insurance and Occupational Pension Supervisors) has been aimed a developing a level playing field within hybrid capital. The question that begs asking, however, is, “is this is actually a realistic goal?”
Jean Dessain, Fortis: I was invited recently by the European Commission as an industry expert and the first thing I would highlight is the gap between market participants, investment bankers and issuers and the reaction of some regulators and commissioners. They expect so much from hybrid capital and sometimes it is quite unrealistic. At this stage there is no deep convergence.
They feel the need to reach an agreement on something. Will it be a good agreement and a stable base to build on, despite the divergence and differences in tax legislation? I’m not so sure.
The key question we need to ask ourselves is what we expect from hybrid capital? Hybrid capital is first of all a servant instrument and, just to pick an example, one country asked the question about why is it that in case of distress there is never an instrument that manages to protect the company that issued the instrument, confusing liquidity on the one side and solvency on the other.
If a company like a financial institution becomes distressed, the first point that will be hit is not solvency but most likely liquidity. If you expect hybrid capital to solve a liquidity issue, you are thinking the wrong way.
At the same time, I think everyone feels the need of a level playing field and we probably now have something we can use as a starting point.
Jennifer Moreland, Morgan Stanley: With respect to the level playing field and how realistic it is to actually achieve convergence, I think part of the disappointment that has been felt throughout the market related to the set of proposals has been the fact that the rules were a lot more prescriptive than people were expecting. As a result, if you accept the point that regulators want to see more loss absorption in hybrids and you then try to follow the plan that has been proposed, the result will probably be more divergence rather than convergence because of the fact that all the legal and the tax systems in the individual countries cannot also converge in the same way that, theoretically, a regulatory framework can.
Sean Richardson, RBS: We all had the same starting point, which was the Sydney press release, and we all used that as a framework in each member state to build our regulatory framework. But we all took different paths simply because of our domestic laws. We have different regimes for tax and solvency in each jurisdiction, so while we are all aiming to achieve the same goal, we have taken different routes. For example, in the UK we write the instrument down from the outset, whereas in France we have a temporary write-down and write-up.
David Soanes, UBS: It all depends upon what the reality is going to be when these instruments are called upon to behave in the way that they are meant to. In the UK, clearly, they don’t, given what happened to Northern Rock. So what’s happening in the UK is every instrument issued by the major UK banks, with the exception of preference shares, seems to be money good from the position of state ownership.
Steve Sahara, Calyon: I think there is a distinction between a level playing field, where you talk about the 30%, 50%, or whatever amount of hybrid capital you allow, versus the route of getting to hybrid capital within the various jurisdictions, and that hasn’t been clearly delineated in the communications from CEBS. I am somewhat sympathetic that they have 25 different jurisdictions they are trying to bring together, speaking different languages, with different priorities. But I think there needs to be more openness so those critical distinctions can be broken out and we can then focus on those objections or suggestions we may have for improvement.
Alvaro Camara, Merrill Lynch: If there is anything that this crisis has demonstrated, it is that access to capital is crucial. We feel CEBS has a very prescriptive view of what capital should do and how it should behave and be constructed, whereas banks should have the ability to take a much more substance-based approach, look at the instrument and issue capital that is accessible to the market. Features that they are proposing we see as complex to implement and posing additional risks that make distribution even more challenging.
David Soanes: If, when push comes to shove, the authorities decide that they can’t afford for one bank’s capital to be wiped, be it Tier 1, Upper Tier 2, Lower Tier 2, or whatever, and they have to make it all good, then it’s all a waste of time. If that’s what the UK is going to do, what’s France going to do, what’s Germany going to do? When it really comes down to it, how loss-absorbing will this stuff be? So far, in the UK, it’s not loss absorbing.
Jean Dessain: The big issue –- and we saw it in the reaction of the Belgian regulators, when they asked us for is a clause whereby they can decide that the trigger will be considered as not being hit — is that if Fortis, to take our own example, stops paying coupons on Tier 1, we will be pushed directly into a major liquidity issue. If there is a liquidity crisis and then on top of that Fortis is pushed into a corner and does not pay the coupon on a hybrid, then it is the end of the institution.
I think regulators have started realising that the loss-absorption mechanism could cause a lot of problems; the balance between being in a bankruptcy situation and being in an ongoing situation is very narrow.
Steve Sahara: I think you both touched on two points that are related, which is, why have hybrid capital? Either you meddle with it and it doesn’t function in the worst case anyway, so why meddle, or why have it at all? If you want to control the amount of common equity that you put against your assets, that’s another way to regulate the cost of financing those assets. If we agree that there’s a role for hybrid capital because it’s more cost effective, then we should be looking at ways to make it cost effective.
The CEBS changes, if anything, will only result in a higher cost, which is then contrary to the point we are making, which is that hybrids are cheaper equity. So, it is one or the other; either you think there should be a more efficient way of funding and we should then look at ways to make it market acceptable, or you don’t think you should have a layer — a small layer at that — of efficient capital and you just meddle with the amounts of common equity you put up against your assets.
David Soanes: But the only losers in the Rock situation so far are the real equity holders. From the hybrid aspect — and they had a lot of capitalisation coming from hybrids –- it was zip.
Jennifer Moreland: Except the preference shares.
David Soanes: That was small number compared to the rest. The legal form became the big issue there rather than Tier 1; Basel was meant to have introduced innovative or non-innovative Tier 1 as distinct from preference shares as another form of loss absorbing capital and it has clearly been a total and abject failure. As for all the discussion that is going on now, frankly they are fiddling while Rome burns.
Jean Dessain: But that is because there is no bankruptcy. If Northern Rock was pushed to bankruptcy, then it would be a completely different situation.
David Soanes: But the regulator/government/treasury sort of mixture in the UK will not be unique in terms of how other countries will react to a similar crisis. Look at Japan.
Jennifer Moreland: At this point, other than the preference shares,
Northern Rock’s hybrids actually haven’t really absorbed losses through any recapitalisation. However, I would probably place some emphasis on the other aspects of the loss-absorption capability of a hybrid, such as its perpetual maturity and deferrable nature. It is true that we are still thin in terms of actual data points on deferral and no-one has really gone past the call date yet, but a lot of these tests are coming over the next couple of years and I think it is important to keep in mind that those are also what provide hybrids with more loss-absorption capability in addition to just this recapitalisation.
Steve Sahara: If it is worthwhile to have tiers of capital that are cheaper, then we should focus on making those efficient. Otherwise, we have Tier 2, but because it is not loss absorbing, or not as loss absorbing, it keeps going on and on to the point where it doesn’t make sense and you come back to basics.
Jean Dessain: I think it is a bit premature to say it is not loss absorbing. It is also a way for the bank to provide some stability, because, basically, having the opportunity to access different kinds of investors and to broaden out the investment base is also quite important. There are times when you cannot access the equity capital markets for whatever reason, so it is nice to have another source of capital. I would not throw the baby out with the bathwater too quickly.
David Soanes: But nobody has really missed a coupon. Tokai 9.98s were famous for having missed a coupon but that was not loss absorbing. Is it true that no bank at any stage has ever been in a situation where they really shouldn’t have paid that coupon?
Alvaro Camara: Yesterday, Irwin Financial announced that they were not going to pay a coupon on their preferreds.
David Soanes: So, it has started, yes.
Alvaro Camara: And you have the WestLBs and IKBs, who are already going to miss coupons, but that’s not optional but trigger based.
Sean Richardson: And we had Resona Holdings which deferred on their coupon.
Jean Dessain: We could face the situation of institutions being willing to call but the regulator actually taking the decision.
Steve Sahara: That’s a key point. I think a lot of the proposals undermine the role of the regulator to step in and stop payments and act appropriately. Taking the Northern Rock case, you question whether that can happen objectively.
From my point of view, hybrid capital is useful, but it’s asking too much of it to have a mezzanine layer of security, which is part debt, part equity, absorb losses in the fashion that is being proposed. You don’t necessarily ask common [equity] holders to put in more money. You can’t make them put in more money when a financial institution is in trouble, and from some of the language that’s coming out of CEBS, it seems like they expect that type of commitment from the capital holders: ‘it is not enough to make the initial investment, we want you to be prepared to step up afterwards’. That’s not really how the market works.
Jennifer Moreland: One of the proposals from CEBS that I personally like, and this may be an unpopular viewpoint to express, is the requirement to include a regulatory overlay on all of the coupon payments. My personal view is that hybrids are there to absorb losses; that’s exactly why people get extra spread for them. You know that there is a chance that deferral can happen — sometimes that’s cumulative, sometimes that’s non-cumulative — and up until now it is true that not much has happened, but the regulators are suggesting that they should have the power to step in and, for instance, force Northern Rock to defer payments.
It may be a small amount in the grand scheme of things, but should Northern Rock have paid coupons last year when things really started to go downhill? Had there been a regulatory overlay, then at least some of the loss absorption could have started to kick in.
Steve Sahara: I think structurally, though, their hands were tied a little bit with the RCIs.
Jennifer Moreland: That’s right. That’s why I think with the new proposals from CEBS, depending on how they go through, that this feature is something that makes sense in terms of enhancing loss absorption in a way that is supposed to matter.
Steve Sahara: In the extreme, this point about loss absorption would suggest that a bank or financial institution should go out and buy puts on its own stock so that if it goes south it actually has something that creates value. But I don’t think many regulators would see that as capital.
Raphael Robelin, Bluebay: The danger here is that the regulator is going to look at things from his own standpoint and not necessarily realise that, certainly in the current market, there is a big distribution issue as well. It could well be that the regulator is frustrated that Tier 1 capital is not really behaving like capital — and there are issues in the case of Northern Rock — but let me tell you that investors are very frustrated as well, because they had mandates to buy fixed-income securities, they bought what they saw as primarily fixed-income debt at arguably very little extra spread, rightly or wrongly, and obviously they are now facing huge losses in that particular space.
The danger with the regulatory review, in particular if the investment banks do not have enough input, is that we are going to come out with a well-framed structure that will not be sellable, certainly to an institutional investor base, in which case it does more harm than good, because we are in a world where financials needs access to new capital. It’s in the interests of the regulator to ensure that this capital-raising exercise can be achieved, and if it is going to become more difficult then I think that is obviously a threat to the system.
Steve Sahara: That is a key point; it is a fixed-income product, and to build in more equity risks implies going to a different market. That is why I made my somewhat light-hearted comment about selling calls or buying puts. You would need to start addressing an equity derivatives-type market and then you should probably be dealing with the asset side of the balance sheet rather than the liability side. It has always functioned quite well as a fixed-income product and is best served when it addresses the needs of fixed-income investors.
Alvaro Camara: The other concern is that, ultimately, CEBS is looking for a convergence not only within Europe or amongst the banking industry, but also with the insurance industry and ultimately with other Basel members. However, we don’t think that the CEBS proposal will be sponsored at all by the US banks. The Federal Reserve is already focusing on the accessibility of the capital markets to their banks to and, additionally, Basel is conducting its own review. What we are worried about is that there is going to be a two-stage process to a review of hybrid capital that only adds to the uncertainty.
Jean Dessain: I don’t think that we should look at hybrid capital as being quasi-equity: it is something completely different with its own merits. That some investors feel frustrated with the price movements, I can perfectly understand, but, the same time, I think there is risk assessment to be done. You should not blame the instrument because the price behaviour was not what you expected. Maybe the market was over optimistic about the instrument and didn’t properly assess the risk associated with this type of product. Assuming the instrument was well designed with a clear purpose, I still think that most of the Tier 1 hybrids issued do match the use they were designed for. Basically, the cost moved up, but that was the same for the senior funding.
Raphael Robelin: I am certainly not saying that investors should be surprised by the way Tier 1 debt has performed, but there is a risk that, after years of complacency as always, when you have been burnt or scarred you are much more cautious. If the framework is changed to make hybrid capital look more like equity, I think that fixed-income investors who are already questioning whether they should have had hybrid capital in their portfolios in the first place are likely to decide against it. The inclusion of hybrid capital in most fixed-income indices is quite recent and for years you had hybrid capital as a non-index bet when your guidelines allowed you to invest in them.
If the next step is to make this instrument look more like equity, the question is whether it is an appropriate investment for a fixed-income investor base. If the answer is no, then obviously the next question is: who is going to buy it?
Laurent Frings, SWIP: The question is one of what Tier 1 instruments are and whether you want loss absorption as a true feature. Clearly, we have some issues there, for example with Northern Rock. I believe that regulators and other parties want to have this feature in place and clearly CEBS is trying to address that.
In terms of the investor base, I think there is a clear working path to go down in terms of whether it is the right instrument for us, yes or no. If yes, what is the right price? The problem of the last few years was complacency and I think what has happened in the last six months has been a very good thing in terms of putting structuring and understanding what the risks are back on the agenda. Going forward, I think there will still be a market for the instruments, but at a different price; investors will definitely be in the driving seat here.
Raphael Robelin: But it is not only the price; it is also the potential volume. What happens if a large portion of the fixed-income investor audience suddenly decides that they should not invest in these securities? Given the need in the current market to replenish capital, it either means that much more true equity core Tier 1 is going to have to be raised, or that you need to find a whole new investor base. I am not sure where this investor base will come from in a market where everybody is squeezed on the liquidity front and trying to find new sources of capital. There is a risk that the regulator enforces more equity-like rules, which then cause a big problem on the distribution side.
Laurent Frings: Possibly, but I think that the bottom line is that investors need to differentiate between the issuers. You mentioned Northern Rock coming at probably too tight a level for the last couple of years or more, and all the second-tier issuers were coming at very small spreads versus very strongly capitalised names. I think we are going to see a much bigger differentiation between the prices for different issuers. The market will still be there for the strong issuers, but not necessarily for the other ones who will be left to go to a different type of market, be it equity, converts or otherwise.
Jennifer Moreland: I think this is exactly the criticism that the market is levying on the CEBS proposals; that, by having underestimated the impact on the investor side, they may have actually cut off their noses to spite their faces by undermining an important source of capital right in the middle of a banking crisis. The timing is therefore being criticised for that reason, as well as for how it coincides with the overall Basel process.
Raphael Robelin: What is very clear is that investors are facing huge uncertainties on the fundamental side and, to some degree, a lack of ability, given the lack of disclosure, to perform ad hoc, in-depth, bottom-up analysis at the issuer level. On top of that, there is regulatory uncertainty as well. We have a situation where banks are in desperate need of accessing the capital markets and issuing new capital and the environment is particularly unfavourable because the fundamental issue has been compounded by the regulatory uncertainty.
Steve Sahara: We have talked a bit about loss absorption and some of the headline security features, but one of the other CEBS components proposed is the 2% trigger, where you would then actually get written down or converted to common. Given the situation regarding transparency disclosure accounting changes, which are still being debated, how do you know when you are hitting the trigger? How do you, as an investor, monitor that when financials are lagged? Which side of the books is it; is it regulatory books, is it IFRS books?
Those types of feature are not well thought out and, in terms of the investors’ ability to monitor the risk, I don’t see how it can really be done in an effective timeframe — and, again, Northern Rock is probably a good example of the inability of investors to see it coming sometimes — based on current disclosure and transparency.
Sean Richardson: This goes to Jennifer’s earlier point of regulatory intervention, because it is inherently hard to set the right trigger level, so an important role for the regulator as well.
IFR: If I can just seize on one phrase used, which was, ‘not well thought out’; Is it the consensus that it has not been well thought out?
Steve Sahara: It is a very complex problem and I think that CEBS should be applauded for trying to find some simple solutions. But finding simple solutions to complex problems doesn’t work very well in a political environment and I think that’s what’s making it difficult for them. So, we are just now getting access to respond to what they have said, so it is good they are allowing us that access, but that’s clearly required because it is not a problem that’s simply solved.
Alvaro Camara: It goes back to the point that David raised at the beginning, which is that hybrid capital is meant to be a loss-absorbing subordinated fixed-income instrument, but, at the end of the day, it is structured under a certain framework giving rise to a bankruptcy. If the regulators will not allow that bankruptcy and liquidation procedure to come naturally then, instead of changing their hybrid instruments, they should revisit the bankruptcy and the liquidation procedures for the banks before entering into the discussion as to how hybrid capital should deal with it, because, obviously, otherwise you are designing a product in a vacuum that is not relevant to what the regulators would ultimately do.
Steve Sahara: Right, and it may work now, but in the next crisis 10 years from now, it might work in exactly the wrong way.
Jean Dessain: But they are doing a very difficult job, basically, because we moved from a principle-based approach with the Sydney press release and we see that with a principle-based approach we have no convergence, no level playing field. So they are trying to take just one step more in order to make sure that we have some kind of convergence, and the big question is: how far do they need to go?
Obviously, those countries with the most lenient regulations are claiming that it is a shame and they cannot live with it, but in a country like Belgium, where we have the most tricky regulations and we are so impeded, anything that could come from CEBS is perfect!
Something that surprises me is that when you look at the way the pricing of Tier 1 has moved from a year ago to today, and then when you look at senior funding, it is much more dramatic on the senior side. It is not a solvency crisis, it’s primarily a liquidity crisis; there is no trust between financial institutions, and this is the major cause.
IFR: We have not seen much in the way of Tier 1 issuance, so is there a recent marker that we can compare?
Jean Dessain: We did a transaction recently, so there is a market. There is not a huge market, everyone is a little bit in shock and issuers are thinking, “Should I issue now, knowing the current spread?”
I think, for the time being, that Tier 1 risk is good compared to senior risk, because the big issue is not the collapse or bankruptcy of the institution, it’s the risk that you take on getting the coupon. For most big institutions –- I’m talking about Double A names, not Double B – I think the way in which the regulators went about their responsibilities and the way they managed the liquidity crisis was poor and financial institutions are suffering from the way it has been addressed. The confidence and trust within the system are not there.
Steve Sahara: There are two related points there. One, CEBS, as the name implies, is a very European proposal; it doesn’t necessarily travel that well. The other is that it is reflective of things that could best be contemplated by strong banks, Double A type credits. When you talk about a level playing field, these changes don’t level the playing field for either emerging Europe or lower-rated credits. They have a much more difficult time building in equity features to their securities; it is far easier for the strong banks to do those things.
IFR: But is the danger that we are going to end up with one size fits nobody?
Jean Dessain: You can rely on investment bankers to find solutions! Well, I hope so, anyway.
Jennifer Moreland: By virtue of the nature of the process it was compromise driven and I give CEBS a lot of credit for having come up with a proposal that truly is a compromise among all of the different European frameworks. As a result, virtually every country will need to change something about the instruments and some countries will have easier solutions than others, but everybody does need to compromise a bit, and, in that respect, I think CEBS does deserve a lot of credit because it is not an easy job to have attempted to come up with a set of rules. But I think your point is potentially correct that one size fits nobody.
IFR: So it is a fine idea and a laudable sentiment, but ultimately doomed to fail?
Steve Sahara: Fundamentally, if we believe hybrid capital has a role in providing lower-cost capital to financial institutions, then do we think it currently works? I would say, for the most part, yes, it works like debt in a strong market and when banks are healthy and it works like equity when they are not. I don’t personally see that these proposals make the product better.
IFR: And what will the impact be on supply?
Steve Sahara: Apart from the classic economic supply/demand balance, it depends on what the securities would look like and the price you sell them at. But the fact that you can have a tiering in the market — the old securities and the new securities — doesn’t make it any easier for investors to price things, to value things, to know what to sell when things get a bit shaky. It just doesn’t help in the process of investors being able to quickly and easily trade what they want without having to try and pull out a five-year-old prospectus and figure out whether this one is like that one, et cetera.
Jean Dessain: We are just entering a new cycle for the product. We started with an absolutely non-commoditised product and then, over time, a position emerged with standard pricing.
Now, with the CEBS, we are opening new markets, new worlds with new structures. We will quite probably see innovation and then commoditisation will once again come around; it is just a question of time. It is probably good for the industry to have a shock that forces everyone to think about what is really behind a product, what we are designing, what we are selling, what we are issuing and what are we buying them for.
Jennifer Moreland: I agree that the CEBS proposals, if they go through as planned, are not going to kill the product, because we will find structural solutions that meet the needs of most of the issuers and there will eventually be a clearing level at which investors are willing to buy whatever product emerges. My only criticism would again be that the timing is not optimal: we are going to go through this period of uncertainty –– of potentially several years -– of figuring out exactly what product makes sense for each issuer and where the clearing level is for a country and issuer, or the market in general, right in the midst of a global banking crisis.
Steve Sahara: But do you see the proposals as an improvement to the product?
Jennifer Moreland: I do not think that hybrid capital needs more loss absorption in order to provide the support to the system that it should. I don’t think that it needs to function exactly like equity in order to still be a very strong support to the European banking system in general, so I don’t think that we need additional loss absorption built in. I therefore would disagree with the regulatory community’s attitude in that respect. I think instead it’s creating disruption in terms of structure, price and access that wasn’t necessary.
Raphael Robelin: From an investor’s standpoint, if you make this class of securities more equity-like, you are obviously taking the risk that fixed-income investors will feel that it is just not a natural investment for them. Will it stay in most dedicated fixed-income indices? That remains to be seen.
Alvaro Camara: We have already seen the impact of the NAIC’s views on life insurance companies’ investments in the States, where they have been out of all Tier 1 and all corporate hybrids. So there is a concern that, by making it more equity-like, you are closing the distribution channels, and it is access to capital that is the primary concern.
Raphael Robelin: We certainly saw the effect that had on the US market at the time against a very benign market backdrop. So, going through the same level of regulatory uncertainty at a time when the banking sector is going through a global crisis is unwelcome to say the least.
Alvaro Camara: What percentage of total capital is placed with institutional investors? Probably 60%, 70% or even 80%. So, if it leaves retail investors holding the hot potato, that is not conducive to a potentially safe system.
Steve Sahara: Again, we have been focused on the things that are problematic in Europe, like loss absorption, but with regard to the very first precept, the aspect of permanence, we have it pretty easy here because most countries can issue perpetual securities that are still tax efficient.
We mentioned the US earlier, and there is Japan, there is Korea; there are places where this is not possible, and that alone could cause these proposals to meet significant resistance on a global basis. Therefore, it could all be a waste of time. There is a need to more quickly bring the global community into it, such as the Fed and the various other major G10 parties who are likely to be impacted.
Click here for Part Two of the Roundtable.