Saturday, 20 October 2018

IFR Bank Capital Roundtable 2015: Part 1

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IFR: Welcome to this IFR Roundtable. There are a number of issues around where we’re headed on this great debate on bank capital. Blueprints for TLAC, MREL and related initiatives have been published and commented on. How will they impact the banks? What is the total capital requirement going to be? How will it be met? What are the ratings impacts? What’s the issuer perspective, and of course what’s the investor perspective?

It’s been an interesting year-to-date for the structural elements that have emerged, around HoldCo and OpCo issues, local currency versus hard currency, and we’ve seen interesting pockets of capital issuance. In short, where are we on this road to regulatory reform?

Before we get into the detail of the capital issuance debate, let’s put it in the context, not just of FIG DCM but overall DCM, in terms of isolating how important this is as a theme. Sandeep, could you to give some opening comments in terms of where the capital theme fits into FIG in terms of how important it is and where FIG DCM fits into the overall theme set against SSA, corporate high yield, and emerging markets?

Sandeep Agarwal, Credit Suisse: The debt capital market business this year is probably running around 20% below the levels we saw last year across corporates, EM and SSA. FIG volumes this year are flat if you include self-issuance. If you exclude self-issuance, it’s probably about the same: down about a quarter from last year.

However, what is good to see within FIG DCM is the composition of supply diverting towards more capital issuance from previous years as the regulations become clearer. There was a bit of a hiatus during the course of the early part of 2015, primarily because people were waiting to see what happened with the TLAC proposals issued in November 2014. The high expectations we all had around Tier 2 have stalled a little ahead of further clarity. However, in the meantime, AT1 issuance has kept pace with what we saw since second quarter of 2014.

Overall, the fee pool remains fairly healthy, because the M&A cycle in the corporate segment continues to be strong. While Europe itself is not seeing a lot of M&A, there are a lot of inbound deals and in-market consolidation that is leading to activity and/or issuance. The FIG market is continuing to issue senior, covered, and capital in a space which looks reasonably robust but which has a lot of thinking to do as rules get clarified.

In the SSA space, governments are going to need financing, and while issuance is low, demand for duration is keeping the excitement alive. The market is clearly grappling with negative rates, something I think most of us are concerned about, but otherwise liquidity supply from the ECB is keeping the markets very buoyant overall; so the market is in a good shape.

IFR: Daniel, how is the capital debate impacting on the FIG funding space in general?

Daniel Shore, HSBC: Over the last couple of years, a lot of issuers have been looking about what they can actually do but there’s been a lot of uncertainty about what some instruments we have actually do. With Tier 1, issuers know what it does for the balance sheet, so it can help you on your leverage ratio; it can help you on optimising your capital structure. Banks are very focused on ROE, ratings and duties to our shareholders.

Issuers are comfortable with that and how they deal with it. I agree with the point Sandeep raised about Tier 2 and expecting more of that, what with the TLAC and MREL proposals. It’s clear that issuers have been sitting there waiting to see what Tier 3 is. How are investors going to value senior in different formats, whether it’s under the proposed German legislation or whether it’s contractual? Until that’s seen, I think there’s a lot of people sitting on the sidelines wondering how to truly optimise their capital structure and what instruments they’re going to be using.

They’ll still use senior, covered; they’ll still use Tier 1 and they’ll still use Tier 2, because they’ve got buckets for those. The other thing that’s key around this discussion – which is still uncertain – is you’ve got UK companies with HoldCos, you’ve got European banks that don’t have HoldCos. Are they structurally disadvantaged? What’s going to happen there? You’ve got US banks with HoldCos but with a lot of structured notes in those HoldCos. Will they get an exemption for that? If they do, then Europe really is disadvantaged.

We’ve come a certain way down the road but I still think we’ve got another big step to take over the next 12 months when we will hopefully have more definition to allow banks to think about the right instrument to issue and the right price for it; at this stage we’re not certain about where they fit into the capital structure.

IFR: Let’s talk more specifically about the capital side. Khalid: there’s been a lot of capital issuance of late. What do you make of it? Is it front-running final regulatory formats? If so, is that wise?

Khalid Krim, Morgan Stanley: I don’t think it’s front-running the regulatory environment; People have been waiting for the AT1 market since 2013 but we’ve only been in a CRD IV environment since last year so it’s basically banks reshaping their capital structure to the CRD IV environment. The activity we’ve seen is banks going out into the market and establishing with investors their new AT1 or continuing to increase their total capital with Tier 2.

We haven’t seen – and I agree with Sandeep – the amount of Tier 2 that people were expecting or forecasting so far. But I think it’s work that banks are doing in terms of shaping their capital structure to a CRD IV framework. What banks are not doing – and we expect them to do in the second part of this or early next year is to implement MREL and TLAC. But it’s basically a building block; it’s moving from CRD IV, having Tier 1 and Tier 2 already in the capital structure, and moving to the next space in the debate.

And that is: how do I reassure senior creditors that in a bail-in environment I have enough loss-absorbing capital, and what the form and shape that capital is taking – is it Tier 1, is it Tier 2, is it Tier 3 or other type of securities? It’s communicating to my senior unsecured creditors: “this is the environment you’re going to be facing in a TLAC world or in an MREL world”.

So far, activity has been high in the AT1 because that’s a market that a number of banks were waiting to access, pending clarity on the tax side – for instance, the Dutch banks – or pending clarity on the regulatory side; some banks in Europe didn’t have that at the same speed, for instance, like the Swiss banks had in the CoCo market or in the Tier 1 market, or the UK banks had with the PRA proactively giving guidance about the shape of these instruments. I think the CRD IV transition is where we are, and the next step is the total capital framework and building up total capital for senior creditors in a bail-in context.

IFR: Has the initial novelty around TLAC subsided now? And in terms of the focus of the debate that’s emerged since the proposal came out in November, how has all of that been embedded into structural features that we’ve seen in AT1 issuance year-to-date?

Gerald Podobnik, Deutsche Bank: The whole debate has calmed down and become more structured and detailed in terms of analysis. When the first proposal came out, everybody thought: “this is totally new but has nothing to do with what MREL has pioneered in Europe”. There was a lot of debate about either we have to create new products or we need HoldCos everywhere. There was a very simplistic view, I think, at the beginning to say: “this structure is favoured here; that structure there”.

Now we are in the situation where people understand that both concepts, TLAC and MREL relate to each other very closely and they can be seen as one form of another. TLAC is globalising the European work that has been done before, with certain global realities built into it. It’s something that should be valued around the world. The whole debate about what it actually is has moved on from a simple view to a broader view.

In Germany we have a draft law proposal out there that was passed in the Cabinet that will make its way into the parliamentary debate over the next couple of weeks and months. So there are other ways to deal with the requirements than to create new instruments or change the structure of the bank completely.

What has changed as well is that people are embedding the whole TLAC debate within a broad environment because when we talk about calibration, we have other forces emerging right now. We have the whole Basel IV debate where risk assets might be completely different, so when regulators calibrate ratios that are based on RWAs or on leverage ratio this has to be included in the thinking.

The next thing is leverage ratio. TLAC has a leverage ratio requirement test. If the leverage ratio isn’t 3% for everyone but something different that Basel will finalise over this year, then we are in a different situation so this is another important topic. The third topic that is featuring in all of this is the whole structural reform debate or ever-growing trend of subsidiarisation where we see local regulators around the world demanding local capital, like we’re seeing with the US.

All of this fits into the debate about internal TLAC, how you downstream funds, and how you manage your capital structure globally. It’s broadened massively in scope, from: “I have to change my set-up as a bank”, or: “I have to structure an instrument” to: “this is actually part of a bigger effort to make sure banks are not too big to fail”.

IFR: Michelle, the ratings process has been a big driver of the capital issuance debate for quite some time now. To what extent do you think the ratings world is impacting or informing the direction of travel in capital?

Michelle Brennan, S&P: We hope the update to our criteria that we published in April helps us to reflect more clearly some of the trends we see in terms of the likelihood of default for banks. We recognise that the regulatory initiatives around loss-absorbing capacity – even though they’re still unclear in terms of their exact definitions, exact calibration and so on – will have implications for potentially improving the likelihood of default for various banks.

We like to think of our criteria as reflecting the risks that we see in the market or the opportunities that banks have to enhance their creditworthiness, rather than driving the outcome. We believe that the decisions about the structure of a balance sheet and the decisions about the structure of an instrument shouldn’t be guided by a rating agency but by a bank’s management. We don’t provide advice; we comment on what we see from the entities.

But the way we finalised the Additional Loss-Absorbing Capacity (ALAC) criteria does reflect that there are a lot of moving parts still in the regulatory framework and also that it’s impossible to sum up the overall loss-absorbing capacity of an entity with one single measure, with one single number that will tell the whole story, that will grasp and take into account all the complexities of what a potential resolution process could look like for that entity.

The resolution processes are evolving, and the final decisions around the nature of resolution and what the balance sheets will look like then are still things that people don’t know the full answers to. We look to build-in principles in our criteria that allow people to think about the various features that could enhance the position of the bank or not.

IFR: Paul: how do you see the direction of that travel for the ratings story and how that is impacting on how the market develops?

Paul Oates, UBS: The banks themselves have being trying to front-run the agencies to some extent. We got the new ALAC criteria from S&P in April; we had the Loss-Given Failure (LGF) criteria from Moody’s earlier in the year, and Fitch have indicated how they want to approach it. What’s driving the banks’ thinking is that it’s been clear from the agencies for a while that they are considering removing State support from banks or reducing it.

A lot of bank ratings are at particularly sensitive levels; where if they do lose one or two notches from their rating, they cross into areas where short-term issuance becomes problematic and there are a lot of collateralisation requirements. A lot of banks have been saying for the last year or so: “we know this is coming from the agencies. How do we get our stand-alone ratings or our ratings high enough to offset this eventual removal of support”?

Because it is quite clear that’s the direction of travel from the regulators, the agencies have to reflect that in their ratings. Before this year it was very much about how you move the stand-alone up through just pure AT1-type capital issuance, which gets a lot of agency credit and actually moves the capital instrument ratings up as well, because you can’t really do too much to improve your business position, or your funding and liquidity, or your risk position over the very short term.

The only real tool banks have got to protect ratings is capital, and to issue large volumes of it. What we have now with these new criteria that are coming in is clear indications from the agencies on how they’re going to be treating Tier 2 and potentially other types of loss-absorbing capital. S&P in particular has, very wisely, been quite broad in its inclusion of what instruments would work for ALAC to allow the criteria to work with whatever we get in terms of the final structure of what instruments work for TLAC.

We’ve got a little split between some of the agencies and others. I think S&P has taken a very forward-looking approach by making arrangements to; assess what banks’ issuance plans are over the next one to two years, potentially even longer if States are supportive of that”. Therefore, the ratings aren’t necessarily that sensitive at the moment, but some of the other agencies are in the middle of removing State support right now.

At other agencies, Moody’s in particular, the module they’re using to assess to what can offset State support, in terms of loss-absorbing capital, seems a bit more backward-looking by looking at what banks have in the present. I think a lot of issuers are thinking: “what can we do in terms of Tier 2 or some HoldCo senior issuance to offset that immediately”? What we’ve seen in the last six months, particularly from the UK banks, was preparation for Moody’s support removal.

IFR: Steven, from an issuer perspective the world has changed a lot over the last few years, and it’s an evolving world. How do you view the landscape? Issuers need to create enough regulatory capital but there’s also the issue of protecting senior unsecured creditors as well, which may be rendered more complicated by the issue of subsidiarisation and the trapped capital issue. There’s a whole range of moving parts here. How does the current state of affairs and direction of travel inform your day-to-day world?

Steven Penketh, Barclays: Yes, there has been a lot of uncertainty in the regulatory capital and TLAC space to contend with over the course of the last three or four years. I’m pleased to see, however, that with every iteration of the TLAC term sheet (although people roll their eyes when settling into respond to yet another consultation document) we do end up edging closer to clarity, which is good for all market participants.

The extant uncertainties relate to calibration, transitional timelines and the structural shape of TLAC stacks for banks going forward. Issuers therefore need to execute BAU capital and funding plans against a backdrop of ambiguity.

The one thing you can do when there are so many different interpretations of regulatory change – and who knows how many conflicting articles have been produced by sell-side analysts recently (and it’s extraordinary how many of them are ill conceived) – is to try and bring as much clarity to your end investor as you possibly can.

That obligation actually manifests itself in two different ways. Firstly, you’ve got to spot and identify the risks as you go through a transition period and secondly, you’ve got to try and mitigate those risks as best you can. You then have to articulate how you perceive a way through the ambiguity over the course of the next four or five years to the Street. Investors want to understand what you are doing to try to mitigate potential negative impacts for them.

That’s the best issuers can do at the moment as there are many things that are outside our control. Ratings are a good case in point. As well as being volatile, the different outcomes illustrate how many people have very different interpretations of the way in which credit risk is evolving through transition periods and towards end-states. You’ve got to stay on top of all of the market movements as and when they happen and just make sure you stay true to that fundamental principle of explaining and mitigating risk as best you can.

IFR: Laurent, as an issuer Steven is facing elements of uncertainty and lack of clarity; you are as well so you have an accommodation of sorts.

Laurent Frings, Aberdeen Asset Management: As Steven was saying, there are still a number of issues out there, whether it’s calibration or quantum of capital, whether it’s subsidiarisation and the structure of companies. So many questions still need to be answered from an investor’s perspective, just like from the issuer’s perspective.

In terms of how to think about it, how to position ourselves to that end-point as well as the way we think about investing and pricing different instruments issued by different issuers, the good thing is we’re getting more clarity week by week. We’re still aware there are a number of issues but there is definitely more clarity nowadays.

From my perspective as an investor, it’s very interesting to see what the rating agencies are doing now, whether it is looking at ALAC or Loss-Given Failure because ultimately this is exactly what we have been doing for a long time.

It’s basically putting together the PD and the loss severity, and getting to the point where we gauge what risks we are taking and how we should be pricing those risks. It’s a good development. I think too many investors are still focusing too much on resolution and loss severity, as opposed to that PD element, because a lot of banks are doing a lot of good things, whether it’s on the risk profile of the assets of the balance sheet, as well building a lot of cushion that’s protecting us as senior debt holders.

When we look to where some issuers are still printing, be it in senior or in sub, there is still very little differentiation between those issuers with different capital stacks and how, effectively, if something happened in resolution, how you will fare as a debt holder. It’s quite interesting. There is still, in my mind, a lot of mispricing of risks out there, which is ultimately good for us as investors.

You have some banks with, let’s say, 12.5% or some with 20% total capital ratio, and they both print senior unsecured debt at similar spreads. Is that right? Is that wrong? Clearly, it’s a function of the PD as well. There are a lot of other elements within it, whether it is the regulatory framework and the regional framework for different issuers if they are from different jurisdictions etc. But at this point in time it feels to me still that whether you look at the US and the way they price holding company versus bank and the way losses move up the different structures, or in Europe where some issuers trade in senior unsecured, for me doesn’t make any sense.

It is good for us and we can play those themes. It’s interesting again that in Europe in particular a lot of investors still believe that a resolution is a next-year situation with BRRD. In my mind, as we’ve seen so many times, a resolution framework can be changed and passed over a weekend, so it’s very interesting. The investor psyche has still not evolved as much as I thought it would by now.

IFR: In terms of just on that pricing piece, the differentials between the various classes of funding and capital, is there an accepted market norm as to where Tier 1 debt should be priced relative to Tier 2 and the senior unsecured piece as well?

Sandeep Agarwal, Credit Suisse: I will talk senior HoldCo-OpCo differentials both as an issuer from Credit Suisse’s point of view but also as a capital market participant. Credit Suisse has been a big issuer of HoldCo debt out of Switzerland. We have done almost CHF7.2bn of issuance year-to-date in the US, euros and Swiss markets; Barclays has done some primarily in the US markets but also in euros.

I think the differentials are starting to become evident in the market. Whether they’re right or wrong is a matter of how the regulations ultimately pan out, what the rating agency actions are and how the risk assessment is from the investor point of view. So there is a lot to play for and it will take time for this to stabilise.

We have seen a clear differential between covered and unsecured, which has stabilised around 30bp to 40bp – although ECB buying is distorting the liquidity picture a little. The differential between HoldCo and OpCo senior, at least for the European banks, appear to be settling around 40bp to 45bp; it’s about 40bp in the US, closer to 45bp in Europe. For US banks, that differential is around 15bp to 25bp, depending on the bank you look at.

We know that the Tier 2 trades about 75bp-100bp off senior for statutory PONV Tier 2; I can complain about Credit Suisse’s 5% trigger Tier 2 that is significantly wider, but let’s forget that for the time being because it’s an odd structure from a pan-European point of view.

My argument is, when you look at PONV-triggered instruments, which are going to be triggered when CET1 in the bank is 5% at the very least; we can argue whether that number is 5%, 6% or 7% but the point is that about half the equity is still in play. So probability of the resolution hitting HoldCo senior debt is significantly lower. Therefore, the differential between senior OpCo and HoldCo versus that to Tier 2 should be less than half as well. This is not the case today .

So, I do think the place where the senior to HoldCo differential should ultimately sit should be closer to the senior, probably more in line with the US; perhaps a little wider because of the frameworks. Then with S&P and Moody’s creating a two to three-notch differential between these instruments, you come to a 25bp to35bp differential argument . That’s where I would like to see it go from an issuer perspective.

Steven Penketh, Barclays: I completely agree with that, but the question out there at the moment, certainly from an issuer’s perspective, is: how to achieve that. This is where transparency is absolutely key. I don’t think there’s been a better illustration in the capital markets over recent years of an imperfection in markets given an information set.

If you’re very transparent about the nature of the risk that is held at the holding company vis-à-vis the operating company and people understand the way that the capital hierarchies work as a matter of law in the relevant jurisdictions, it should be very easy to rectify any anomalies and close those pricing gaps (by spotting the risk, mitigating the risk and educating the market).

However, the market is proving incredibly stubborn on a pricing basis, because it tends to focus on relative value versus all of the other issuers out there in a very technical sense, irrespective of the fact that some issuers are much better than others at mitigating risk and enhancing disclosure. I think that some fundamental considerations are being missed by the market, because investors are too focused on the quantitative analytics of: “what is the actual spread differential on a relative basis?”, which are in themselves distorted because they are missing some key qualitative differences that would require more subtle analytical judgements regarding different issuers, profiles and legal and resolution regimes.

I don’t know whether Laurent has a view on that but I find it a little frustrating as an issuer – and I’m sure that Sandeep does too – though it should correct in time. You are talking about new regulations, new rules, and disclosure obligations that aren’t uniform as yet. If you think about the TLAC term sheet, they’re saying: “you should disclose your inter-company capital flows in 2019”. That’s a long way off and if you’re trying to get the benefit of disclosure through a transitional flight path, that’s not going to be any use to you.

As you start to see greater transparency from different issuing houses over the course of the coming months/years, hopefully you’ll be able to see a proper compression in this ‘misinformation arbitrage’ (as I call it) that doesn’t necessarily follow the fact pattern of loss-given default. But to Laurent’s point, that doesn’t necessarily address the PD side, which is still a fundamental analysis of the underlying business proposition.

Laurent Frings, Aberdeen Asset Management: I completely agree with that. The point I was making around how you price different structures was not even going into the holding company versus operating company differential, but it’s just the same argument in that there is still a lot of laziness – let’s put it that way – from market participants, which from our perspective can be quite good.

To Steven’s point, disclosure is going to be very important. Interestingly the FSB met with a number of market participants not too long ago, and there was a lot more discussion around disclosure than I thought there would be, which is very welcome because ultimately the issue is one of understanding the framework and pricing instruments during that transition period, because we are not at that end-point.

Taking different timeline views is painting a very murky picture, but the point with us as investors when we buy risk today, we typically price it with risk that we can see over the next 12 to 24 months and it’s really hard to fast-forward four/five years down the line. That’s the issue we face, which creates massive problems for Steven, obviously.

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