Waiting for the regulators
’Going concern’ contingent capital was heralded as a crucial new instrument for the new regulatory regime, but so far there have only been two deals. Some market participants believe the format is the future of hybrid issuance but others expect it to coexist with Tier 1. The Basel Committee released new guidance in July, but the future of this market will not be apparent until there has been more regulatory clarity, as Matthew Attwood reports.
With just two contingent capital deals successfully completed so far, the asset class is still in its infancy. Its supporters argue that it could represent the future of the hybrid market. But with continued uncertainty over the regulatory treatment of the structure, it is still too early to tell.
Lloyds was first out of the traps with a contingent capital deal last November, a €7.5bn Lower Tier 2 transaction that is convertible into equity if a core Tier 1 threshold of 5% is breached. That trade, the result of an exchange offer for existing Tier 1 and Upper Tier 2 securities, was followed in March by a transaction from Rabobank targeting new money, a 10-year deal of €1.25bn, featuring a write-down of principal to 25% of par if the bank’s equity capital ratio falls below 7%.
Since then, the market has languished, with opinion divided as to which of the two will be the model for future deals. The Basel Committee has since published a proposal on ’gone concern’ contingent capital (discussed in a separate feature in this report).
Some argue that the Rabobank trade was specific to the issuer and could not be replicated by banks that did not benefit from Rabo’s enviable credit rating. But one banker involved in structuring both deals rejects that view.
“It could be replicated by other issuers,” said Prasad Gollakota, head of EMEA capital solutions at UBS. “There were people before and during Lloyds saying the deal might fail, and when it was a success they said it would only work for an issuer going through a distressed situation and that no one would buy a new issue, then we saw Rabo and people said that structure is restricted to them because they’re triple A. But the truth is that markets evolve this way. You get exceptional cases and stronger credits first – it doesn’t mean they won’t work for others.”
Both issues have advantages and disadvantages. Lloyds’s equity capital note is not ideal for a fixed-income investor to hold, because most investment mandates are not compatible with equity-linked and equity-convertible instruments. That said, the prospect of a recovery play is an enticement Rabo’s senior capital note structure lacks. The SCN’s major drawback is that it effectively subordinates the holder to the level of equity or even junior to equity, because the equity holder participates in any upside while the SCN investor is effectively cashed out. The SCN’s major advantage is that it is relatively easy for a prospective investor to calculate expected losses and returns, even if the contingent loss event is severe.
Gollakota believes the Rabo SCN could be replicated by future issuers, pointing out that the deal’s unrated status was a stumbling block for investors. This, he believes will be remedied in time. “The features themselves, while some investors would have preferred to there to be a write back up or some sort of conversion into equity, were acceptable given Rabo’s equity capital buffer. The direction of all regulatory capital entails the inclusion of ongoing loss-absorption mechanisms, so the agencies will have to come to the party. It’s a matter of time.”
The rating agencies’ problem with the format as it stands is the discretion associated with the trigger – they don’t feel comfortable assessing an instrument’s credit-worthiness on the basis of an issuer’s own assessment of its risk-weighted assets.
Justification to issue
While Rabo brought its deal to eliminate tail risk, most issuers will bring contingent capital deals with a view to obtaining regulatory benefit. But exactly what treatment deals in this format will receive is not yet clear. Although the Basel Committee had previously suggested they would find a home in the capital conservation buffer, the latest word from Basel is that this buffer has to be composed of common equity, leaving unresolved the question of where contingent capital will sit. As this supplement went to press, this and other topics relevant to systemically important banks, such as bail-in debt, were still officially under discussion.
A key consideration is the instrument’s relationship with Tier 1. “We see contingent capital as an instrument that will be used next to hybrid Tier 1,” says one banker involved in the development of new capital instruments. “I’ve heard some people express the view that contingent capital is the new hybrid, but we firmly believe it’s a different and additional layer of capital next to Core Tier 1.”
UBS’s Gollakota points out that issuers will need a justification to issue in the format if they believe a deal would price close to Tier 1, rightly so given that the regulatory merit has not yet been settled. “If you’re issuing something where you’re unsure that it will get Tier 1 treatment today or in the future, then why would you pay close to Tier 1 pricing?”
Pricing is of course a central consideration and some market participants question the efficacy of an instrument with a remote trigger like 5% of Tier 1 from a cost perspective, assuming hybrid Tier 1 can still get done.
“For the double A banks likely to issue, the trigger is so remote that contingent capital would effectively be insurance,” said one syndicate banker. “Unless you’re told to issue it by a regulator, why would you bring Senior and Lower Tier 2 at close to Tier 1 pricing if you think you’re never going to blow a big enough hole in your balance sheet to need it?”
He also points out that for a bank to have a sufficiently meaningful amount of contingent capital relative to its balance sheet to make a difference to its capital ratios if the instruments are triggered would mean very sizeable volumes. “€500m or €1bn won’t work for a double A bank with a trillion-euro balance sheet – you’d need €5bn or €10bn. If every bank had to issue that kind of amount it’s a lot to take out of the market. Who would buy it all?”
This leads back to the question of distribution. Assuming that contingent capital targets the same group of investors that sponsored Tier 1 over the last decade or so, a lot of them won’t be able to participate if there are equity characteristics to issuance. Retail funds and hedge funds might be able to take the paper, but the dominant accounts in the market – like pension funds and insurance companies – will not. They could participate in a SCN-style structure, but an SCN-dominated market is likely to be more expensive than one characterised by issuance of the type pioneered by Lloyds.
Whichever format is favoured, there will have to be a process of investor education if contingent capital is going to attract enough participation to function as intended. Some investors, for example, expressed a preference for old-style Tier 1 over the Rabo deal, even though the trigger event on the contingent capital trade would probably lead to liquidation.
For now, the market’s future hinges on decisions made at the regulatory level. Most market participants believe the format will coexist with Tier 1, but that how the two will relate to each other is not yet clear. The new hybrid Tier 1 rules will emplace standard features, such as a write-down or conversion into equity, which are also used in contingent capital instruments.
The market is waiting to hear from the regulators how the two instruments will be positioned, specifically when each is intended to absorb losses and how the respective triggers will relate to each other. When that guidance as to what contingent capital is intended to achieve is given, along with clarifications on how it will be treated in each pillar, which regulatory bucket it will appear in and whether there is to be a specific request for systemically relevant banks to issue in the format, the future of the instrument will be clearer.
The Basel Committee’s reluctance to identify systemically significant institutions when it published its proposal for ’gone concern’ contingent capital in August suggests that it is not yet a certainty that issuers will be required to issue in the format.
The slow pace of regulatory decision-making and communication has kept capital issuance in general to a minimum throughout the year and few in the market expect this to change soon.