New proposals set out by the Basel Committee will see the Lower Tier 2 asset class assume a burden-sharing role in the case of a bank’s non-viability. While many conversations will be had concerning the details contained in the recommendations, LT2 is sure to look and feel different. Philip Wright reports.
It was all change for the Lower Tier 2 market on August 19, when the Basel Committee released its new consultation document entitled “Proposal to ensure the loss absorbency of regulatory capital at the point of non-viability”.
Under the terms of the proposal all regulatory capital instruments will be required to contain a mechanism in their documentation ensuring that they will take a loss at the point of non-viability. This, says the Committee, should take the form of a write-off or conversion to equity once a bank cannot support itself in the wholesale market.
The proposal hinges on the definition of the concept of a “gone concern”. The Tier 2 debt capital instruments in question have always been designed to become loss-absorbent when a bank enters insolvency and liquidation. The Committee argues this should apply at the point of a bail-out as well, to ensure capital instrument holders do not become the unintended beneficiaries of a public sector bail-out. The proposal precludes the use of a temporary write-down mechanism, as such a residual claim would be senior to the common equity injected by the state.
As far as the Committee is concerned, “the increased downside risk will provide an incentive for the investors in capital instruments to monitor the risks taken by the issuing bank. If a bank takes more risk, and the risk of loss to investors increases, buyers of existing instruments in the secondary market, or new instruments in the primary market, will demand a higher coupon. This sequence of events should help impose additional market discipline on banks”.
Weighing the options
One option considered but discarded by the Committee was to stoprecognisingTier 2 as regulatory capital for systemically important banks. This was regarded as too complex and damaging. Naming systemically important institutions would carry moral hazard implications. Subordinated debt is also viewed as both an important indicator of a bank’s health and, in the case of banks not taking excessive risks, a cheaper capital source than common equity.
Despite this, some market participants are likely to be disappointed. “There was probably some residual hope that Lower Tier 2 would only be drawn upon in the case of a wind-down and spared any burden-sharing in a rescue scenario, but that was somewhat optimistic in my view,” said Georg Grodzki, head of credit research at Legal & General.
Lower Tier 2 issued to comply with the new regulations will probably come at a cost. “It is likely to become more expensive if issued in the new form,” said Steve Sahara, head of DCM solutions/hybrid capital at CA-CIB. “Tier 2 issued with either a permanent write-down or equity conversion is significantly more equity-like than old-form LT2 so could be more expensive for banks to issue.”
While there is talk that transactions from perceived strategically important banks might be subject to more stringent treatment, thus acting as a playing field leveller, this remains conjecture at present.
As the proposals appear to stand, “national champion first-tier banks may find it easier to access LT2 funding in the proposed form, with other smaller second and third-tier banks finding it more challenging – either the new-form LT2 could be too expensive or not feasible to issue if the investor base is too restricted”, said Sahara.
While the reasoning behind the proposals is well understood, there remain concerns that the measures could be overly draconian. Commerzbank analysts summed up the view in a research note published on September 3 and attention-grabbingly subtitled ‘Bond issuance to become extinct?’.
“Regulators are currently trying to resolve the so-called bondholder moral hazard, where bondholders rely on the systemically important banks being bailed out by their governments to avoid making losses while taxpayers suffer. While the regulators’ rationale is clear, they might be well on the way to taking it a bit too far,” they wrote.
And the audience for the new-style paper would likely be very different from what has historically been the case in the LT2 market. Currently, it is broadly similar to that for senior instruments but that would change to there being a greater crossover with Tier 1-buying accounts. This would make for a smaller investor base than is the case at present and this is further complicated by the possibility that the securities would not be rated.
“The agencies may have difficulty rating these instruments on the basis that they have become too equity-like, making it substantially more challenging for them to determine the likelihood of an investor getting his money back. The more equity-like you make these instruments, the more loss-absorbing and the greater potential reduction of nominal value alternatives you build into them, the higher the risk that one or more of the agencies may conclude they’re not comfortable rating these instruments. And there are a lot of investors who by mandate or statute can only invest in rated instruments,” said Marc Tempelman, head of EMEA financial institutions, Capital Markets & Financing, at Bank of America Merrill Lynch.
And his colleague, Daniel Bell, co-head of new product development, envisages a certain degree of Mexican stand-off in the way that any new-style transactions would be viewed.
“I expect they have asked the rating agencies what they think but the agencies typically won’t commit until there’s a deal to be rated,” he said.
Grandfather clock ticking
But there are other conversations to be had even before the subject of any innovation is raised, namely what is likely to happen to current outstanding LT2 paper and the way it is treated.
“Unless clarity on grandfathering is provided, the consultation paper may complicate issuers’ decision-making about issuing capital,” said Peter Jurdjevic, head of the capital products group at Barclays Capital.
Edward Stevenson, head of UK/Northern Europe FIG origination at BNP Paribas, expects all existing issues to be grandfathered. That will have a significant effect on supply in the final few months of the year.
“It is highly likely that everything will be grandfathered and, if so, there will be much more LT2 in the current format,” he said.
However, next year will probably witness a shortage of paper, he said, the result of which will be the tightening in of existing issues and a widening gap between transactions launched under the current and the new frameworks.
This is a view shared by the analysts at Commerzbank in their credit note, but only on the proviso that the grandfathering approach that is eventually adopted is as benign as market participants are hoping.
“Depending on the grandfathering features of existing Lower Tier 2 and how long it will count as capital, the outstanding Lower Tier 2 of banks perceived as being of good credit quality could tighten in substantially due to the future rarity of the asset class,” they wrote.
As for any new-style issuance, there is no guarantee that an homogenous asset class will evolve, given that an element of discretion as to the minutiae is afforded local regulators.
According to the Committee: “The proposal is specifically structured to allow each jurisdiction (and banks) the freedom to implement it in a way that will not conflict with national law or any other constraints. For example, a conversion rate is not specified, nor is the choice between implementation through a write-off or conversion. Any attempt to define the specific implementation of the proposal more rigidly at an international level, than the current minimum set out in this document, risks creating conflicts with national law and may be unnecessarily prescriptive.”
The natural corollary of this is that both issuers and investors will be able to pick and choose between the various structures available.
“We could see some jurisdiction arbitrage, certainly in the early days as things settle down. But I reckon we should arrive at some sort of consensus in the end,” said one DCM official.
For all the conjecture, the document is only a proposal at this stage and could be amended. The timing of its publication coincided with a time when many of the likely protagonists were away from their desks and, as such, the possible ramifications are still being calculated. Market participants can respond with comments to the Committee by October 1 2010, and modifications after that are not being ruled out.
The current timeframe sees rules published by the end of 2010 and set to take effect at the beginning of 2013, although even this could be subject to change along with the content itself.
“As a result of the impact studies conducted by the banks in H1 2010, we expect further watering down of the current proposals and potentially an extension to the original timeframe,” said the Commerzbank analysts.