On the face of it, Latin American banks face less pressure than their developed market peers to raise additional capital under Basel III.
In Brazil, for example, the region’s largest financial institutions had an average Tier 1 capital ratio of 12.8% in the third quarter of last year, just shy of the 13% hurdle required under the new capital accords but significantly better than the 8.9% European average recorded by the European Banking Authority stress tests in August.
Although investors were happy to buy Banco do Brasil’s recent Tier 1 perpetual as public-sector risk with a 9.25% coupon, it’s not clear that other LatAm banks will adopt the controversial structure to raise Basel III compliant capital. While retail accounts lapped it up, institutional investors are demanding more certain structures and higher risk premiums to play ball.
Indeed, the luxury of generally well-capitalised banks last year encouraged Banco Central do Brasil to accelerate its Basel III schedule and it expects to have key components of the new regime in place by July, two years ahead of the Basel committee’s own timeline.
Significant uncertainty, however, still remains over how the central bank will interpret the new accords and whether key sources of capital relief available under the present domestic Brazilian regime will be permitted. “We need more clarity from the central bank on how it will interpret Basel III in the light of important local differences before we can talk about how much additional capital Brazilian banks will need to issue in 2012,” says Marco Pierry, LatAm bank analyst at Deutsche Bank in Sao Paulo.
“LatAm banks are well reserved with little leverage. In this relatively safe banking environment, the significant oversubscription on the BdB perpetual shows you that there is strong appetite for this paper”
For instance, existing rules allow banks to count deferred tax credits associated with bad loan provisions as part of Tier 1 capital, which is currently worth about R$20bn, equivalent to 40% of Brazilian banks’ total equity base, according to Deutsche. BCdB said last year it would make a final decision on whether deferred tax credits would qualify for Tier 1 treatment under Basel III by December 2011, but the market was still awaiting confirmation.
Meanwhile, BCdB is also poised to remove domestic banks’ ability to recognise revenues from loan sales upfront, forcing them to wait until final maturity. Although this will probably not be a huge concern for the three largest lenders, which have leveraged their scale to generate loan and ROE growth of some 20% per year, the smaller lenders who recycle capital by off-loading loans to bigger banks may find themselves more constrained.
“There is a huge pool of LatAm dedicated money out there, and financial institutions are among the largest constituents in the regional equity indices. LatAm banks are well reserved with little leverage. In this relatively safe banking environment, the significant oversubscription on the BdB perpetual shows you that there is strong appetite for this paper,” Pierry said.
After several years of 20% loan book growth, a string of large ticket acquisitions and a mandatory dividend payout ratio of 40%, government-controlled BdB ended 2011 with the lowest Tier 1 capital ratio of the large Brazilian banks at 11.1%, according to Moody’s. The agency also highlighted BdB’s R$22bn of subordinated debt classified as Tier 2 instruments, which accounted for 39.1% of Tier 1 equity, and R$2.3bn of perpetual hybrid debt instruments, the eligibility of which as Tier 1 capital components is expected to change under Basel III.
Unsurprisingly, it was the first regional bank into the market this year with a structure to test market appetite for regulatory capital before the regulations are finalised.
“Structuring a deal like this in the face of regulatory uncertainty is a special challenge and the outcome represents more of an interim solution than a template for future issuance. We know how Brazil adopted the first two Basel accords, but we don’t yet know how Basel III will be implemented. This necessitated a structure with sufficient flexibility built in, so that covenants could be conformed to Basel III as it is codified in Brazil,” said Chris Gilfond, co-head of LatAm credit markets at Citigroup in New York, which was joint bookrunner on the deal.
As indicated by the US$7bn order book, BdB generated excess demand at the tight-end of price guidance of 9.25%–9.5% for its BB rated offering allowing joint bookrunners BB Securities, BNP Paribas, Citi, HSBC and Standard Chartered to print a US$1bn transaction with significant value left on the table.
The result is even more remarkable taken in the context of Rabobank’s US$2bn Tier 1 perpetual priced in November to yield 8.4%. Sources close to the deal suggested BdB should have paid at least a 100bp spread over the BBB+ rated Rabo deal given the four-notch rating differential alone. With the deal trading up significantly in secondary trading, it seems fair to assume that investors considered both structure and price to be right.
Private bank investors, principally from Asia and Europe, accounted for 50% of the demand, which dealers say was a welcome surprise after Asian private banks failed to get excited about a Bradesco five-year senior deal priced one week earlier. Indeed, that private banks accounted for all the Asian demand for the deal, and more than half the European demand.
“The BdB perp developed strong momentum in the Asian and European private banking networks driven by the attractive coupon. We knew that private wealth would be a factor given the strong presence of offshore money of LatAm origin within the European private banking networks, but we didn’t know it would be a determining factor. The depth and strength of the Asian bid exceeded our initial expectations,” Gilfond said.
Gilfond notes that although real money and hedge fund investors initially shunned the deal on the basis that the spread on offer didn’t reflect the risks presented by the structure, institutional interest gathered pace as it became evident that retail demand was sufficient to get a US$500m transaction at the 9.25% level.
Seeking a generous spread
However, institutional investors, particularly dedicated emerging market fund managers, are reluctant to support the BdB deal in public, and argue that emerging market bank capital in general should come at a more generous spread to senior bonds.
“We take into account the relative value offered by LatAm names versus European banks and pay a lot of attention to structure. The BdB perpetual offered a poor structure from an institutional perspective,” said Polina Kurdyvako, founder of the BlueBay emerging market corporate bond fund at BlueBay Asset Management.
Investor concerns focus on the structures treatment of bondholder write-downs and the issuer’s ability to amend covenants governing loss-absorption after issuance without bondholder approval. Under the current covenant package, bondholders will absorb losses after reserves and capital are exhausted. BdB is permitted to amend the covenants to allow for bondholders to absorb losses when the bank’s Core Tier 1 ratio falls below 6.125%. While Basel III recommends a minimum Tier 1 ratio of 5.125%, Brazil has not yet determined what its minimum level will be.
“The majority of institutional investors we talked to embraced the transaction, as they viewed BdB as a strategically crucial source of finance for the Brazilian economy”
“If Brazil sets its ratio above 6.125%, these bonds, even after the permitted amendments, would not comply with Brazilian Basel III requirements and the bank could exercise its right to a regulatory call,” Kurdyvako said.
As a concession to bondholders, BdB committed to amend covenants to allow for a write-up of the previously written-down principal after its Tier 1 capital ratio returns above its regulatory minimum, should Brazilian regulators permit such a clause. So far, the Brazilian regulator has not commented on whether or not this will be allowed. Moreover, no country has allowed for this to date.
Karina Saade, a director with BlackRock’s portfolio management group in Brazil was also unimpressed by the spread offered by the BdB structure, especially after institutional investors had successfully forced higher spreads on traditional 10-year subordinated deals from Bradesco and Itau earlier in the year on over supply concerns.
“Current pricing on the recent ‘old school’ sub debt issues has been attractive for institutional investors but that has not been the case for the Banco do Brasil structure,” she said.
While emerging markets specialists deemed the structure either too aggressive or too uncertain, other institutional investors were comfortable taking a probability-weighted approach to the risk analysis.
“The majority of institutional investors we talked to embraced the transaction, as they viewed BdB as a strategically crucial source of finance for the Brazilian economy,” Gilfond said.
Retail in the driving seat
It is no secret that the US dollar Reg S market has become a critical investor base for financial institutions seeking to raise hybrid capital, with Asian investors playing a particularly important role in anchoring recent deals from developed as well as emerging markets. Indeed the presence of several brokers with large Asian private wealth networks in the offering syndicate for the BdB perpetual indicates the strategic importance of this investor base.
Notwithstanding lingering uncertainty around how much additional capital regional banks will require under Basel III, the opportunity for attractive subordinated funding presented by global retail networks will encourage Bradesco and Itau to follow BdB’s lead into the Tier1 market, without departing materially from the its perpetual structure.
“Banks are always opportunistic issuers. They will hit the market when there is demand and supply will increase when spreads tighten and will decrease when spreads widen. Overall, given the large loan growth expectations for LatAm banks next year, we forecast about US$18bn of senior, subordinated and Tier 1 issuance for 2012,” said Saade.
However, it’s not clear that the other big Brazilian banks will come to market soon, or that they will use the BdB structure, which relied on strong retail demand and institutional comfort with the borrower’s role in national economic policy.
“The other large Brazilian banks may have a future need for capital, but it’s not imminent. We don’t foresee a wave of lookalike deals coming. The BdB structure made sense for that issuer, but it’s hard to make a case that it makes sense now for the larger, well capitalised banks,” Gilfond said.
Will investors have the same appetite for small Brazilian banks and other regional jurisdictions like Chile, Colombia and Peru? While the offshore LatAm link will likely support European private bank appetite for national champions, borrowers without strong name recognition may find it more difficult to achieve such attractive levels.
“LatAm banking fundamentals are among the strongest in the world, the borrowers have strong domestic support, and sub debt is a high carry play. These three factors confirm our view that most of the banking issuance would be well supported as long as they come at attractive spreads”
“The further you migrate from the Brazilian large-cap banks the smaller the audience becomes. Smaller regional banks will probably use a good chunk of the Asian demand, and will need strong support from European and the US to work. Moreover, deals that come before regulators have announced final rules will struggle with emerging markets dedicated investors. The list of potential buyers is definitely shorter for second-tier banks,” said one DCM banker.
LatAm banks lacking an international investor base have received strong support from local investor bases in Chile, Colombia and Peru where the lack of competing corporate supply in those markets has seen spreads between subordinated and senior debt compress significantly. Indeed, the general lack of supply of emerging market corporate paper outside of Brazil should mean that investors are at least willing to listen to the smaller regional banks.
“LatAm banking fundamentals are among the strongest in the world, the borrowers have strong domestic support, and sub debt is a high carry play. These three factors confirm our view that most of the banking issuance would be well supported as long as they come at attractive spreads,” said one LatAm fund manager.
While institutional investors struggle to digest the premium associated with the regulatory uncertainties of the BdB perpetual, a recent 15-year non-call 10 subordinated Tier 2 deal from Peru’s largest private-sector lender Banco de Credito Del Peru suggest an another hybrid capital raising route for the regions’ banks.
The deal, which was placed with dollar investors under Reg S/144a documentation at a spread of 489.5bp over the 10-year Treasury, priced at a spread of around 90bp over its equivalent senior bonds by exploiting local Peruvian regulation that amortises the equity treatment of subordinated bonds in the final five years of maturity.
Faced with the prospect of a sharp coupon step-up in year 10, investors viewed the deal as a 10-year trade while the borrower received Tier 2 capital treatment on the securities for the first 10-years of the transactions’ life. Regional banks will no doubt be attracted by the prospect of raising subordinated debt that will receive equity treatment for 10 years, at the cost of a 10-year bond.
To view the digital version of this report, please click here.