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Keith Mullin, IFR: Good morning and welcome to this IFR Roundtable on Bank Capital. There’s a lot going on in this area, whether it’s resolution frameworks, crisis management and capital requirements directives or other reform initiatives. And it’s undoubtedly one of the single biggest issues that needs to be resolved if we’re to move away from the negative feedback loop between sovereigns and banks. David, can you make some opening comments as to how you see the issues facing the bank capital market and outline the major challenges?
David Marks, JP Morgan: Well, I think the question is perhaps best addressed to the investor in our midst. Because it’s a buyer’s market and all of us sitting round this table are, to a greater or lesser extent, speculating on what the investment community is going to be able to tolerate going forward. For European FIG issuance, we’ve seen very robust support out of the Asian markets, and from time to time from the European institutional investment community as well. But we’re well aware of the limitations of depth of that particular market.
We’re also all cognisant of the fact that it only takes one weak deal or a couple of competing deals for the bank capital market to shut down for a month or two. When you look at the quantum of capital that needs to be raised, the negative jaws between debt redemption either through exercise of calls, maturities, or the renewed bout of bank liability management you’ve seen in the last few months, there is a significant gap that’s opening up. And even down to the most investor-friendly of structures, Tier 2 perhaps point of non-viability (PONV), the depth of institutional demand is still relatively uncertain.
So I think it’s primarily a question for investors right now. Because even though in terms of the structuring and evolution of characteristics it’s felt a bit like Groundhog Day, we are pretty close now to final clarity. Perhaps the big topic remains how temporary write-down may work for Additional Tier 1 (AT1), but the real question is going to be what’s more suited to the investment community.
Georg Grodzki, Legal & General: I work on the fixed income side but we’re in close contact with our equity colleagues, so I can summarise the joint view between equity and fixed income at Legal and General Investment Management, which is one of grave doubts about the potential for the amount of capital that is supposed to be provided by the markets to be made available.
I also have grave doubts about banks’ business models going forward, assuming we will be stuck for a prolonged period of time in the current rating environment, in the current yield and credit spread environment, and in the current regulatory environment.
We’ve abandoned any expectation that there will be any reversion to the pre-2008 set of parameters and regime. That means we almost have to go back to square one, as far as the definition of a viable bank business model is concerned. The old model was cheap debt, meaningful leverage, and regulatory risk weightings that were fairly optimistic with respect to assumptions of downside risk.
Going forward, there won’t be any more cheap debt for quite some time. That’s not just because of the sovereign crisis, but also because of the regulatory view that senior unsecured debt is a type of contingent capital and also because of the issuance of secured debt. So a number of factors (I’ve not listed them exhaustively) will prevent a return to the days of sub-Libor or Libor plus a few basis points floating-rate note issuance.
There certainly won’t be any cheap hybrid capital. That’s partly because of the ratings of those instruments are too low to enter mainstream investment-grade indices. But even if the ratings were high enough, institutional investors’ memories are sufficiently long to remember that the inclusion of hybrid debt in investment-grade indices was one of the recipes for the disaster we lived through.
I can see the mandates for institutional money managers being rewritten, such that they will explicitly rule out hybrid bank capital, regardless of index inclusion or not.
And as to recent forms of innovative hybrid capital, such as CoCos, we see problems with those because we can’t hold equity for a start. And we would therefore take the losses and hand over the upside to somebody else. Apart from that, we find it unfair that we as a potential holder of CoCos might lose money in an irrecoverable fashion, whereas equity holders still have the upside.
Unless the blueprint for these instruments is rewritten, such that there is a buyback possibility, they are definitely a non-starter for our type of funds, even if they entered investment-grade indices.
So that’s basically the very thick cloud which we are facing at the moment with respect to the investability of banks on the debt side and the investability of banks on the equity side. And that means it’s going to be very challenging to make those targets with respect to Core Tier 1 ratios.
Sandeep Agarwal, Credit Suisse: I think the question is less about distribution of these instruments at this point. That’s step two. Step one, which I think needs to be solved, is that the design of these instruments is not yet set in stone.
And there is a lot more uncertainty about issues that we getting in terms of how the loss-absorption characteristics of these instruments actually come into play. Until such time that we get clarity on that, I think it is very difficult to argue one way or the other that there is no demand or the demand is too expensive.
Whenever transactions actually have happened in designs that have come into play – at least in Switzerland and I can speak for Credit Suisse, – the demand factors are not the constraining factor. It is the design and the clarity on that that was probably the first step. I think the second challenge that we have is that we are talking about all this in a macro environment that is fundamentally weak and unresolved, with the sovereign crisis that we are facing.
Taken together, I think it is a very challenging environment in which to even talk about what capital structure we need to aim for and what kinds of instruments we need to issue. Distribution will be a risk/reward kind of situation. Some investors will not be able to buy, but others will. Mandates will change over a period of time if that’s the regulatory environment that we’re dealing with.
And if not enough debt capital is available, then you have to go to the equity markets to raise equity. And then banks will need to decide whether or not the cost is sufficiently cheap to pass on to their asset base, and generate the returns they really need. But this will only happen if we have some clarity as to where we want to go.
IFR: So let’s talk about product design. Sandeep: what’s your read of where we are? Are you comfortable that policymakers have got it right, in terms of where they’re going with this?
Sandeep Agarwal, Credit Suisse: I think we’ve have taken baby steps, and that’s been the case for the last two years, which is a bit ridiculous. But when you have 17 or 27 people trying to decide on a construct, there is always going to be a necessary delay. But I think where we have got to is that as far as Tier 2 debt is concerned, the real outstanding point is simply the PONV language and the definition of that. The rest is pretty clear.
What is unclear, as far as Tier 2 is concerned, is also the quantum of total capital that people need to operate with. Because we are now talking about the bail-in of unsecured debt, and there is this concept of simple subordinated debt coming into play. So we need to just figure out the level of total capitalisation we need to deal with.
With respect to the Tier 1, I think the PONV is still an outstanding point. I question the fundamental utility of a Tier 1 instrument with a 5-1/8% trigger because I just think it is so close to PONV that it will just not find enough relevant space between the equity and the debt spectrum.
The other point about dividend stoppers, which is the third point with respect to the Tier 1 space, is also an outstanding point. And I think it’s a concerning point. Either we will have to lump it, or the EU will change direction in line with Basle and be a little bit more accommodating.
Steve Sahara, Credit Agricole CIB: I would agree with that. There are certain themes that are coming out quite clearly already. We’re in a horrible environment to talk about downside-only instruments that transfer risks onto investors who are typically fixed-income investors on the more conservative end of the spectrum. They are more concerned about preserving principal than getting a return for the risk they take.
For many people, financial institutions still appear to be somewhat black box-oriented asset risks determined by political process. So although we can start to see the outlines of the types of instruments regulators want, and can understand the motivations for them wanting the progression or evolution of features, it’s just not the point in time to be asking people to stick their hand in the black box when it’s pretty clear there’ll be some sharp teeth waiting for them without knowing what the upside could be, what the availability is, what liquidity there is in the market, what hedging might be available for them; all the typical things investors might want for an asset class to be attractive to them.
So if you’re selling something that’s equity-like, normally it’s on the back of a growth story, a profit story, good news. The good news isn’t really in sight at this point in time for the majority of issuers. There are exceptions of course, and people have had transactions done at certain times, when markets are more bullish and in certain markets where perhaps perception of risk is differently calibrated. So I think longer term positive, short term a bit challenged in terms of opportunity.
IFR: Marc, what’s your view of this notion of trying to create and design product in a bad environment? What difference do you think it’s making to the direction of the whole debate around capital and loss absorption?
Marc Tempelman, Bank of America Merrill Lynch: I think good environment/bad environment, all people around this table are involved in some way, shape, or form in designing instruments, because we’re supposed to look for solutions.
I agree with the observations made so far in terms of the uncertainty that’s still out there. But the risk that I perceive is that despite the initial attempts to come up with something that can be consistently deployed across all 27 jurisdictions, we are likely to end up in a world where there is going to be structural differentiation between jurisdictions.
In a number of revised drafts or near final versions of directives, there’s a large degree of flexibility left on the table for individual regulators. And that can affect trigger levels and loss-absorption mechanisms. And one shouldn’t ignore local tax law and/or corporate law, which would then influence the structure even more.
If I continue to think about the investor base, just to make their lives even more complicated, with regard to mandates and everything that has already been mentioned, there will continue to be structural differentiation by jurisdiction and potentially as far as by bank.
It doesn’t take away from the beautiful principle that we’ve all set out to achieve, which is consistency to make it easy for the market and all of its participants to do relative value assessments based on credit. I suspect we will end up in a world where it’s still going to be a combination of credit and structural differences.
IFR: Even with banking union?
Marc Tempelman, Bank of America Merrill Lynch: Well, I’m certainly not in the camp where I am convinced that we’ll have a fiscal union tomorrow or anytime soon.
IFR: Or in our lifetime?
Marc Tempelman, Bank of America Merrill Lynch: Well, those are your words. I’m not going to go that far. Plus I’ve got very high personal life expectations. But leaving that aside, as long as union is not achieved and despite the best intentions that one can have, we will have local differences that will make life for structurers possibly more interesting but life for investors certainly more challenging.
Johan Eriksson, UBS: I would like to take a slightly more positive view here. It’s obviously a fact that a bank can’t be better than the sovereign it’s operating under. But if we leave aside the issue of sovereigns for a moment, if we leave aside the issue with investment mandates, assuming that they can change if there are fundamental reasons for them to do so, I think we are in a situation where there has been a massive improvement.
We can have all sorts of views about whether regulation is optimal and what should change. There are some outstanding issues when it comes to temporary loss-absorption specifically. But I think it’s an obvious conclusion that regulation has improved massively. And the ability of regulators to act and identify risks before they materialise in huge losses has improved immeasurably.
We have a hugely increased level of capital in the system. We have significantly reduced capital requirements. And that’s an ongoing trend, so there’s still an adaptation period ahead of us, which will further strengthen the system from my point of view. We have significantly reduced leverage.
The key uncertainty, which I think we’re all suffering from, is the non-viability issue. I think from the point of view of the Crisis Management Directive it’s quite clear that it’s aimed to be very close to the level of insolvency. In the UK Banking Reform White Paper, it is specifically stated that the SIFI buffer and the ringfence buffer are both real buffers and do not form part of the minimum requirement. That in itself will be taken as an important supporting statement by other regulators who have grappled a little bit with where to set the local minimum requirement.
From my point of view, that suggests that non-viability is an issue. It’s an uncertainty. But it’s not necessarily hugely different from a normal concern about insolvency and what that might imply for investors. Taken together, from my point of view, the key change that’s negative – these are all more or less positive or neutral in my view – is the fact that we can no longer rely so much on public support to support creditors.
I would have thought that that’s a manageable change, from the point of view of investors assessing the risks that they’re exposing themselves to. And on that basis, I don’t see any reason to doubt the sustainability, and the profitability ultimately, of the banking system once we get through a period of sovereign repositioning, restructuring, and recapitalisation, I’m quite positive.
But obviously that is a two to five-year horizon. It’s always nice to have a long-term view in your opinions, because it’s much more difficult to prove you wrong at the end of the day, but I’m quite positive. And I think the capital instruments we are all trying to promote are sensible, in my view. They’re much better than what we had in the past.
In the past, hybrids were debt instruments really. Today they are loss-absorbing instruments. Whether we think that the 5-1/8% trigger in AT1 instruments is too low to be economically relevant. I agree with that personally, but that’s not necessarily always going to be the case, depending on jurisdiction.
I think it will be a great environment. From the point of investors, I think to the extent that there is a secular increase in spread, it’s a great improvement from a return on risk for investors.
Steve Sahara, Credit Agricole CIB: When you mention old format hybrid securities being debt, the biggest flaw is how they were used in terms of stress rather than how they were designed. They were meant to be debt in good times, meant to add something like equity in the bad times. But it wasn’t really the way people used them and that calls into question whatever we design for the future. Will they be used as we hope they will in the next crisis?
So the human element still remains one of the hardest risks for an investor to try and anticipate, especially in a long-term security. That to me remains one of the hardest elements to calibrate or predict. I’m sympathetic to the investor risk on that.
David Marks, JP Morgan: think it’s right and appropriate that we started off on a conservative note, if only because of the ongoing sovereign crisis. But because we’re all involved in structuring around this table, the length of process we’ve suffered generally in Europe is frustrating, in contrast to the clarity and simplicity that Swiss banks are enjoying in terms of their capital raising. And the US banks, too, which are issuing Basel 3-compliant Tier 1 at competitive levels with the ability to include dividend stoppers.
I think one of the other things that gives me some confidence is the rate environment we’ve got. I don’t think any of us have ever seen the investment community quite so bar-belled between fear and greed, exemplified in the flight to quality in Bunds, US Treasuries and Gilts and the reach for yield and the demand for high-coupon paper, which is still not being met, for example, by emerging market supply. Clearly a low-rate environment will benefit demand for this asset category as we go forward.
One of the frustrations we all have is perhaps some of our, I wouldn’t use the phrase lobbying, but some of the feedback that we provided regulators and policymakers around the design of new instruments has often fallen on deaf ears; perhaps less so in Switzerland than in the rest of Europe.
In these last few critical months, it needs to be investors themselves who make it clearer what they’re willing to buy. Some of the fatigue we’ve seen in this regulatory debate has not been helpful. I would put out a plea to investors that this is the last lap and it’s not constructive simply to say business models are not fit for purpose. We also need to know what characteristics will be acceptable going forward.
Steve Sahara, Credit Agricole CIB: Just to throw something in to follow that up, clearly loss absorption all the way up the capital structure is not good for senior funding. In a perverse way though, doesn’t it force a greater acceptance of loss-absorbing securities further down the capital structure? Because I don’t think over time investors on the whole can ignore the banking sector as an asset class, and if all the assets from that sector have loss absorption, you can pick your yield point. And to the extent it’s known what risk parameters are associated with that yield, then you buy or don’t buy.
So without loss absorption being forced up into the senior 2% of the capital structure, that’s an interesting financial engineering exercise. If the whole industry is being funded with something that can force losses onto investors, it seems like there will be an evolution of mandates, if only to be a different class of investor funds that can be put to work in the sector.
And then I think you do hopefully see professional investors monitoring the banks more closely, assisting the regulators’ aims of trying to know better what the assets are, what risks they entail. And hopefully we have a stronger system as a result of it.
Georg Grodzki, Legal & General: Let me lay out a few principles which are sacred to us. Number one is the hierarchy of capital. As a higher ranking creditor, you want the lower ranking portion to be a cushion. You don’t want to be a cushion for them. I’m not satisfied that in the draft versions of various templates for capital instruments and the new legislative or regulatory frameworks for the treatment of certain classes of stakeholders or creditors this principle is fully recognised.
What was released by the EU a couple of weeks ago [the bank recovery and resolution proposal] was not 100% clear on that either. They left it strangely unclear whether shareholders have to be wiped out before senior debtholders can be bailed in. That’s totally unsatisfactory. Senior debtholders should have shareholders as a cushion.
The other principle is the sanctity of contracts. There have been some examples of contracts being changed retroactively by regulators. That is not helpful to maintain or foster confidence in the reliability or enforceability of the contractual terms of investments you’ve agreed to. The degree of regulatory flex or discretion, which is becoming almost a new mantra, is scary. The regulators seemingly reserve the right to over-rule whatever has been agreed if they see that as necessary or helpful to preserve financial market stability or whatever.
We now have to factor in regulatory risk as an additional downside factor. That of course means we need to get paid for it. How much, who knows? But certainly the bank will have to pay for that. And that brings us back to this business model question. Nobody knows whether it’s really going to work. But obviously it would help if there was growth. It would help if governments brought their deficits under control. It would help if we didn’t lurch from one quantitative easing discussion to the next.
Then we would have an environment which is less extreme and distressed than the current one. That said, the gross numbers are not that disastrous. We’re not facing a 4% or 5% decline in GDP or 10% plus unemployment rates in the major economies. But when you read the papers, you get the impression that we’re almost falling into the abyss. That’s not the case.
But it would help if of course there was growth, if interest rates were slightly different and if central banks were the lenders of last resort rather than first resort. But I don’t think that’s going to happen any time soon. I wish I had the imagination to see an exit from the current troubles, but I struggle.
So in the current environment it’s doubly hard to redesign the business model of banks, with high regulatory discretion and uncertainty about the hierarchy of capital. And that’s the other point: a potential revision of risk-weighting rules, which is overdue. The 0% loss-content assumption for government bonds in the OECD is so misplaced and outdated.
But once you open that can of worms and introduce risk weightings to government bonds or raise risk weightings for mortgages (which is also overdue), you embark on a new journey where everything suddenly starts to move about. And as an investor you have even more uncertainty to deal with, so you stay out or stick to secured debt instruments hoping that that is territory the regulators won’t dare to touch.
And there won’t be any clever liability management exercises which disenfranchise or expropriate you the way you were with hybrid debt securities. So maybe you just stick to the corporate world because it’s less subject to this seemingly never-ending flow of goal-post movement.
David Marks, JP Morgan: We need to return to a credit environment where investment decisions can be taken bottom-up rather than top-down, which unfortunately for many financials in Europe is a challenge at the moment. There’s no doubt about that. One of the issues we all have is the number of jurisdictions where you can truly conduct a bottom-up credit analysis is pretty limited.
Nonetheless what we do need at this point in time is a genuine consultation, a rallying call for investors to take the lead in providing input around how, for example, the design of temporary write-down could and should work.
Georg Grodzki, Legal & General: I would find it encouragingly constructive if that taboo were to be dropped and we could think of something. Sadly we would have to get the rating agencies on board, because even a short-lived downgrade to D would mean forced selling. Either that or we ignore the rating agencies completely.
But we’re not there yet because the way our funds are managed, or the way the mandates operate (not that there’s such a deeply embedded reference to ratings that it would be impossible) but that’s another issue. But the key aspect is to get regulators cognisant of the fact that there is no tolerance for an irreversible loss inflicted on senior or even subordinated debt holders, whilst equity holders escape reasonably unscathed.
David Marks, JP Morgan: I completely agree. That has to be the article of faith. And I think one interesting bit of feedback that we’ve had from the liability management exercises has always been investors are never happy when losses are being inflicted. We’ve seen some which have been less voluntary than others in that regard but what really seems to upset people is when the hierarchy isn’t being respected; so for example when Tier 2 holders are offered the same as Tier 1 holders.
Oliver Sedgwick, Goldman Sachs: On the investor side, if you’re a real money investor, and you’re buying corporate debt at 50bp-100bp over, senior financials at 100bp-200bp over, you have the ability to buy dated must-pay subordinated bonds at 400bp-plus, what’s the incentive for a real money manager to go as far as Tier 1?
I guess the point around write-down, write-up clearly makes it more palatable from the investor’s perspective. But if you think about the genesis of Tier 1 there was a nice incentive for real-money accounts on the belief that you were going to get your coupons, because deferral risk was low, the probability of being called was high, and therefore it was a dated must-pay-like instrument whereas now you’ve got such a range of instruments and by-and-large the Tier 1s are not going to be investment-grade so not any institution can play.
And when you’re comparing your return to an index that’s got a large component of either senior or senior corporate/senior financials, there isn’t going to be the same push factor for real money to participate.
So from the syndicate side, it feels more applicable that there’s going to be a different sector that’s going to follow this in the world that transitions out of where we are now. And that’s one that’s going to be dedicated money that’s more designed, or comfortable, and the mandates are built-in to encompass the loss absorption and the volatility of these instruments.
