IFR ASIA: Well, there’s always been a degree of resistance to Basel in Asia. India, China, you name it, they never wanted to apply these rules to a state-owned system, but they’ve got them. It’s sort of the same with TLAC. It’s happening whether you like it or not.
SEAN MCNELIS, HSBC: In Asia central banks and regulators of course want the implementation to reflect the business models of banks in the region – ie, banks tend to be primarily deposit-funded and are in many cases state-owned. I think I differ slightly with Brian on how TLAC is likely to be implemented in the region. Clearly, post the initial proposals that emerging markets G-SIBs be entirely exempted from TLAC, the Chinese authorities had discussions at the FSB level around a delayed implementation to reflect their specific circumstances. So ultimately the TLAC rules for the four Chinese G-SIBs will be implemented in 2025 and with full implementation in 2028 or earlier if credit-to-GDP growth warrants. This gives a long lead time for the banks to be able to prepare to meet the requirements.
However, when we look at the potential volumes involved, it’s approximately US$500bn based on today’s RWAs for the four G-SIBs in aggregate. Even if 60%, 70% of that goes onshore, it’s still a substantial volume in the offshore markets. And, unlike the European banks, the Chinese banks are also growing RWAs at 10% to 15% per annum. So looking to 2025 – admittedly a long time away – it’s probably nearer US$800bn to US$1trn of total TLAC requirements.
The Chinese authorities are clearly very engaged at an FSB level on this topic. We expect that they will finalise their implementation of TLAC in the PRC in the coming years in order to allow the banks plenty of time to begin to issue what will be quite substantial volumes ahead of the 2025 implementation.
IFR ASIA: So what do they need to do to allow that to happen?
SEAN MCNELIS, HSBC: Basically the authorities need to decide the format for TLAC. Without going into huge detail there are essentially three different formats that a central bank can take. There’s a statutory approach, where you amend legislation and insolvency law to allow certain instruments to rank junior to ‘excluded liabilities’. And basically that’s what the German authorities did, for example, with their framework.
Then you’ve got a structural approach – the UK, Swiss, US, Japanese approach – where you have a clean holding company that simply issues ‘clean’ holdco senior debt. That’s probably the easiest solution if banks are set up in this way, which they’re not in Asia, generally. A few banks are set up with holdcos, but not many and, certainly, in China none are.
So then the other option is what we call Tier 3, so that’s some sort of subordinated security – subordinated either by contract or by statute (if there is no statutory resolution/bail-in regime in place). We’ve seen the first such instrument recently from Nykredit – a Danish bank. It’s a senior, priority bail-in-able security – ie, a senior instrument with a contractual clause allowing for loss absorption at the point of resolution. We’ve seen a number of countries in the EU and also Canada adopting similar approaches. For example, the French will use a non–preferred senior approach, which will be a senior security, but which is subordinated to ‘preferred’, ordinary senior debt in the context of a resolution.
It remains to be seen which of the three approaches the Chinese authorities will ultimately take with respect to TLAC, but they are examining all of the available options and will select the one most suited to the Chinese banking sector and economy.
IFR ASIA: I think I was with you until the third one. That’s complicated, right? Because there is already Tier 2.
SEAN MCNELIS, HSBC: Okay. Well, Tier 3 TLAC is a new product. It can rank ahead of Tier 2 but after ordinary senior unsecured. Interestingly, if you go back a year it would appear that jurisdictions that have not yet implemented TLAC were perhaps looking to favour that type of Tier 3 approach. However, we’ve seen holdco senior TLAC issuance from the US, Swiss, UK, and Japanese G-SIBs, and I think it’s been quite successful. In Australia, the regulator, for example, has said that they’re going to monitor international developments closely and they’re in no hurry, because none of the banks are categorised as G-SIBs. So they’re in a strong position where they can monitor global developments and decide on the best and most appropriate approach to implement TLAC for their internationally active banks.
Outside of China, Japan and Australia, from the discussions we have had with regulators and the banks themselves in the rest of Asia, I would agree with Brian that it’s not viewed as being an imminent requirement. It’s definitely a second stage, but I would expect it could be very much on the cards that the TLAC regime could be extended to the D-SIBs in each of those jurisdictions in due course – so TLAC is not likely to be relevant only for the 30 G-SIBs globally!
IFR ASIA: To the other Sean: when you’re assessing a bank, senior or subordinated or whatever, do you look at total loss-absorbing capacity, all the capital buffers that they show you. How big a factor is that?
SEAN CHANG, BARING AM: Yes, sure, definitely. This is one of our considerations when we do the analysis. We will have the third party information on that, but obviously like Sean just mentioned, the sophistications and the complexities of these instruments would need some kind of differentiations in terms of price and valuation. And that, probably, will imply for high cost for those banks, which will kick back in to the balance sheets and income statement, and how those banks will perform in the coming years.
So we look at these types of instruments on a standalone basis, on the issues, on the standalone risk level, obviously one consideration is also at the top level, whether those banks are going to be viable in the coming years, during the term of our investment.
With all these together we need some justification. That’s what we are foreseeing these instruments will become – we will need huge price variations to lure people to invest into these instruments. Take ANZ at close to 7%. The next time they issue other types of instruments, maybe a senior note or maybe other subordinated bonds, how do they differentiate the price. And that will actually how we’re going to invest on those types of things.
IFR ASIA: Specifically on TLAC, though, would you expect some sort of premium on holdco senior debt versus opco senior debt?
SEAN CHANG, BARING AM: Yes, sure. And like I mentioned earlier these types of instruments are yet to be tested in case something happens. You know, how does it compare at the holdco to the opco? The credit ratings could be different, but what about pricing? What about valuation? How much differentiation do investors need? Probably our observations will be slightly different to Fidelity’s or whoever else, and that comes into the market consensus. As yet, this is yet to be developed.
BRIAN WEINTRAUB, DEUTSCHE BANK: If I put on my investor hat, I love all these developments. For what I deem as very little incremental risk – if any, back to the Japan example, arguably, there is zero incremental risk – I’m getting paid a higher coupon. Even if it’s one basis point higher, it’s better than before.
We won’t have enough data, historically, for 20 years to model out if the notching differentials are statistically correct on opco versus holdco debt, on a Tier 3, on whatever statutory form of bail-in senior debt. We won’t have the data on historical recoveries and default rates for a long time. So right now we’re just relying upon what the market tells us, and my starting point on this is, yes, there is some incremental risk. There just has to be. But perhaps the loss is less – because if there is a huge stack of TLAC to absorb losses maybe I’m only going to lose a tiny piece, whereas today maybe I would lose the whole thing.
Again, we don’t know what the data will look like. But, okay, maybe there’s a tiny bit more risk and if somebody is going to pay me 30bp more for that, fantastic!
SEAN MCNELIS, HSBC: There’s an argument which I think probably will hold true for the initial trades, which is that for the first transactions, arguably, you are looking at a bit more risk for investors but this diminishes over time as the ‘stock’ of bail-in securities increases, and we expect banks to raise that stock to the FSB required levels well ahead of the TLAC implementation dates. Once there is more TLAC on the balance sheet, then your loss given an event is much lower. If there were a problem today with a G-SIB, in the resolution of one of these banks for the first few years, because there won’t be that much of a stack of TLAC, as an investor you’re first in line, but of course by 2019 that stack will be in place.
So, arguably, as we saw with PONV, we will see the premium shrinking in the secondary market over time. If you recollect that was a big discussion point three years ago – what is the appropriate premium for PONV? – and we have clearly see that PONV premium shrink over time.
BRIAN WEINTRAUB, DEUTSCHE BANK: It was so scientifically 50bp at the time.
SEAN MCNELIS, HSBC: At the moment we’re carefully monitoring TLAC premiums (holdco versus opco senior spreads) across different jurisdictions and markets. So for Japanese G-SIBs at the moment it’s as low as 10bp–15bp in secondary because of the points Brian has mentioned, whereas for EU banks it’s between 30bp and 70bp. In the US it’s very low as well, because it’s historically the way they’re set up with holdco issuance having been the standard even prior to TLAC. The Swiss levels are similar to the EU banks. As I mentioned we would expect to see that premium compress over time!
IFR ASIA: So you actually want to be in the first ones then in that case?
SEAN CHANG, BARING AM: Well, I think to some extent I also agree with Sean’s view, those premiums will probably reduce over time. Investors probably will come to a consensus that the incremental risk might not be worth that much. But I think, partly, it also has to do with the liquidity in the system. The market is actually flooded with liquidity and the whole valuation system has been distorted to some extent.
At the end of the day, when people are all fighting for the same pool of investors, investing in bank capital has to offer some kind of differentiation, right? Not to mention that sovereign risk in different jurisdictions can be different. It may not happen this time around, but maybe when there is more and more of this type of instrument available, then fighting for the same pool of investors means banks will need to differentiate that risk premium.
JOHN BARRY, NAB: What’s interesting with TLAC – even if some of the local regulators don’t accept the concept of Tier 3 – I think Asia will be a very valuable as a potential investor base for that product. You can anticipate that US, European, UK bank issuers will approach the Asian investor base with gusto.
MARK YOUNG, FITCH RATINGS: At least until the Chinese come to market and that’s the big elephant in the room. I just want to touch on what Sean said earlier. It’s fine that these banks are starting to issue this new form of capital, but what are they actually going to do with the funding?
IFR ASIA: Go on….
MARK YOUNG, FITCH RATINGS: This is likely to have quite a big impact on business models, which has not really been considered at the moment. As an example Chinese banks have got loan to deposit ratios of 75% to 80%. HSBC is a deposit-funded institution. They don’t need more funding, in particular more expensive senior debt. What are they going to do with this money to generate a return?
IFR ASIA: They’re going to pay their staff more, aren’t they?
MARK YOUNG, FITCH RATINGS: Well they now need to find some activity to invest this money to make a return, otherwise it’s going to burn a hole somewhere.
SEAN MCNELIS, HSBC: Yes, it’s more a consideration for deposit-funded banks that otherwise wouldn’t raise wholesale funding – how to deploy the funding without increasing RWAs (ie, to avoid the circular problem of investing TLAC proceeds in RWAs that require more TLAC). However, for the majority of banks TLAC will simply be replacing opco senior debt so it’s not actually incremental issuance that needs to be somehow deployed.
MARK YOUNG, FITCH RATINGS: Exactly, this issue has yet to play out.
With regards to China, the big question is how much TLAC will they need to issue. If you consider between now and 2025 and the potential asset growth of the banks, you could be talking about a trillion dollars in TLAC potentially coming to market. That is also before one considers the potential prospects that their banks may also need to be recapitalised in that time frame. That type of volume could be hugely disruptive for other issuers over that period.
BRIAN WEINTRAUB, DEUTSCHE BANK: That’s true. But I keep operating under the assumption that there will be some China compromise. Perhaps deposit insurance counts for 2.5% of RWAs – and I’m totally hypothesising here – or deposits from state-owned institutions are TLAC-eligible as long as they’re greater than US$10m.
You can come up with a whole bunch of ways around it, because could you actually raise US$1trn or whatever the number is, divided by four banks over 10 years? Is it actually technically possible? I mean I’m sure it is, but it will all go to price. It’s supply and demand. Do you have a view on will there be a compromise in some way?
MARK YOUNG, FITCH RATINGS: In the back of my mind, I think given the size of these volumes, I think there almost needs to be some sort of compromise. What it is I don’t know, but for the market to absorb what is going to come down the track, it’s going to be fairly disruptive.
SEAN MCNELIS, HSBC: I think you’re right. The DIC (Deposit Insurance Corporation) recognition in Japan has reduced the TLAC needs of the Japanese banks to probably less than US$25bn in aggregate, after their recent issuance. The numbers are very manageable, especially in the context of the opco debt refinancing for the three banks in the next three years. So, if the banks refinance opco senior with holdco senior going forward, their TLAC requirements can easily be met. The Japanese G-SIBs are able to count their funded deposit guarantee scheme up to 3.5% of RWAs over time.
China is also putting in place a deposit guarantee scheme. So if they were to put in place a funded DIC in the same way as Japan does then clearly they could get ex ante recognition under the FSB proposals for that. Or indeed, as you say, they could even potentially bail in other liabilities.
However, from what I understand, the bigger issue is the model to which you alluded earlier – that the banks are deposit-funded.
If you look at Japan or the large European banks, they’ve all got a lot of senior debt as a percentage of RWAs. So it’s really about refinancing opco senior to holdco senior. That’s what the European and the Japanese banks have been doing. The Chinese banks just don’t have much senior debt outstanding as a percentage of RWAs. So meeting the TLAC requirements requires them to generate a lot of funding that they don’t otherwise need in the short term because they’re so well deposit-funded.
There is no easy solution. And I take Brian’s point on innovative ways of meeting the requirement in particular the recognition of a DIC. It’s really too early to say what the ultimate solution will be in China. It may very well be a combination of approaches.
IFR ASIA: When they do raise it, where does it go? They can’t just sell it to other Chinese banks, since the whole point of TLAC is that it goes beyond the banking system.
SEAN MCNELIS, HSBC: Yes, and as a matter of fact the Basel Committee has already issued a consultation paper on this matter and we expect the rule to be finalised shortly. They’re proposing to treat an investment in TLAC by any internationally active bank – you don’t need to be a G-SIB, but any internationally active bank – as if it’s Tier 2. In other words, you need to deduct it from your own Tier 2 capital once holdings reach a certain level.
IFR ASIA: Ouch.
SEAN MCNELIS, HSBC: Yes. That’s, of course, deliberately meant to discourage other banks from buying each other’s TLAC debt, such that the risk is distributed outside the banking system. So, yes, as you know, short-dated senior bonds from banks, historically, were often sold in part to other banks. But the TLAC product will be sold more to asset managers, insurers, etc. Som.e investors have asked about the depth of demand for TLAC. Investors had similar concerns around AT1 and Tier 2, but the market developed for these products and the same is true for TLAC. The level of demand for the US, European and Japanese TLAC transactions has been strong and we would expect this to also be true for the Chinese G-SIBs when they begin to issue.
BRIAN WEINTRAUB, DEUTSCHE BANK: In the China context, similar to what happened with AT1 and Tier 2, this needs to be very state-directed. We can’t just sit and hope that the price is right and institutional investors actually buy this. I’ve got a chart in front of me, it’s got a selection of seven or eight offshore Chinese bank bond deals to date, and 68% of the demand came from Chinese banks.
IFR ASIA: Right. I’m surprised it’s that low actually.
BRIAN WEINTRAUB, DEUTSCHE BANK: That’s what the data looks like for this sample. To get that to change, what other institutions in China can buy this? That’s insurers, state pension funds, city governments, state governments etc.
I don’t know what the answer is to this, to how they’re going to meet the RWA number, but there needs to be a plan of sorts. The numbers are just too big to say, “Okay, we changed the law. Go ahead. Go issue.” Which is effectively what has happened in every other country in Europe. The market-based solution in my mind is not a palatable outcome here.
SEAN MCNELIS, HSBC: With AT1, when we spoke three years ago, you asked me “what’s the potential volume of AT1? Where is it mostly going to come from?” I said, it’s mostly going to be China. It’s a brand new product for them. Unlike Hong Kong and Singapore etc, there were no legacy AT1 rules in China, and the volumes would be large, because they were required to get to 1% of RWAs – the efficient level.
I think with TLAC it’s the same again, because the Chinese banks have limited senior debt volumes in their capital structure and there is this new TLAC requirement from 2025 for the Chinese G-SIBs. In Europe, by the way, legacy senior debt is still recognised up to 3.5% of RWAs, over time. So opco senior is, essentially, grandfathered, up to a certain level where it’s bail-in-able.
Even if the Chinese authorities were to argue that their existing opco senior could be bailed in, the Chinese banks just don’t have enough of it already outstanding. So what you have is a new requirement, which is, approximately, 6%–8% of RWAs that you don’t have on your balance sheet at the moment, similar to AT1 three years ago. That’s the challenge, but of course the Chinese G-SIBs have plenty of time. The 2025 deadline is quite a while away!
MARK YOUNG, FITCH RATINGS: Given the volume, would this not force other jurisdictions to sit on the sidelines and wait for all of this to happen?
IFR ASIA: That’s a fair question.
SEAN MCNELIS, HSBC: Well, a bit like with AT1 and Tier 2, there was a general concern that there was a going to be a glut of supply, and I know it’s something that I, for one, would have written about at the time. But, as things played out, the supply from China was very well absorbed by the market
We’re going to see the European, US and the Japanese banks frequently accessing the market for TLAC, but the Chinese issuance is not going to start for a while until the framework is clear. But, of course, once the framework is in place I think we can expect to see substantial issuance. What is also clear as with AT1 and T2 is that there is an onshore and an offshore investor base and both of those investor bases are likely to offer sufficient depth for the requisite volumes
BRIAN WEINTRAUB, DEUTSCHE BANK: If it’s the German approach it’s already started.
IFR ASIA: Because your existing senior then counts?
SEAN MCNELIS, HSBC: Everything would qualify overnight. It is also possible that the authorities would elect to apply eligibility only to prospective issuances, not retrospectively – this is the Canadian approach.
BRIAN WEINTRAUB, DEUTSCHE BANK: The question that Mark posed on what are they going to do with all the funds they raise, it’s the same question with what they have raised to date, TLAC or otherwise.
IFR ASIA: One of the things we’ve noticed with the Chinese banks is the senior debt they issue comes from everywhere – Luxemburg, Dubai, London, Singapore, Hong Kong and then head office, all do deals, in some cases within the space of two weeks. Can they keep doing that if it goes into a TLAC bucket?
SEAN MCNELIS, HSBC: Yes, a branch is the same legal entity as the head office. So basically the short answer is that they can. From a purely legal perspective, provided you put in certain language in the documentation making clear that the authorities in China can bail in the security, then it would be fully TLAC eligible – there is no specific need for it to be head office rather than branch issuance.
To Brian’s point, depending on the ultimate approach taken by PBoC, all of that senior debt could simply be TLAC-eligible. There’s no reason to assume that the point of issuance or anything would change. Those branches all have funding needs, so they actually do need dollar funding, which is why they’re doing it. So I think you can expect that to continue.
MARK YOUNG, FITCH RATINGS: Although you could expect it to be a bit more coordinated than it has been to this point.
IFR ASIA: That’s a lot on TLAC. Just wondering if anyone else has got anything that we should be putting on the table here?
MARK YOUNG, FITCH RATINGS: Sean mentioned this earlier, we haven’t seen an event yet in Asia of real substance, but the credit cycle is clearly turning for banks. I think there’s a question whether that meaningfully changes investor interest in this class. I suspect not, because most banking systems in the region do have relatively good absorption buffers.
However, we have the regulatory environment which is pushing capital requirements up. Up until this point, capital ratios in Asia have been relatively comfortable. Now those buffers are being squeezed which will force banks to look at improving their capital ratios. To the point Brian mentioned earlier with regards to the Japanese banks, they don’t need this amount, but it’s also relative to the rest of the world. The Europeans in particular have been pushing up those ratios fairly quickly. If you start comparing Asian banks to their European counterparties, they’re beginning to lag behind.
Those pressures are beginning to do their part in terms of funding and capital management strategies going forward.
BRIAN WEINTRAUB, DEUTSCHE BANK: If I could just pick up on that point, it’s a question we’re constantly asked. I like discussing this, but I hate being asked it because there are no answers. What capital level should we be at? What do you recommend? Where should we be? Even if you look through a simplistic lens and say you want to be in the top quartile of your peers, then that becomes a bit circular, because if everyone wants to be in the top quartile then it’s just a continuous build-up over time.
Across Asia I think we’ve seen much less articulation around capital strategy. Sure, everybody has public numbers you can look at, but we don’t hear a very clear framework from many Asian banks – we aim to be in the top decile on a Tier 1 ratio, or we intend to grow organic capital by X per cent, or to pre-fund AT1 under these conditions, whatever it may be. I’m excluding Australia and Japan, by the way. I’m talking more about emerging Asia.
IFR ASIA: To some extent the pressure will only come from the regulators here. Asian banks are waiting for the regulators to tell them what to do, aren’t they?
BRIAN WEINTRAUB, DEUTSCHE BANK: I think it’s a bit circular, because if you sit and wait for the regulators, that answer is fine in the first investor roadshow. By the second roadshow it gets a little old, by the third one it’s like, look, the world is all moving in this direction. The answer of, “I’m just waiting to hear what the regulator tells me.” That’s the worst at that point. It’s one thing if we’re waiting for a decision point on what China is going to do on TLAC. It’s probably not appropriate for them today to say, “Here’s my target senior debt and the total bail-in capacity and so on.” But there’s still a broader question around what are you doing around capital which could be addressed.
SEAN MCNELIS, HSBC: Banks in Asia are increasingly looking at strategies to optimize their capital levels and that isn’t only through new capital raisings.
One point that we should also discuss is liability management. We’ve seen a huge amount of that in Europe. Banks basically looking to address inefficient legacy instruments that no longer full qualify as regulatory capital through buyback or exchange offers. It’s about replacing old Basel II instruments that are no longer fully compliant, getting full capital recognition from a new instrument.
To date in Asia we’ve seen most banks just say, “Well, I can just wait and I’ll refinance it at the call date”. There are accounting and other factors to consider but it is an effective way to substantially improve your capital ratios for limited additional cost. I think we will see more of this in the coming years.
IFR ASIA: Yes, there was a DBS one wasn’t there?
BRIAN WEINTRAUB, DEUTSCHE BANK: They did an opco-holdco exchange, which we worked on.
SEAN MCNELIS, HSBC: Yes, and there have been a few others, but its been limited out of Asia, whereas in Europe it was a big theme. I think we’ll start to see other Asian banks start to look at LM solutions too.
SEAN CHANG, BARING AM: Also this will be a chicken and egg situation for bond investors, equity investors. They also look into those figures. So whether it’s for repayment, it’s for capital replenishment, that all depends on the same things.
IFR ASIA: Maybe the last question for you, what do you want to hear from a bank when they come and talk to you about buying their capital securities?
SEAN CHANG, BARING AM: Well, when you look into the numbers, they actually need to show you that their capital is strong for you to be a long-term investor on the instruments. And you really need statistics on their profitability and their background to bak you up, because these instruments are becoming more complicated.
IFR ASIA: Gentlemen, thank you very much for your time.
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