In the face of the European Banking Authority’s evident scepticism about sustainability-linked bonds, some investment banks are looking to redesign the product for bank issuers. But even tweaked structures appear unlikely to feature on deeply subordinated bank capital instruments, whereas the outlook for green or social junior debt is more positive.
One banker said the EBA’s AT1 Monitoring Report in June was “less helpful than we would have anticipated”, and the regulator is unlikely to provide further clarity for six months. Banks may engage privately with it in pursuit of guidance and soft approval of revised structures, however.
“We don’t think the door is closed to sustainability-linked structures if we can design features that respect prudential criteria and regulators’ concerns,” said Nik Dhanani, global head of strategic solutions at HSBC.
“We clearly expect sustainability-linked bonds could become a more mainstream part of the bank funding market, if endorsed by relevant authorities,” Dhanani said. Regulators may “also be sensitive to operational feasibility in terms of approval processes, particularly if we see a wide variety of different structures”.
One of the regulator’s concerns hinges on SLBs’ possible link to issuers’ credit standing.
“Ultimately, any kind of element that potentially has a credit-sensitive feature to a metric linked to sustainability or some other ESG factor could prejudice the regulatory eligibility of the instrument – at least from an incentive to redeem,” said Monsur Hussain, head of FI research at Fitch Ratings.
These concerns weigh less on senior SLBs. “It seems as though there's a limited future for SLB issuance in AT1 format, but beyond own funds, if we look at the other part of the liability structure, particularly towards senior, I think the future is bright,” Hussain said.
Even so, the regulatory risk involved makes it unlikely that many will soon seek to follow the lead of the sole bank SLB issuer, Berlin Hyp – an atypical issuer that was able to side-step the fraught question of SLBs’ eligibility for MREL calculations.
This impasse is difficult for banks that had hoped to use SLBs to bypass capacity limitations on their green and social use-of-proceeds bonds. Having exhausted the assets eligible for these, the sustainability-linked product would eliminate the origination challenge and enable banks to align their lending with ESG targets more broadly.
“Despite the EBA’s caution, the strategic objective of solving for MREL-eligible SLBs is very much front and centre for issuers,” said Charles-Antoine Dozin, head of capital structuring at Morgan Stanley, who judges senior preferred and senior non-preferred formats as viable for pioneering the product.
Subordinated obstacle
If senior SLBs are challenging, incorporating the structure into banks’ junior capital – Tier 2 subordinated debt and AT1 quasi-equity – appears nearly impossible. “The only safe place” for bank issuers to offer SLBs is senior preferred and covered debt, said Caroline Haas, head of climate and ESG capital markets at NatWest Markets.
“These instruments have a very specific prudential role to shore up capital. What you cannot have is sustainability triggers that could impede the capital requirement.”
“We would not advise mixing own funds and SLBs for an inaugural transaction. That adds another layer of complexity,” said Dozin.
Junior SLBs are not outlawed, though, one banker said. “There are structures that should theoretically balance SLB principles and capital criteria. However, the EBA has previously advised issuers not use certain features, and cited unnecessary complexity as the rationale; it may be that a similar stance is taken in relation to SLB AT1s, but we need to see how their thinking evolves.”
ESG AT1 is go
In contrast to SLBs, junior green and social use-of-proceeds structures appear feasible despite considerable scepticism towards the only green Additional Tier 1 yet seen in the market. Spain’s BBVA issued the €1bn perpetual non-call 5.5-year in July 2020.
“UoP AT1 is effectively what had been issued by BBVA, which faced some criticism, but I felt much or all of the critique seemed unfair,” one banker said.
“From our point of view, regulatory uncertainty has been dissipated for use of proceeds own funds instruments,” said Dozin.
An increasing proportion of investors in junior bank capital are receptive to green or social structures. “If you are an AT1 buyer, then you're happy to incorporate green use of proceeds, many US investors told us,” said Haas.
Adds Fitch Ratings comment in fifth paragraph