Bank capital: Turning away from common stock

In the prevailing environment of high asset quality and soaring earnings enjoyed by many banks, they and other financial institutions are finding that regulatory capital needs typically exceed the economic capital they require to run the business efficiently.

"There is an increasing sensitivity to the difference between economic capital and regulatory capital needs," says Marc Jones, JP Morgan's head of origination and product development for European financials. "In order to maintain an improved return on equity, people are focusing on the hybrid instruments in order to achieve what they consider to be the optimal capital mix." Hybrids such as preference shares have the perpetual characteristics of equity and rank at the bottom of the balance sheet just ahead of common stock, but they offer investors a fixed rate of return.

Banks have been stepping up their issuance this year and in greater amounts for a variety of reasons. On the one hand loan growth is returning in some economies for the first time in five years. A key driver is the desire to refinance capital raised earlier. Also, in a consolidating sector some institutions are using hybrid capital rather than equity for acquisition financing. For instance, France's Axa-UAP insurance merger will raise the equivalent of Ffr6 billion ($1 billion) of perpetual subordinated debt. Also, Bank Austria raised $700 million in 20-year subordinated debt to finance its Creditanstalt acquisition.

Not only has the volume of issuance grown, but it is now possibly going deeper than before in terms of the degree of subordination and risk. "Historically it was the more traditional-dated subordinated debt," says JP Morgan's Jones. "But banks are going more into perpetual and/or cumulative instruments and making greater use of the different alternatives open to them," he says.

The impetus for the broader use of hybrid capital, like most trends in debt issuance, came from the US in the wake of last year's heavy issuance of capital securities amounting to roughly $30 billion to $40 billion within a period of five to six months. This was a tax-deductible source of tier-one capital that is now likely to become more popular in different forms in Europe over the coming months.

Société Générale has already done an issue and others are sure to follow. Salomon Brothers co-managed the $800 million SocGen issue last August for a type of preference share that carried a 7.45% coupon and was effectively a tax-deductible security.

"On an after-tax basis it is clearly a lot more attractive than equity and it is a cost effective tier-one instrument," says Alan Patterson, Salomon Brothers' vice-president for financial institutions. "Banks could choose to satisfy all their capital requirements simply through common shares and retained earnings, but it doesn't make sense for them to do so." He points out that the cost of equity might be 10% at the most efficient level, ranging up to perhaps 14% for some European banks. "When you look at debt securities, they're tax-deductible and capital requirements can be met by issuing a hybrid security that has a lower cost than cost of equity," he says. "Banks have floating-rate balance sheets and will typically look at these instruments on a floating-rate basis."

Designing innovative structures to improve the cost efficiency of bank capital is an ongoing process that has gathered pace since the implementation of the Basle capital adequacy ratios in 1988. The trick is to open new markets as well as lower the cost of securities while satisfying basic regulations. Ten years ago British banks were quick to go to the US market to raise preference-share capital. It was a relatively straightforward instrument but with hindsight it was innovative at the time as a capital security.

Less innovation has been seen in lower tier-two capital which has become a more commoditized security, but one structure that has become relatively common in the past few months is the step-up and call bond. This is designed to get round a problem associated with the regulatory treatment of tier-two capital, which is that the capital value is gradually amortized over the last five years of the security. For example, if a 10-year bullet is issued, it may need to be refinanced as it approaches maturity because of capital requirements. From the bank's perspective, amortizing a bond for regulatory capital means that it effectively becomes senior debt but still commands subordinated-debt rates. The solution is known as a 10 non-call five step-up. A call provision is put in from one day after year five and the bank is able to call it with five full years of 100% capital treatment. A coupon step-up is put in at the end of year five. On day one, the margin is set at 30 basis points over Libor, for instance, then in year five the coupon would be reset at 80bp over Libor.

Last year Royal Bank of Scotland was the first UK institution to issue in the US with step-up perpetuals to help it comply with Basle recommendations. The bank went back into the market in March with an issue of $150 million of undated subordinated floating-rate notes, with a 10-year call option.

"It is very expensive to continue the issue but as it is a perpetual bond issue it can be treated as upper tier two capital," says Ron Huggett, Royal Bank of Scotland's head of capital raising and long-term funding. "We issued at a spread of 111bp over 10-year treasuries. If it is not called in April 2006 it is then repriced at 215bp over then five-year treasuries. This gives the investor comfort as we are likely to call the issue." Huggett says the bank had used step-ups previously in the sterling market but it was the first time it had tapped the yankee market. "We would consider using it again," he says.

Subsequently the UK's Abbey National issued a US dollar step-up bond. So did Bank of Scotland, although this was a 144A issue and so restricted to qualified investors in the US. The 10 non-call five structure has now become quite standard in many European countries, but not all. For example, France once allowed the 10 non-call five step-up but no longer does. Sweden amortizes to the call date, which defeats the purpose of the call, so no-one issues there. The step-up-and-call technology has been applied in different markets, to both upper and lower tier-two capital. It makes sense, particularly for raising upper tier-two capital, as it is a perpetual security.