In a quiet corner of the capital markets, a furious race has been taking place for the past two years. Teams of well-paid financial engineers have been striving to build the perfect tax-deductible tier-one capital security for European banks. Accusations of intellectual theft and skulduggery are quick to fly. And it’s little wonder. A standardized, easy-to-use tier-one structure would be irresistible to bank treasurers looking to trim their cost of capital. The firm that makes a name for arranging these deals would be in line for a string of juicy mandates.
Most of the creations brought to market so far have been unwieldy. Tax-deductible tier-one capital has to look like equity as far as bank regulators are concerned but be sufficiently debt-like for interest payments to be tax-deductible. That usually requires a special-purpose vehicle incorporated in a tax haven. (For German banks, which have an exemption from the Basel rules, things are rather simpler, but that’s another story.) In a typical tier-one deal the SPV issues preference shares and lends the proceeds to the parent bank.
The resulting creation flies, but only just. And that is why only a handful of European banks have issued hybrid tier-one securities since 1998, when new Basel guidelines opened the way for their use in all BIS countries. Capital securities may be several hundred basis points cheaper than equity, but they are monumentally complex. Putting a deal together requires months of patient negotiation with tax authorities and regulators. Offering prospectuses tend to be hundreds of pages long and packed with enough get-outs to keep the clumsiest Houdini happy.
Hardly surprising then that investors remain wary of the product. “Investors are concerned about the complexity of tax-deductible tier-one securities and the high degree of variation between different structures,” says David Lyon, head of debt capital markets for financial institutions at Barclays Capital. “It is very difficult to evaluate a non-homogenous product as an asset class.”
Barclays Capital has not played a big part in the tier-one market so far, and its entry in the great tier-one contest, the Reserve Capital Instrument, looks quite unlike any of its rivals’ offerings. Like most tier-one instruments the security is undated (tier-one has to be perpetual), with a step-up and call providing a synthetic maturity. But unlike other hybrid tier one deals it is not issued by an SPV. The security, documented not as a preference share but as a straightforward Eurobond, is a direct obligation of Barclays Bank. Better still, the prospectus is only 37 pages long.
On its maiden flight the new structure stayed airborne. The deal was launched in the wake of a sharp fall in equity prices. It didn’t help that HSBC was also in the market. Barclays’ UK rival issued a e600 million tranche of tier-one securities as part of a jumbo multi-currency capital-raising exercise – using conventional SPV structures – to pay for its acquisition of Crédit Commercial de France.
In these difficult conditions, Barclays’ tier-one deal was priced at the top end of a range of 225 to 245 basis points over the 10-year Bund. But being a direct obligation of Barclays Bank gave the bonds a higher rating than an indirect SPV structure and, reckons Lyon, saved Barclays’ some 25bp to 30bp.
So why has no one tried this before? “People have become very focused on the indirect SPV model,” says Lyon. “And they’ve tried to bolt the successful US SPV structure onto a non-homogenous European market. We grew our structure out of existing European securities – standard upper-tier-two and the old-style sterling preference share market.”
At the heart of the structure is sleight of hand designed to make coupon payments look different depending on your perspective. Coupons or dividends are important in tier one. That’s because there is a single, crucial difference between upper-tier-two capital and the more expensive tier-one kind: the first is cumulative and the second is non-cumulative The issuer can miss payments on both types of security. On cumulative debt the bank has to make up missed payments later. But on non-cumulative securities it does not.
A clause in the Barclays transaction, the alternative coupon satisfaction mechanism, says that if the bank defers a payment on the securities, investors will be made good by the issue of new shares worth the amount owed to the bondholders. An independent bondholders’ trustee (Royal&Sun Alliance) would then sell the shares, convert the proceeds into euros and pay the bond holders. That would dilute existing bondholders, but no cash would leave the bank. “The bond is cumulative for investors but not for the bank because deferred coupons may only be paid via an issue of equity,” says Lyon. “Consequently, Reserve Capital Instruments have superior cash-conserving powers since the resources of the bank itself are not reduced when a deferred coupon is made.”
Rivals charge that Barclays has lifted this feature from the stock settlement clauses that have been used on several recent tier-one deals to strengthen the synthetic maturity. But Lyon says the structure harks back to the payment-in-kind feature in the sterling preference share market. “We are placing our structure in the midst of European capital precedent,” he says.
But how sure is Barclays that these securities will count as tier one capital, or that they will receive the favourable tax treatment without which the deal makes no economic sense? Well, in either instance, as with other tier-one bonds, the deal can be called. But a new feature also allows Barclays’ bonds to be converted into senior upper-tier-two securities. “We are monetizing our confidence in the tax and regulatory status of the structure,” says Lyon. “If for any reason we do lose deductibility, the security can be exchanged for upper tier two debt with a coupon cut of only 40bp – less than the historic spread differential between tier one and upper tier two debt. That would be the most expensive upper-tier-two that Barclays would have in existence.”
So has the plucky British outsider found the secret design that will make the tier-one securities market fly? That partly depends on how the authorities in other countries respond to the structure. But for UK banks at least, the relative simplicity of the instrument is likely to be a strong draw. The proof that Barclays has hit on a winner will come when other firms start to borrow the idea. In the capital markets, plagiarism is always the sincerest form of flattery.
