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.
“In the last 18 months or so we’ve seen a far greater maturity of the investor base in Europe for hybrid capital instruments,” says David Marks, JP Morgan’s head of syndicate for hybrid capital. “There is a greater acceptability of these types of transactions, due largely to an improvement in bank credit across Europe. There has been an upgrading in credit quality from the rating agencies, a generally more benign economic climate and also ever more contracting spreads that put pressure on investors to work a little harder to look outside the traditional instruments. It’s fair to say a few years ago investors were reluctant to use subordinated debt and there was never really any pressure to do the necessary work to put that onto the list of eligible assets. The incipient advent of the euro has made many portfolio managers examine how the wheel turns in a single-currency environment.”
In the past 18 months or so some European markets for subordinated debt have developed. The dollar has been and remains the mainstay of most regulatory capital markets, but in January Salomon Brothers led a Dm110 million ($64 million) 10 non-call five FRN for Norwegian insurance company KLP, while in August Denmark’s Unibank issued a 10 non-call seven in Deutschmarks.
“It is a nascent market and hasn’t yet fully developed,” says Salomon’s Patterson. “We’ve also seen the beginning of some buying by European investors of fixed-rate subordinated debt issues in US dollars. The Euromarket is characterized historically as a floating-rate market in securities and the yankee market has been fixed-rate. But from late 1995 through to the first half of last year we saw a series of about seven issues of fixed-rate subordinated debt marketed at European investors. The markets are more integrated than in the past. We’ve seen US investors buying Euro-products and they asset swap it out into fixed rate at the call date, and we’ve seen European investors become more comfortable buying some of the large liquid yankee bank issues.”
The growth of securitization
Asset-backed transactions are also enjoying fast growth in Europe as a means of enhancing yields by removing low-yield assets from the balance sheet. According to Andy Clapham, head of securitization at NatWest Markets: “The collaterized loan-offering market has been the biggest one over the past 12 to 18 months. Since the launch of our Rose One last year, NationsBank and SBC Warburg have come to the market with collaterized loan offerings. We’ve now raised two; CSFB have brought out their deal; Bank of Tokyo Mitsubishi have done a couple of transactions; ABN Amro’s deal [believed to be $8 billion] is in the market; and there are probably 20 other institutions that are looking to do collaterized transactions.”
NatWest’s Rose One transaction enabled the bank to securitize unrated loans in large quantities to the amount of $5 billion, and thus in one transaction increase the yield across a large portfolio of loans. NatWest’s Rose Two, issued in dollar- and sterling-denominated FRNs, was launched in September. Clapham says NatWest is now turning its thoughts to Rose Three and may be looking at innovations that could make it a slightly different deal.
“Banks realize that investors want to see a better return on their equity, and there are lots of other financial institutions around which they can put their capital into, particularly with the conversion of building societies,” says Clapham. “Hence they have become more aware of the need to improve their capital returns. More treasurers of financial institutions are now looking at securitization as a capital-management tool.”
Emilio Botín, senior vice-president and head of financial planning at Banco Santander, says the bank was the first in Spain to tap the collaterized loan offering market. “We did five issues in the last two to three years, mainly mortgage-backed securities,” he says. “This is definitely a growing trend. There has been massive growth in the US and the Euromarkets are next in line.” Banco Santander raised about Pta50 billion ($344 million) from each issue and it announced in October that it planned to launch another one for a similar amount. “Commercial loan packaging is the next step which we will be looking at next year,” he says.
Until now Banco Santander had been financing itself through the issuance of plain-vanilla preference shares, mostly perpetual preferables callable after five years for its tier-one capital. It has issued tier-two subordinated debt, some of it perpetual and some with fixed redemption dates. “We have looked at convertibles to reinforce our capital base but we are not too convinced because of the dilution that this would have on shareholders’ equity,” says Botin. Banco Santander has this year done three issues of subordinated debt with fixed redemption dates totalling $300 million.
The benchmark for these issues is the US market, where historically the differential between senior and subordinated debt has been much tighter than that in Europe. JP Morgan’s Marks says this has been one of the positive influences in terms of the contraction of spreads. But there are still important sectors of investors in Europe that will not buy undated paper, and while the soft redemption created by the step-up instrument goes a long way towards broadening the investor base, for many it is still an absolute necessity to have a defined maturity.
“The remarkable thing about this year is not only the product innovation but also the broadening, depth and diversification of the investor base for these instruments in Europe,” says Marks. “That ranges from deals we’ve done in mainstream currencies such as sterling, dollars, Deutschmarks and French francs, to pesetas, Belgian francs and others. It would have been difficult to visualize this even 12 months ago. What is also worth highlighting as a trend is that many of the investment banks have been somewhat ahead of themselves in their ability to distribute paper. In the benign spread-tightening environment we’ve seen it’s possible to get away with fairly tightly priced deals, in the hope that the market will tighten on the European side and one will be able to sell the deal back into the US.”
Enter the opco pref
“Probably the biggest structural innovation that has captured the banks’ imagination at the moment is in the tier-one preference share market,” says Salomon’s Patterson. These are the so-called opco (operating company) preference securities, which are the type SocGen issued. The securities are issued through a subsidiary in a tax haven. But whereas most issues through a tax-advantaged vehicle would not count as tier-one capital because the issuer is not deemed to be an operating subsidiary of the bank, opco preference securities do rank as tier-one capital.
There have been several such issues by US banks, and European banks are keen to develop comparable securities for their own markets. “The opco pref promises to open a new type of security to an important group of banks that have not been able to issue it before,” says Patterson. “They carry a significantly lower cost than pure equity and they get tier-one treatment.”
While there has been a significant broadening of the investor base this year, some market participants say that there has also been a worsening of the execution quality of some of the transactions done. They say many firms are pursuing mandates without having a fundamental distribution capability. This may provide a lower cost for issuers, but the risk is that the end placement of paper will be much poorer, especially in conditions such as the recent world stock-market turmoil.
“The equity market trading performance will probably be weaker, with the result that the issue will not have been as well distributed and placed,” says JP Morgan’s Jones. “Clearly all high-yield hybrid instruments tend to sneeze when the emerging markets catch cold. The spread performance of different yields, however, has been quite marked. While some dated subordinated debt deals have widened only 5bp, where senior bank FRNs have widened, some have gone up 10bp or 15bp.” He says this depends on how much of a particular deal the market believes is actually placed with investors and how much is still on dealers’ books. “I think it’s fair to say there has been some dramatic spread-widening on certain deals in the last few days,” he said in late October.
Clearly, recent stock-market volatility demonstrates this is an asset category that still requires a risk premium. It may have diminished for certain types of issues but the way a transaction is done is still important.
