Bank capital – From a trickle to a flood

Who needs tier three?

Marks: surprised by European demand

Take the archetypal European bond investor, perhaps not the Belgian dentist of lore but a successful Italian fashion designer. She used to get a double-digit return on her Italian government bonds but, according to the story we have all learnt by heart, the introduction of the euro has brought yields on government bonds down to rock-bottom levels.

Add another entry to the long list of products – corporate bonds, high-yield bonds, municipal bonds, asset-backed securities, convertibles and so on – which can give her a yield pick-up. Subordinated bank debt, say its supporters, is the perfect asset for Europe’s yield-hungry, but conservative, investors. Buy the subordinated debt or preference shares of a bank you know and trust and you will get higher returns without the need to bet on the fortunes of some unknown telecoms company or distant emerging market.

The growing enthusiasm of European investors for bank capital issues is one of the reasons for a big increase in issuance this year. In the first three-quarters of 1999, according to Capital Data, issuance of bank subordinated debt was already greater than the total for any previous year. Some $31 billion had been issued, compared to only $18 billion in the whole of 1998 and just over $25 billion in 1997, the previous record year.

And bankers agree that more paper is being bought by European investors. The biggest bank capital raising exercise this year was the eight-tranche offering for NatWest in September, which was intended to finance the acquisition of Legal & General, a deal which was later aborted in the face of Royal Bank of Scotland’s hostile bid for NatWest. David Marks, vice-president at JP Morgan which acted as bookrunner on the debt offering, was surprised by the level of demand from European investors. “We had demand from 65 investors in one tranche alone,” says Marks. “Eighteen months ago we would have been lucky to get a quarter of that number.”

The most dramatic increase has been in the volume of tier-one securities, the most equity-like paper. In 1998 European banks issued just over $7 billion-worth of tier-one paper (excluding pure equity). Between January and October, issuance of tier-one securities by European banks totalled more than $13 billion.

Chunilal: “We have barely started”

It is this explosion of tier-one paper, rather than the rise in subordinated bank debt issuance, that is getting bankers excited. Fees for putting together and selling these securities can be as much as 2%. That looks mouthwatering to firms pocketing less than 50 basis points for underwriting even corporate bonds. The reason fees are generous is that bank capital issuance is a complicated business. These are finely crafted instruments, say their advocates, individually tailored to suit the capital and tax requirements of the issuer. Many bond houses, sniff the experts, lack the expertise to structure these securities correctly.

And banks know the pitfalls of the bond market better than most. Paying an extra basis point or two on senior debt may not be the end of the world. But if the bank gets a lousy price for its capital that will directly affect its return on capital. “You want a safe pair of hands when you issue capital,” says Damien Chunilal, co-head of Merrill Lynch’s European financial institutions group. “No bank will take execution risk.”

No more tiers

Bank capital securities are not a homogenous asset class. The different tiers of bank capital make up distinct markets with their own peculiar characteristics. The most senior bank debt is the least interesting to underwriters. Lower tier-two debt is the poorest quality capital as far as regulators are concerned, and is therefore the cheapest for banks to issue. It is a standardized product which is frequently issued and generates underwriting fees on a par with those of corporate bonds. Although it is cheap for banks to issue, the BIS guidelines limit this type of capital to only one-quarter of a bank’s total capital.

If a bank wants to raise tier-two capital but is full to its limit of lower tier-two, it needs to issue the next most senior form of capital: upper tier-two. (Tier-three capital – see box – adds a new complication to this scheme.) Unlike lower tier-two, this capital has to be perpetual and interest payments can be deferred. But these bonds are cumulative, that is, if interest payments are missed, the investor has the right to receive them later. These peculiar characteristics make upper tier-two much less attractive for banks to issue than lower tier-two.

Those two types of capital together make up a bank’s supplementary capital. But the capital that regulators care about most is core or tier-one capital, those funds that a bank can really call on if it is in trouble. The BIS guidelines stipulate that at least 50% of a bank’s capital has to be tier-one, which for the most part consists of equity and retained earnings.

But banks hate to issue equity. It dilutes their existing shareholders and dividends on equity, unlike interest payments, are not tax deductible. That is why banks have spent years trying to persuade regulators to class certain very junior types of debt as core capital.

Various instruments have been used to raise tier-one capital. Germany has its own unique product, the silent participation, a dated, tax-deductible instrument through which banks can raise core capital provided the securities are bought by German investors. The Basel rogue states of Spain and Portugal (like Finland, Spain and Portugal are not part of the BIS accords) have for several years allowed banks to raise tier-one capital through special purpose vehicles. In addition, several European banks have raised tier-one debt capital in recent years through US subsidiaries, particularly real estate investment trusts (reits).

The turning point in the development of a standard form of hybrid capital instrument came with the publication in October 1998 of new BIS guidelines on what types of securities would count as tier-one capital. The guidelines say that capital raised through a structure involving SPVs can count as tier-one capital. But banks can have no more than 15% of their tier-one capital in this form.

It is now up to national bank regulators in each country to fall into line with these guidelines and several have already given SPV structures the green light. Sweden is perhaps the most advanced jurisdiction. In Stockholm, regulators and tax authorities got together and created a new legal instrument, the capital contribution note – issued directly by the bank rather than by a special-purpose subsidiary – which counts as tier-one capital for regulatory purposes and debt as far as the tax collectors are concerned.

But in most countries the situation remains murky. In the Netherlands and Belgium, the regulators are willing to view SPV issues as core capital, but the tax authorities are not convinced these securities should be tax deductible. Those Benelux banks which have issued have had to keep the proceeds in the US. In Italy, banks can issue using credit-linked structures, a method similar to the SPV structure, but issuers face tax problems.

In France regulators continue to resist the use of SPVs. It may be no coincidence that France has lagged behind other European countries in its acceptance of hybrid capital structures given that its biggest banks, the organizations that have most to gain by lobbying for a change, have been distracted for much of this year by the three-way takeover battle between BNP, SG and Paribas.

French banks, which led the way in issuing through US operating companies, still have the option of issuing through reits, but raising capital in this way can be nightmarishly complicated. “The banks that have issued through reit structures are unwilling to go through that rigmarole ever again,” says one banker.

The country where banks have been lobbying the authorities hardest to allow tax-deductible tier one issuance is the UK. In March the industry scored a victory when the Financial Services Authority granted its approval in principle to the SPV structure (though it still wants to give the go-ahead on a case-by-case basis only). The sticking point was the reluctance of the tax authorities to treat interest payments on these securities as tax deductible. The Inland Revenue relented in July but that has not yet led to a flood of UK issues. The reason for that may be that several of the banks which have been lobbying hardest for a change in the rules have been distracted by M&A activity.

New rules have given supply of hybrid tier-one securities a boost. But other types of bank capital raising have also increased this year. There are two main reasons that banks have become more keen to issue the various forms of capital. The most pressing is consolidation. Unlike in the US, where acquisitions tend to be paid for in equity, European banks have been buying each other using cash. That creates a need for extra capital, especially where the price paid for the acquisition is greater than its book value. “Any goodwill created in an acquisition must be deducted from capital,” points out Gregor Gruber, executive director at Morgan Stanley. “So the ongoing consolidation in the banking industry will reinforce the requirement to issue new capital. There has been healthy issuance of upper tier-two capital this year. That has been driven largely by acquisitions. But upper tier two is a relatively expensive form of capital, so institutions only issue it when they can’t use any more lower tier-two.”

Banks can also increase their returns by raising cheaper forms of capital. That typically means replacing expensive equity with cheaper debt. “A more aggressive approach to capital management has been spreading through Europe,” says Marks at JP Morgan. “More and more banks are looking at better ways to manage both their assets and liabilities.”

But given such overwhelming incentives to issue capital instruments, the volumes of issuance are not yet huge. European banks have considerable capacity to increase their tier-two capital, and only a handful have dabbled in the hybrid tier-one market. “We have barely started,” says Chunilal, at Merrill Lynch. “Most European banks have a great deal of capacity to raise more tier-one capital through capital securities.”

Tell that to the investors

The reason that the market is taking time to gather pace is that most European investors remain wary of subordinated debt.

The benefits to investors are well rehearsed. These issuers are usually familiar to investors; they will be followed by analysts and for the extra return they provide, the increased risk over senior bank debt is minimal. “There is a comfort factor in buying well-known names,” points out Ben Katz head of preferred securities origination at Lehman Brothers. “There is usually more research available than for a less frequent borrower.”

Bankers are particularly keen to stress the low default profile of bank subordinated debt. “The dated product, that is lower-tier-two paper, is ideal for the new spread investor,” says Jonathan Gittos, vice-president at Morgan Stanley. “Banks have a lower default history than corporates. So these securities give a lot more yield for not much extra risk.”

Because banks are uniquely dependent on perceptions of their solvency, they will be very reluctant to miss any payments. Investors will only suffer, say bankers, when things get so bad that even senior creditors get hit. Needless to say, this is not an argument banks make to regulators when trying to convince them to classify debt as capital.

Several bankers point out that the number of cases where major banks have suspended payment on their subordinated debt or preference shares is zero. In the early 1990s Christiania and Den norske Bank kept up payments on their upper-tier-two debt even when the government had to step in to recapitalize them. Likewise, Banesto and Crédit Lyonnais continued to service their upper-tier-two debt and preference shares when they went bust in 1993 and 1994.

That’s the theory. In practice, the reason that no subordinator debt holders have suffered at the expense of senior creditors may simply be that there have been so few bank failures in which subordinated debt was outstanding. That may change as the product becomes more popular. And though it’s true that governments don’t tend to let big banks fail, the threshold for being classed as a big bank is rising all the time.

But investors may be wrong to focus on the subordination of this debt. “The greatest risk for the investor is not subordination risk but extension risk,” explains Chunilal at Merrill Lynch, “the risk that the investor will be left holding paper which yields less than the market rate.”

The classic model for selling subordinated debt in Europe is for an issuer to place it through its own retail distribution channel. In other words, a lot of bank capital instruments end up being sold to customers of the bank. But bank subordinated debt sold to retail investors is perpetual. That means that if interest rates go up, bank depositors could be left holding paper that yields below the market rate. Those securities issued to institutional investors, by contrast, always have a step-up. A step-up and call feature acts as a synthetic maturity and prevents investors being stuck with this paper in perpetuity.

If eurozone interest rates rise from their current low levels, will retail investors complain in a few years’ time that their banks did not fully explain to them the risks of buying perpetual debt? And there is another problem with this method of selling bank capital instruments. “How likely is a bank to defer payment on a security that is held mainly by its own depositors?” asks one banker. “That makes it less valuable as core capital.”

Relying on retail

But retail investors are the mainstay of the European hybrid tier-one capital market. According to Merrill Lynch’s calculations, some 42% of the $14 billion of tier-one capital securities issued by European financial institutions since October 1998 were targeted at European retail investors, with 21% targeted either at US retail or what the firm categorizes as global retail. Issues targeted at US and European institutional investors accounted for 20% and 16% of issuance respectively. In about 75% of European retail-targeted issuance, according to Merrill Lynch’s research, the issuer played a very significant role in distribution through its own branches and private client network.

The main reason for the popularity of retail deals is that they can offer better pricing than those targeted at institutional investors. The institutional market is a second-best choice. Institutional investors demand higher prices and synthetic maturities in the form of step-ups and other devices.

US retail investor form the original market for bank capital instruments. As a result, the US market is much deeper and more sophisticated than that in Europe. But access to US retail investors is limited to those banks which are SEC registered. Few European institutions are.

“The different markets are attractive in different ways,” says Chunilal at Merrill Lynch. “The US market is bigger, deeper and generally more sophisticated, but the European market can be more tightly priced. It is important for issuers to consider all markets and look at which is best on the day.”

While issuers pay similar spreads for lower-tier-two paper in the US and Europe, the pricing of upper-tier-two paper is markedly different in the two markets. US investors demand a higher premium to compensate for the fact that interest payments on this debt can be deferred than do European buyers.

For tier-one securities, the main difference between the two markets is not so much price but availability. The US market is much deeper and issues can almost always be done there. In Europe, the market is much more patchy. “European investors are just not comfortable yet with tier-one securities,” says one banker. “Traditionally, this stuff has been called ‘shares’ and that is very off-putting for bond investors. It’s too much of a new thing for many of them.”

But some believe that Europe is becoming as fertile ground for bank capital raising as the US. “Since the introduction of the euro, Europe has begun to rival the US in terms of the depth of demand,” says Gittos at Morgan Stanley. “At the beginning of this year, dated subordinated debt was mostly being bought by the same group of investors as bought Deutschmark issues in 1997 and 1998, mainly Dutch and German investors. That began to change from around March, when the number of investors began to grow rapidly. Now sales of these products are broadly spread throughout Europe.”

“The European bank borrower now has a choice of markets for the first time,” says Tim Skeet, head of the financial institutions group in Dresdner Kleinwort Benson’s global markets division. “A few years ago the market in Europe was mainly an FRN market, it was relatively thin and it was denominated in dollars. Now the market offers more depth and it is possible to raise capital in euros.”

Most bankers agree that the introduction of the euro was a turning point for the European investor base. “If NatWest had been doing its deal a couple of years ago it would have almost certainly looked at the dollar market first,” says Marks at JP Morgan.

Growing competition

Competition to provide access to that growing European investor base is fierce. Merrill Lynch and Goldman Sachs are the acknowledged market leaders in raising hybrid tier-one capital. These firms were instrumental in the development of this market in the US and have so far dominated European issuance. This year, Merrill Lynch has stormed ahead, acting as bookrunner or joint bookrunner on some $8 billion of the $13 billion or so of tier-one capital issues by European banks.

Merrill’s many rivals point out that this is an embryonic market and that the any league tables based on the small number of deals completed so far are of limited value. Only a handful of firms other than Merrill and Goldman have acted as bookrunners on tier-one issues this year (other than self-led deals). Salomon Smith Barney is the most prominent firm after Merrill and Goldman. But several other banks are working hard to develop their capabilities in this market. Warburg Dillon Read poached Barry Zins from Merrill Lynch in 1997 to head their bank capital operations, and the firm has led several deals for European banks in the past 12 months. ABN Amro, Deutsche Bank, Dresdner Kleinwort Benson, Lehman Brothers and Morgan Stanley all have teams dedicated to this market.

The market leaders believe that the difficulties of structuring bank capital instruments creates high barriers to entry for this business. “Every transaction is unique,” says Chunilal at Merrill Lynch. “The basic principles are similar, but there can be no set model which can be used as a template for any deal.” Merrill Lynch claims to have the biggest product development team with eight members of the bank’s global new product development team based in London.

Some say that too much is made of the high barriers to entry and the work involved in structuring these products. “Having armies of brilliant lawyers and accountants may have been the way into this business two years ago,” says Skeet at Dresdner Kleinwort Benson. “Then you had to spend a great deal of time working out exactly what products would be allowed. Now there is more clarity in the regulations. We can expect the market in Europe for capital instruments to settle into a more consistent pattern where the banks involved distinguish themselves through the quality of their research, their secondary market commitment and their distribution.”

Other firms complain that the emphasis on clever structures can be misplaced. “We believe in the principle of keeping it simple,” says Barry Zins, executive director, fixed income at Warburg Dillon Read. “Unnecessarily complex structures mean that products lack transparency. Investors aren’t able to make useful comparisons and that harms the development of the market.”

Clearly, distribution capability is important as well as structuring expertise. “This business demands critical mass,” adds Chunilal. “You need to be focused on origination, you need a focused product development team and you need global distribution: that means both institutional and retail, US and Europe, so that you can hit the best market at any given time. Few banks have invested enough to achieve that critical mass.”

The market for other forms of bank capital is more evenly spread, with firms such as JP Morgan, Deutsche Bank and Morgan Stanley making a strong appearance in the league tables for all bank subordinated debt in addition to Goldman and Merrill. JP Morgan is one of several firms which believe that their M&A advisory work gives them an edge in this business. JP Morgan led the large bank capital raising exercise for NatWest in September after having advised the bank on its proposed takeover of Legal & General. Morgan Stanley is also striving to build its profile in the bank capital raising business by capitalizing on its links with financial institutions.

Several firms are making efforts to expand the capital instruments market into new areas. The most promising avenue is raising capital for insurance companies. Among the handful of deals completed this year, most of them upper-tier-two deals, are several from Europe’s largest insurance companies. Swiss Life, for example, issued €850 million in April; Swiss Re brought a €250 million deal in June and the UK’s Royal & Sun Alliance issued €500 million in September. “I believe recent issues by large European insurance companies are harbingers of a growing appetite for capital instrument issuance on the part of insurance companies,” says Zins at Warburg Dillon Read.

Insurance companies do not have the same need for regulatory capital as banks, since their regulatory environment tends to be more relaxed. What is becoming increasingly important to insurance companies, however, is their credit rating. A ratings culture has grown in the insurance business in Europe in the past few years. Now, credit ratings are one of the first things potential clients demand to see when buying insurance and the agencies have become de facto regulators for the industry.

There is a clash of ideas between Moody’s and S&P on the value of subordinated debt for rating purposes. S&P gives greater recognition to the powers of subordinated debt to bolster an issuer’s senior credit ratings than Moody’s, which has long been sceptical of the relevance of these securities to an issuer’s creditworthiness. But there are signs that Moody’s attitude is softening. It has circulated papers which appear to suggest that it may in future give greater acknowledgement – it shuns the term “equity credit” – to an issuer’s subordinated debt when it calculates ratings.

The ratings culture has given insurance companies a new emphasis to structure their balance sheets effectively. “A number of big insurance company players in Europe have got religion about capital management,” says Tom Keatinge, associate at JP Morgan. “They now have treasury departments and are carrying out the same modelling exercises as banks.”

That has revolutionized attitudes towards subordinated debt and preference shares, especially in the UK. “Hybrid capital was once seen by UK insurance companies almost as a white flag,” says Keatinge. “It was something they might issue if they were in financial difficulties or just before they demutualized. Now, the biggest UK insurers are reassessing their entire capital structure and issuing subordinated debt to bolster their credit ratings.”

Insurers have one big advantage over banks when it comes to raising capital: their paper can be, and usually is, bought by banks. But if banks buy the debt of other banks they have to put a full capital weighting against their holding, that makes it uneconomical for banks to buy bank paper. As a result, insurance companies have a funding advantage over banks.

And enthusiasts maintain that insurance company debt has several advantages over bank debt for investors. By buying bank debt an investor may be taking on exposure to emerging markets, for example. Whereas insurance companies tend to have very different risk profiles: their risks are on the liabilities side and are less correlated with economic downturns and financial crises, such as an unexpected natural disaster or a large product-liability lawsuit against a customer.

If hybrid capital is useful for insurance companies, it should help any company which values its credit ratings. And some bankers believe that more and more companies will come to see the value of issuing such securities. “Since corporates are not regulated in the way that banks are this is not regulatory capital,” says Zins at Warburg Dillon Read. “But capital instruments are useful for corporates as a balance-sheet management tool. They allow companies to raise capital in lieu of equity through instruments that are non-dilutive, so that can help their share price, and it can also be important for their credit ratings.”

But the capital management revolution, which is now starting to affect insurance companies and the more clued-up corporates, has left many European banks untouched. Whole swathes of the banking industry in Europe still benefit from cheap capital in the form of state ownership and guarantees from governments. Bankers are eyeing up the Landesbank sector, which may soon have its state guarantee withdrawn by order of the EU, as a promising source of subordinated debt issuance.

Another reason to expect banks to issue capital instruments in greater volumes in future is that regulators have at last decided to allow companies to buy back their own shares, something that was until recently prohibited in several countries, notably Germany.

But the greatest driver of issuance in the immediate term is likely to be M&A activity. Big acquisitions are likely to lead to larger deals.

In the meantime, some bankers caution that the firms involved in underwriting bank securities have to do more to allow the market to flourish. “We see a market that is growing and becoming more transparent,” predicts Zins at Warburg Dillon Read. “We want to see the creation of an active and transparent secondary market and we would encourage all participants to stand behind their deals to create a market that is of greater service to both issuers and investors.”