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Banks ponder regulatory capital conundrum

Basel III, Dodd-Frank and market pressures are forcing banks to bolster their tier 1 and loss-absorbing capital levels on their balance sheets, a process that is under way but far from complete. There are few palatable options on the capital-raising menu.

Market pressures remain high for banks to hike their core tier 1 capital to as much as 10%, according to some observers, amid fears over regulatory pressures, dodgy assets on bank-balance sheets and dubious risk-weighting of assets. And that’s before the debate about the composition and threshold for loss-absorbing capital takes centre stage as a buffer on top of higher core capital.

As a result, the capital-raising challenge for banks remains despite years of balance-sheet repair and self-congratulatory statements from regulators that banking systems are sufficiently capitalized.

Banks are now pondering their options – and with a stock market rally in the US and Europe, could equity issuance be one way forward?

“It is not a one-size-fits-all model,” says Steven Solmonson, senior vice-president of Spectrum Asset Management. “Issuing additional core tier 1 common stock is only one option” – one that many will consider a last resort, given the desire to avert dilution.

However, some are calling on banks to raise this capital via equity issues, supporting further lending.

“US banks currently fund about 5% of their assets with money from their common shareholders,” Douglas Elliott, fellow at the Brookings Institution, wrote in his blog last month. “This is more than double the pre-crisis levels and is only modestly below the Basel III requirements. Some have called for increasing the level to as much as 30%, a drastic change that would be costly for the economy.”

Ivor Pether, senior fund manager at Royal London Asset Management (RLAM), adds: “Governments would certainly like banks to have more loss-absorbing capital, which means issuing more equity or other instruments like CoCos.

“The problem is it’s very expensive. It makes more sense for banks to adjust their risk-weighted assets and sell legacy assets to get their capital ratios into shape.”

There are other disincentives. Elliot says: “Interest payments on debt and deposits are tax deductible, while dividends to shareholders are not, creating a major incentive for banks and other firms to fund with debt.” Although this could be rectified with a change of policy, that is unlikely, he says.

The most attractive options will be those that allow the banks to reduce risk and leverage to improve asset quality and optimize retained earnings.

“We expect to continue to see banks sell off riskier assets and operations, raising cash as well as enhancing their tier 1 capital level based on the risk-weighted asset formula,” says Solmonson.

Meanwhile, the equity bull market has seen the stock prices for many of the global banks up 30% to 50% on their 52-week lows, demonstrating investors are cognizant of the strides banks have made to their balance sheets as well as depressed yields in fixed income, trigging a push into stocks.

“Banks are likely to try to hold off sizeable new offerings for the foreseeable future, looking ahead for further stock price gains,” says Solmonson.

What’s more, the market has provided a lot of new bank equity, with many existing investors perhaps now tapped out, and new investors hard to find.

“Selling shares to use the capital for regulatory purposes instead of new business is a hard sell,” says Wayne Abernathy, executive vice-president for financial institutions policy and regulatory affairs at the American Bankers Association. Equity investors want their investment to be used for investment and growth, he says.

“Unlike fixed-income investors, stock investors are looking for direct participation in earnings, and thus the risk deleveraging process has changed the playing field for stock investors,” agrees Solmonson. “Stock investors need to take account of the new norm and see how banks restructure operations and management to drive earnings.”

Stock prices will only continue to rise if banks deliver earnings to the bottom line. If they do, it is likely to herald further equity offerings, says Solmonson.

Yet others see it differently. “Now looks a good time to try to raise capital; markets and sentiment are buoyant,” says Ross Pepperell, risk consultant at CheckRisk.

“It may prove a good idea to act now to avoid any potential crowding out next year when more European stress tests are carried out prior to the ECB taking control over supervision,” especially for the mid-size and smaller banks, which face the greatest problems making the necessary adjustments in the given time.

How investors will see it, it remains to be seen. “European bank balances are not marked-to-market, hence it is impossible to form an intelligent opinion about them,” says Frank Jensen, chief investment officer at Origo Asset Management.

“US banks seem attractive due to the way they were tackled in 2008, relieved of bad legacy assets at huge prices and given fresh, cheap capital from Treasury.”

In the UK, bank shares are rising, somewhat surprisingly, despite the prospect of a government sale of bank assets into the market, with Lloyds now sitting at 62.4p a share, above the 61p threshold the government indicated it would be willing to sell at. RBS might also be sold sooner than had been previously thought, says RLAM’s Pether.

On the face of it, long-term debt looks promising, with demand for paper high, but with prices high, and rising rates on peoples’ minds, they might be a tough sell, says Abernathy.

Preferred securities receive tier 1 treatment on the issuer’s balance sheet but are effectively fixed income securities from the perspective of yield-hungry investors, making them attractive, says Spectrum’s Solmonson.

“From the banks’ point of view it is a very attractive alternative to issuing dilutive common stock,” he adds.

With Basel III and Dodd Frank being implemented incrementally over a period of up to seven years, banks are not expected to make sudden, dramatic changes to their capital structure, but to evolve gradually. This also favours preferred securities, the credit quality of which becomes more attractive as balance sheets improve.

“Ordinary debt will worsen the tier 1 ratio, so hybrid CoCo type bonds look the only viable option in the debt space,” says CheckRisk’s Pepperell.

However, he believes “institutional demand for these is likely to be lacklustre as they would not be a good risk-adjusted investment. The risk to coupon and capital would be much higher than previous generations of hybrids”.

Solmonson adds: “Banks are likely to increase their common equity core tier 1 capital levels in due course, dribbled out over time,” but they will want to see their stock earnings and stock prices continue to rise before doing so.

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