As Deutsche Bank’s share price tumbled in late September following news of an eye-watering $14 billion claim by the US Department of Justice against the bank, the vulnerability of its $2 billion worth of AT1 bonds was again the subject of intense speculation.
By September 26 these bonds were trading at 73 cents on the euro – back at levels they last visited in February this year. The performance of the bonds reflects concern not just over Deutsche’s capital position, but also over the exposure of AT1 investors in general to bank solvency.
“If bank solvency drops, then ironically, the AT1 CoCo market shoulders the first loss – before even equity. That is why we had such volatility in that market in February,” says Adrian Docherty, head of FIG advisory at BNP Paribas in London. “It is perverse that AT1 holders can lose their coupon, which is never recouped, while equity owners benefit from the retained cash that automatically becomes theirs. To fix this, we need a mechanism whereby AT1 coupons can be added to the principal or paid in kind through common shares.”
This vulnerability has become a source of acute concern as the Basel Committee finalizes its amendments to the Basel III framework for capital adequacy, known as Basel IV. The risk-weighted asset inflation that these changes could demand spells further trouble for the AT1 market.
“The problem with Basel IV is that the rise in RWAs reduces the capital ratio, meaning that wherever the CoCo trigger is it is that much closer to it,” says one banker.
The increase in capital that banks may be required to find under Basel IV could mean that a CET1 ratio of, for example, 15% under Basel III will translate to a CET1 ratio closer to 12% under Basel IV.
If you are an investor sitting on a CoCo bond that triggers at 7.5% that matters. As one succinctly puts it: “If Basel IV pushes capital ratios below 10%, the CoCo market will freak.”
This market is, therefore, in the unfortunate position whereby bonds are referencing triggers that were set against capital ratios that may no longer apply when the Basel IV revisions are finalized.
“If you have perpetual bonds out there that reference a ratio that isn’t defined – for example it just says that it triggers at “7% CET1 ratio” – what if that ratio gets rebased?” asks Docherty. “Maybe there needs to be updating and future-proofing of trigger definitions for these bonds.” No small task for a market €125 billion in size.
With total loss-absorbing capacity (TLAC) and minimum requirement for own funds and eligible liabilities (MREL) due to be in place by 2019, the focus on both the quantum and form of bank capital is intense.
“If Basel IV is something that the market sees as a silly, interfering regulatory rule change it will have more tolerance,” says Mike Harrison, director in the equity research division at Barclays. “The proximate catalyst for banks to raise capital would be weaker.”
In the AT1 market, the banks with the slimmest cushion between trigger and CET1 ratio have the most to worry about.
Three of the banks closest to their MDA threshold are French, although Crédit Agricole restructured its regional holdings to boost its transitional CET1 ratio to 11.9%, up from 10.9% in August. The French banks’ need for capital is well-known, but the process is being delayed by the passage of the French non-preferred senior law, due in October.
“The large French banks need to raise capital to meet their TLAC requirements in the non-preferred senior market, but the regulations are not yet clear so they will wait,” says Jonathan Weinberger, head of capital markets engineering at SG CIB. “We may, therefore, see some front loading in the tier-2 market this year.”
The new law will see French banks issue non-preferred, or tier-3, notes that will sit between existing senior and subordinated bonds and will be bail-inable. It is the latest European country to introduce its own solution to bail-in, after Germany introduced statutory subordination of existing senior debt to other senior liabilities and Spain took a contractual approach to enable banks to issue senior subordinated notes. The EC is now looking to standardize the approach to creditor ranking in insolvency across the region and may be looking at the French approach as a Europe-wide blueprint.
“We understand that the EC is predisposed towards having a standardized approach, and that the French approach could be an interesting solution,” Eric Litvack, head of regulatory strategy at Société Générale CIB, tells Euromoney.