Hybrid capital under scrutiny

A s banks contemplate subprime losses and concerns over future credit quality in deteriorating economic conditions, shoring up capital ratios by any means would seem a ­priority.

This is made all the more urgent by the fact that leverage ratios on Tier 1 capital have tended to double on average during the past decade, from 10 times to 20 times, as banks sought to maximise return on equity by minimising holdings of regulatory capital.

Sovereign wealth funds have been leading players recapitalising banks in the US, UK and Switzerland. Among those who had fewer friends in high places, Royal Bank of Scotland made the largest ever rights issue by a UK bank, while Bradford & Bingley battled to do the same. Meanwhile, banks with stronger capital bases have not been absent from the market, as they seek to build a war-chest for possible acquisitions among troubled rivals.

Sliding valuations

Despite the continued turmoil on financial markets and precipitous slide in the market valuations of financial institutions in particular, banks have still raised a “surprising amount” of the capital they need with investors, says Nick ­Morgan, head of financial institutions at RBC Capital Markets in London. This is true even for the credit markets, which suffered more severe dislocation than equity in 2007. “You will certainly find some of the bigger financial institutions behind on their wholesale funding strategy for the year but the majority of banks would say that they are slightly ahead of their run-rate for 2008,” says Mr Morgan.

But the pattern of issuance has varied, and one possible source of funding appears to have divided opinion – hybrid capital. “US banks have gone through the whole spectrum” of hybrid issuance in recent months, from plain vanilla to mandatory convertible hybrids,” says Arshad Ghafur, head of convertibles origination at Lehman Brothers in London. “But within Europe, a lot of people have been skipping hybrids and going straight to equity,” he adds.

Cost could be one reason. In the case of the UK’s HBOS, a Tier 1 capital hybrid issue in March cost 450 basis points (bps) over Libor, a world away from similar issues a year previously, which priced with spreads between 100bps and 200bps. The bank subsequently made a rights issue as well. In theory, says Mr Morgan, fixed coupon bonds are still more cost-­effective than having to make dividend payments on equity. Moreover, the coupon payments are deducted for tax purposes, further reducing the relative costs of servicing hybrids.

The wider picture

However, Miles Kennedy, a partner in the financial services advisory division of PricewaterhouseCoopers (PwC), argues that banks will need to consider the wider picture. “You cannot single out one layer of capital and say that it is economically cheaper, you need to look at the whole capital structure as a portfolio. And as a portfolio, it costs what investors collectively demand from the asset side, given the nature and risks of the assets,” he says.

Complexity out of favour

The difficulty of assessing the impact of hybrids on a bank’s overall balance sheet may have played a part in the decision to prioritise equity issuance, according to Mr Kennedy. He believes the loss of equity from bank balance sheets has prompted a greater focus on core Tier 1 capital as a measure of ­solvency. “There has been a general reassessment of the merits of ordinary equity as a source of funding, and a bit of a reaction against complexity – to the extent that any mezzanine capital instruments are complex, there is a disinclination to focus on them,” he says.

In the wake of a credit crisis, triggered by fears over structured products, the sentiment among issuers is also shared by the investors and indeed the regulators. Originally, alongside the implied increase in gearing and higher return on equity, part of the appeal of hybrids to the issuers was the range of tools they offered for managing the capital base.

National variations

These tools include different capital tiers – Tier 1 coupons can generally be deferred permanently if a dividend is waived, upper Tier 2 is deferred on an accrual basis for payment in better times, and lower Tier 2 implies repayment subordinated to senior debt only in a restructuring situation. In addition, the bonds may be perpetual, most often non-callable for the first 10 years or there may be voluntary or mandatory conversion to equity, as well as payment-in-kind toggle clauses on the coupons instead of outright deferral.

Regulators in each country have divergent approaches to what classifies as permanent capital, as well as setting varying limits on the maximum proportion of the capital base that can be composed of hybrids. “As a rule of thumb, we can say the more generous the regulatory cap, the greater the amount of hybrids there are in banks’ capital structures,” says Matthias Ogg, an analyst on the New Instruments Committee at Moody’s. “For instance, in the UK or Ireland, banks can add up to 50% hybrids to their Tier 1 capital.”

In contrast, as there is a tighter hybrid cap in Germany, Switzerland and France, banks there tend to be less reliant on hybrids, while usage in Asia (excluding Japan) is lower still. The ratings agencies themselves tend to use 25% as the limit for hybrids in a bank’s total capital – beyond that level, they are likely to stop applying the benefits of the equity content in hybrids when considering the bank’s overall credit ratings.

The bewildering variety of instruments and regimes “makes life pretty difficult for investors; it has bred a small army of specialists on the buy and sell sides to be able to structure and trade the instruments, to value them and look at relative value; they are much more complex than equity at one end or senior debt at the other,” says Mr Morgan of RBC.

Eligibility criteria

In 1998, the Basel ­Committee for Banking Supervision issued a press release from a meeting in Sydney, Australia, setting out eligibility criteria for hybrid capital. It has taken another decade, until April this year, for the Commission of European Bank Supervisors (CEBS) to propose guidelines for a common EU interpretation of those criteria.

However, these proposals have divided opinions, including those among the supervisory community itself. The UK’s Financial Services Authority (FSA) favours a strict definition which has not met with approval elsewhere in Europe. The authority recently issued a paper making a distinction between what it calls “going concern capital” that can absorb losses during the usual course of business (just as equity itself does) and “gone concern capital”, corresponding to the lower Tier 2, where coupons can only be cancelled in financial distress conditions.

A helpful distinction

Mr Fell from PwC believes this distinction is helpful, especially given the dangers of liquidity risk for banks pushing the safety limits of their capital ratios. He explains: “This point had not been put quite that clearly until the FSA issued its paper: if you are getting anywhere near relying on the ‘gone concern’ capital, then you probably can’t raise any more capital or any liquidity anyway, because no one is going to lend it to you, so it all pushes back to keeping capital simple, and keeping the quality of capital high.”

Capital management

Mr Morgan of RBC agrees, pointing out that there is little to no capital management advantage as a going concern to issuing a lower Tier 2 hybrid rather than straight senior debt.

He also supports the efforts of the CEBS to consider harmonising definitions as a means to create a level playing field for bank capital management and hybrid investors alike. By contrast, the British Bankers’ Association responded to a consultation paper in February by warning that CEBS had “unnecessarily embellished” the Sydney press release, “so that its proposals are overly prescriptive requirements and do not recognise the differences in company law, insolvency law and tax regimes that exist in different member states, which CEBS cannot solve”.

In the corporate world, sentiment toward hybrids also took a heavy knock in April, when French media and technology firm Thomson announced that it would eliminate its dividend for the previous financial year. This opened the possibility of the company deferring the coupon payment on its hybrid in the fourth quarter of this year, prompting a sharp sell-off in the bond towards distressed price levels.

No corporate hybrid analogy

However, Mr Morgan emphasises that bank hybrids are not directly comparable with corporate instruments. He explains: “Corporates have no regulatory requirement to have a certain amount of capital supporting their business, they got into this in a bull market when you could sell almost any capital structure.” The main aim of deeply subordinated corporate debt with coupons that could be permanently deferred was to win equity-style uplift to issuer credit ratings. This allowed the companies to gear up, raising return on equity without increasing the cost of senior debt significantly.

By contrast, at least 90% of hybrid issuance still originates from financial institutions, for whom these bonds play a very different role, as part of the overall regulated capital ratio. “A bank may well decide independently of the regulator to eliminate the dividend on the shares to rebuild reserves, but not to pay a coupon on a hybrid would be something they would have to discuss with the regulator,” says Mr Morgan. Consequently, he does not anticipate any spill-over in negative sentiment from the corporate hybrid market into the financial institutions sector.

Maintaining market access

Moreover, in view of banks’ constant rolling financing needs from the market, deferring a hybrid coupon would be an absolute last resort even if it made economic sense for the institution, because a deferral could shut the issuer out of credit markets for some time. Mr ­Ghafur cites the example of Japanese banks in the late 1990s, when there were ­questions over whether they would choose not to exercise the call option at 10 years on their perpetual hybrids. This sparked a temporary sell-off as the market reconsidered the synthetic 10-year maturity that had been assumed in pricing the bonds. “In practice, even though the replacement refinancing instrument was more expensive, the Japanese banks still refinanced. There was no legal obligation to call the securities at the first call date, but to keep market access open for themselves and maintain investor confidence, this was exactly what they did,” he explains.

Still a valuable tool

However, Mr Ghafur notes that, beyond Japan, there have been very few precedents in the decade since the Sydney press release to help markets understand how hybrids might perform in stressed conditions. “On the European side, there are very few examples of banks deferring or skipping payments on these hybrids. In the US, we have seen people cutting dividends on ordinary shares, but deferrals on hybrids have been limited to only a few isolated instances of small regional banks,” he says. This leaves a degree of uncertainty for credit markets as they reassess the appropriate premium for the subordination and the risk of deferral built into hybrid instruments.

Even so, there is a widespread consensus among market participants that the hiatus in European hybrid issuance is unlikely to extend beyond the current difficult conditions, and the primary market should pick up again during the next 12 to 24 months. “There is always going to be a need on the bank side to have a high level of hybrid capital as part of active balance sheet management, driven by regulatory and by ratings agency considerations alike,” says Mr Ghafur.

Mr Kennedy at PwC adds that financial markets always need to innovate in order to grow, and in particular will ­continue seeking better matches between the needs of investors and those of issuers.

“If there is an enduring shift, it might well be that the more innovative forms of capital funding will play a part in displacing simple debt or subordinated debt, as opposed to displacing equity, because the shift is essentially to favour higher levels of equity capital, with perhaps an enduring concern over the availability and reliability of wholesale funding for the balance sheet,” he ­suggests.