Recent positive noises from the Basel Committee have eased concerns among banks about what instruments will count as Tier 1 capital in the future. But huge uncertainties remain over what form future regulation will take, in particular regarding hybrid debt. Many banks could find that they are forced to revisit a now saturated market for bank equity issuance; either that or come up with more innovative ways of boosting capital ratios. Writer Charlie Corbett

Several events in recent months have conspired to brighten the outlook for the world's banks. After two years struggling with the impact of the financial crisis and labouring under the 'global pariah' tag in the eyes of the public and regulators alike, some light has entered the tunnel.

Solid results for the first half of the year aside, the much anticipated stress tests of Europe's banks produced an almost spotless bill of health. Out of a total of 91 banks tested, just seven failed the Committee of European Banking Supervisors (CEBS) tests. Despite some early criticisms from the media that the CEBS tests were "secretive, rushed and rather unconvincing", the news in July was met with large sighs of relief in the industry, followed by a burst of optimism. Almost immediately after publication of the stress test results, banks across Europe rushed to the bond market and issued billions of euros worth of debt to willing investors. After a drought of supply this year, it was like manna from heaven.

Perhaps more significant for the banks than the stress tests, however, were the positive noises emanating from the Basel Committee. After two years of almost frenzied equity-capital raising to boost Tier 1 capital ratios and pay off government dues, it appears that the Basel Committee is taking heed of banks' self-flagellation and could be prepared to soften its stance on the reform of capital and liquidity.

First announced in December 2009, the Basel Committee's proposals for a reform of its Basel II recommendations on banking laws and regulations (dubbed Basel III) sent shudders down the spines of bankers. The aim of the reform was to tighten the rules regarding Tier 1 capital and create an environment whereby, in any future crisis, it was the industry that bailed out banks and not the taxpayer.

Moving the goal posts

Of particular concern to bankers were proposals to redefine what securities could be classed as Tier 1 capital. At the centre of the committee's sights was hybrid capital. Always controversial, hybrid capital is popular with banks because it has features of both debt and equity. It is cheaper to raise than equity, is non-dilutive and, importantly, it could - under certain circumstances - until recently be classed as Tier 1 capital.

However, the ability of hybrid capital to absorb losses during the financial crisis proved to be severely impaired and its reputation as a good grounding for banks' balance sheets lies in tatters. Regulators are determined to reform it.

The Basel Committee's tough stance sowed a substantial measure of panic and confusion among the banking industry. Credit Suisse banking analysts estimated at the time that, if definitions of Tier 1 capital changed along the lines of the proposed Basel III recommendations, then the European banking industry would have to find a total of €1100bn in order to boost capital ratios to the required level.

This would, of course, have to be achieved through equity issuance and retained earnings: not a pleasing prospect for the world's banks given the record volumes of equity already raised in 2009. A further rush by banks to the equity market in 2010 could prove disastrous for many, as the capacity of global investors to absorb such supply is highly questionable.

"It remains a bit unclear, but what is certain is that if banks need further equity, it will be a rush to the market and it will be a case of 'first come, first served'," says Thierry Olive, head of equity capital markets at BNP Paribas. He also warns of unintended consequences.

"In this case, banks will try to avoid raising extra equity and will instead reduce risk-weighted assets such as lending. It is sound management behaviour not only to raise equity but also to review and reduce lending," says Mr Olive.

Softening stance

However, nine months on from its initial proposals, it appears that the Basel Committee has decided to soften its approach. It is this change of heart, and not the stress tests, that has had the biggest impact on banks' confidence in the past few months, according to Martin Thorneycroft, head of European equity syndicate at Morgan Stanley.

"It has reignited demand for banks among investors and it could also see the return of long-only investors prepared to step into the fray," he says.

While still determined to put the onus of clearing up any future financial crisis on bondholders rather than governments, it appears that the Basel Committee might be prepared to accept as Tier 1 capital some of the more innovative forms of hybrid financing that banks have come up with.

While this has been met with some relief by bankers, it does not yet bring complete clarity to any future definition of Tier 1 capital. This uncertainty has almost completely halted issuance of hybrid capital. In 2010 just a handful of banks have been prepared to risk issuing hybrids before the new rules are codified. Two of those banks are HSBC and UniCredit. Both have attempted to come up with structures that meet the requirements of Tier 1 capital today and potentially in the future too.

In June, HSBC took advantage of US investor demand for yield by issuing a $3.4bn Tier 1 hybrid bond, while UniCredit issued a €500m hybrid bond in July. To some it would appear to be slightly audacious to issue a hybrid at such an uncertain time.

"The European Commission's Capital Requirements Directive [which will implement certain Basel restrictions] is coming into force at the end of 2010, so why issue non-equity hybrid Tier 1 capital before the regulations have been set in stone?" asks one product specialist.

However, in the case of the HSBC and UniCredit deals, certain clauses have been included that mitigate the regulatory risk. HSBC has inserted a so-called 'grandfathering' clause into the deal that allows its hybrid instrument to be flipped into non-cumulative preference shares should the rules change in the future. Investors can also redeem their investment at par. In the case of UniCredit, investors can also redeem at par if the deal fails to qualify as Tier 1 under Basel III.

Equity Raisings by Banks, 2008-10 (year to date)

Equity Raisings by Banks, 2008-10 (year to date)

Weak appetite

Peter Jurdjevic, head of the capital products group at Barclays Capital, says that the HSBC and UniCredit deals "point to the future" of all hybrid issuance. UniCredit's deal contains a loss-absorption provision that allows for interest payments to be suspended and the value of the instrument to be written down should the bank's capital fall below a certain level or a 'loss event' occur. The big question, however, is who would be prepared to invest in a security that offers, ultimately, so little security?

According to Mr Jurdjevic, these deals appeal to hedge funds, as well as private clients and high-net-worth investors looking for yield. "That market is more accepting," he says. But he stresses that the key to issuing such instruments successfully is to "know the structure for achieving the best execution and incorporate the flexibility to deal with future rule changes".

Ultimately, however, what bankers need to work out is how to balance compliance to the new rules with healthy returns for investors. Despite the success of UniCredit's deal, some in the market have raised concerns. One banker close to the deal says that there are too many "discretionary elements" to it. For example, what exactly is a 'loss event' and how does the bank and/or investor know when one has occurred?

"More transparency needs to be put into the documentation defining when loss events occur," says the banker. "When might the coupon be deferred? When might the principal not be written down?"

Mr Jurdjevic believes transparency is critical. "Banks are trying to design these instruments in a way that keeps investors happy, issuers happy and regulators happy," he says.

"We need to develop products that are as certain and transparent as possible but that also provide sufficient discretion for the issuer and regulator over payments to ensure that the instruments absorb losses for the bank in a time of need."

Comfort and confidence?

Nick Williams, head of equity capital markets for Europe, the Middle East and Africa (EMEA) at Credit Suisse, says Basel's announcement that its recommendations concerning capital requirements will not be as harsh as originally anticipated, combined with July's clean bill of health for most European banks after the stress tests, have created an atmosphere of "comfort and confidence" in the industry.

"Basel's latest guidance suggests that the ultimate recommendations will not be quite as draconian as some had feared. As a result, the market is no longer expecting the round of further capital raising to be as extensive as those we've already seen," he says.

However, Mr Williams agrees that the industry needs more clarity from regulators and politicians alike. He says: "There continues to be some tension and uncertainty between the requirement to lend and the need to be more prudent with capital."

It is this paradox that lies at the heart of the banking industry's uncertainty. However, the situation is changing, according to Mr Williams, and "regulators are now more constructive in their tone" than they have been in the past.

You should CoCo

Another source of potential non-equity Tier 1 capital for banks, and arguably another source of regulatory uncertainty, is the contingent convertible instrument - otherwise known as the 'coco'.

This instrument aims to remedy the ineffectual nature of hybrid instruments at absorbing loss in a crisis. The coco converts into equity if a certain agreed trigger point is reached, for example if a bank's core Tier 1 ratio should fall below 5%.

By making the bondholders, and not the taxpayer, responsible for the future financial health of the bank in a crisis, cocos have a strong chance of being accepted as Tier 1 capital by the regulators. The signs are already positive. As The Banker went to press, the Basel Committee said it would give an update of its views on "the use of contingent capital for meeting a portion of the capital buffers" some time in September.

Both Lloyds Banking Group and Rabobank have issued cocos this year, in advance of any final sign-off of their status as Tier 1 capital. In the case of Rabobank's €1.2bn deal, if the bank's equity ratio breaches 7%, 75% of the note's face value will be written down and converted to core capital, with the remaining quarter returned to investors.

Cocos are designed to absorb losses in a crisis and will ensure that bondholders pay closer heed to a group's financial health and do not simply rely on governments to bail them out in bad times.

However, a number of obstacles lie in the path of a rush by financial institutions to issue cocos. Not only do the ratings agencies not yet consider them worthy of a rating, but few investors are likely to buy a product that offers so much risk with evidently so little return. It is also a market open only to the biggest and healthiest banks. Smaller, less well capitalised banks will struggle to attract support for an instrument that converts to equity just at the point when investors want the security of debt.

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David Soanes, UBS' head of financial institutions group for investment banking and global capital markets, EMEA, and deputy head of the bank's global capital markets

Funding paradox

David Soanes, UBS' head of financial institutions group for investment banking and global capital markets, EMEA, and deputy head of the bank's global capital markets, points to a "financial apartheid" that is developing in the industry. "We live in a 'have nots' and a 'have lots' market," he says. Mr Soanes is alluding to the paradox that those that do not need to fund will be able to fund, and those that do need to fund will be unable to.

Mr Soanes is also concerned that the market is being overly optimistic about how forbearing the regulators will eventually be about hybrid instruments. "On top of that is the capacity issue. Is there actually demand for these instruments and will they be tax-deductible?" he asks.

"There are lots of issues still to work through. On the fixed-income side, for example, a product that mandatorily turns to equity will take some getting used to."

Looking ahead, banks will have to continue to wait and see before any certainty comes from the regulators. This will continue to hinder issuance and force those in charge of funding to be ever more innovative.

One thing, however, is certain. Following the crisis, balance sheets will never be the same again. "People still have to deal with the reality that we're not going back to where we were before the crisis. Banks are going to need stronger balance sheets and this will have an impact on overall return on equity," says Mr Williams.

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