Although the amount of capital that European banks raised last year was small compared with their market capitalisation, the market was more active than superficial statistics suggest. Charles Lucas, global head of financial institutions at ABM AMRO Rothschild, reports on banks’ equity capital markets activities in 2003.

Financial institution equity capital markets (ECM) bankers spent 2003 focusing on rebuilding the balance sheets of insurance companies not banks. This was a continuation of a trend that started immediately after the World Trade Center disaster, which both substantially reduced the capital in the insurance industry and hardened premium rates, further increasing the need for capital. In the banking market, the picture and trends were rather different.

Graphs 1 and 2 show the issuance of new shares and sale of listed assets by European banks (both of which improved capital ratios either by increasing capital or reducing assets) from 2000 to 2003. In the context of the market capitalisation of the banks in ABN AMRO’s European research coverage universe (45 banks, E913bn market capitalisation as at December 1, 2003), the amount of capital raised was small.

However, the market was more active than these bald statistics might suggest and a number of significant transactions took place. For example, in November 2003 DEPFA Verwaltungsgesellschaft, the holding company that held a 40% stake in DEPFA Bank, sold its entire stake worth E1.2bn in an accelerated book-build transaction over two days. In May 2003, ING disposed of a 5% stake in ABN AMRO worth E1.1bn in one day, again in an accelerated book-build transaction. Both transactions improved the capital position of the vendors. The largest direct capital raising (E960m) was the Bank Austria Creditanstalt initial public offering in July 2003 that was driven by the parent’s (HypoVereinsBank) need for capital.

The plain vanilla equity markets were not the only story in 2003. A number of banks also tapped the convertible bond markets but, again, usually for the purpose of capital management rather than direct capital raising. A good example was HypoVereins Finance issue of E257m senior bonds exchangeable into its holding of E.ON AG. In July 2003, HypoVereins effectively contingently forward sold its stake in E.ON and obtained a reduced interest cost on its debt but no immediate increase of capital. HypoVereins capital ratio will increase only when the bonds are exchanged for E.ON shares.

Similarly Unicredito issued a E1.2bn bond convertible into its holding of Generali shares. The conversion premium was 30% with the bonds maturing in December 2008 and exchangeable from December 2005.

The dog that didn’t bark

What were the bank capital drivers in 2003 and what can they tell us about the outlook for this year? In 2001 and 2002, the market was concerned about the danger of bad debts. The spectacular failures of Enron, WorldCom, Global Crossing and in Europe the crises at Ahold and most recently Parmalat provided ample justification for such concern.

By the end of 2003, however, it had become clear that bad debts were “the dog that didn’t bark”. It turned out that bond investors were more exposed to these high profile crashes than the banks. Furthermore, the banks’ retail loan books proved resilient and banks had become far more skilful managers of their balance sheets than in previous economic slowdowns/recessions.

Possibly the most visible sign of this improved balance sheet management was provided by the explosive growth of the credit derivatives market, which provided banks with a flexible and cost-effective way of transferring credit risk to other parties. Who were those other parties? While it is not possible to say with certainty, anecdote suggests that a fair amount of the credit risk ended up in the hands of the insurance companies. If so, it should not be surprising that the insurers, not the banks, have been seeking new equity capital.

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Mitigating efforts

The banks cannot take all the credit though. Central banks were quick to ease monetary policy as the economy slowed, and low real and nominal rates made debt service easier for borrowers and mitigated the effect of the stagnant economy substantially.

Without bad debts consuming capital, the next best way of worsening ratios is to grow assets. Two things came to the banks’ aid in this regard. The very factor that made the market worry about bad debts – the slow (even negative) economic growth – had the benign effect of reducing demand for credit. And securitisation had come of age – that, combined with the possibilities that credit derivatives provided, allowed banks to reshape their asset portfolios and thereby to reduce their aggregate risk weightings.

For every generalisation, there is always at least one glaring exception: the continued increase in mortgage lending in the UK is hard to ignore as is the strong house price appreciation in markets such as Ireland, the Netherlands and Australia. However, residential mortgages are only 50% risk weighted to start with and are easily securitisable, and after Basel II is implemented will attract a lower risk weighting, further reducing capital strain for mortgage lenders. To grow balance sheets and preserve regulatory ratios, there could hardly be a better asset class. As shown elsewhere in this supplement, residential mortgage lending will be a prime beneficiary of Basel II and can be easily financed through the growing covered bond market.

Not all good news

But not everything went the bankers’ way: the equity markets slumped, M&A activity almost halted and credit demand was slack. The most direct impact of the equity market declines from the peak in 2000 was on banks with substantial life assurance operations. The combination of declining asset values and increasing liabilities (caused by lower interest rates) eroded the capital bases of the life insurance divisions and in many cases required capital injections.

To address lower profitability, banks focused on operational improvements to improve their pre-provision earnings and by and large most banks were successful. For example, in the main, cost/ income ratios are lower today than had been the norm when life companies were growing rapidly and new business strain was weakening performance ratios.

Short-term predictions

So much for the rear view mirror. What is the outlook for banks’ equity requirements in the short and medium term? Predicting the future is always a chancy business but at the time of writing, a modest global economic recovery seems likely. US economic growth will not maintain the breakneck pace set in the third quarter of 2003 but it does seem likely to continue. Europe is forecast to grow modestly and Asia rather faster. The key to the economic out-turn for this year seems to be the US dollar, which will be particularly relevant for European and Asian banks owing to the export focus of so much of European and particularly Asian industries.

But, notwithstanding the uncertain (but broadly positive) outlook, the steps that banks have taken to address the issues of the past few years leave them well positioned for the future. Fundamentally improved pre-provision returns resulting from operational improvements have enhanced the banks’ ability to generate retained earnings despite increases in risk-weighted assets. And the banks will continue to manage their balance sheets actively through the use of credit derivatives and securitisation. As William Ross, global head of asset securitisation research at ABN AMRO, suggests in his article on page 14, securitisation will evolve rather than cease to be a funding and capital management tool for banks.

Put simply, it does not seem likely that the banking sector will be seeking substantial amounts of new equity capital this year. That is not to say that individual banks will not raise capital for particular reasons. Not every bank looks like the average bank and particular situations, such as acquisitions, will create the need for incremental equity capital.

A good illustration of this was Bangkok Bank’s issue at the end of last year of Bt28bn ($700m approximately) of new shares. The purpose of the issue was to refinance Tier 1 hybrid securities known as CAPS that had been issued in 1997 to bolster capital ratios following the Asian financial crisis. Unsurprisingly given the circumstances when they were issued, these CAPS carried a high rate of interest.

But Bangkok Bank’s capital ratios were healthy and, in theory at least, the CAPS could have been refinanced with new, lower cost hybrid securities. The bank preferred to issue new equity, despite the dilutive effect, to ensure that in the long run it has a strong equity base to fund the expected growth in demand for credit as the Thai economy continues to grow at above trend rates.

Accelerated book-builds

While 2004 is unlikely to bring a significant sector need for equity capital as in the insurance sector in 2002 and 2003, individual banks will use the equity markets to manage their capital positions. The process of unwinding cross-shareholdings is likely to continue and banks will dispose of parts of their industrial share portfolios.

A striking trend in the equity market in recent years has been the increased use of accelerated book-build transactions to execute secondary placements. Previously, large blocks of shares tended to be placed with investors, with the benefit of extensive marketing over a period of days (even weeks) allowing the investment case to be widely marketed. While this marketing was a benefit, the time taken to market the shares carried a cost. Increased market volatility and the activities of hedge funds (some argue that the two are linked) exposed the seller to the risk of unacceptable price falls while marketing was under way.

Far narrower discounts to the market price are possible by placing a block of shares within a single day, collecting orders from interested investors over a few hours, then selecting the market clearing price and allocating the shares to investors. Deal size is not a barrier. For example, in May 2003, ABN AMRO Rothschild acted as joint global co-ordinator and bookrunner for the sale of E1.1bn of ABN AMRO shares being sold by ING. The shares were placed at a discount of 5.2% with 387 investors in 23 countries within a few hours.

Graph 3 shows the value and number of accelerated book-build transactions executed in Europe in 2003. In total, about E35bn shares were placed via 140 accelerated book-build transactions. By contrast, there were only three fully marketed offerings with a total value of E1.5bn.

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Likely impact of Basel II

The impact of Basel II is likely to be more subtle than eye catching. This seems a shame because implementing Basel II is going to be an expensive exercise for the banks, at least as far as complying with the requirements for enhanced risk management is concerned.

With regard to raising equity, Basel II will have an impact on banks’ behaviour only if it meaningfully changes their capital headroom.We do not expect this to be the case (see interview with ABN AMRO chief financial officer Tom de Swaan, page 6). No bank runs its capital at the regulatory minimum – a bank with a Tier 1 ratio of 4%, while technically within the rules, would be grossly undercapitalised in reality – nor at the higher minimum set by its local regulator (even the most daredevil bank operates with some capital headroom).

There are a couple of reasons to believe that Basel II will not have an impact on the requirement for new equity. The principal object proposed in the accord is a change in the way assets are measured and valued from a risk perspective. But changing the measuring methodology does not change anything in reality. No bank will be better or worse capitalised after Basel II than before.

The rating agencies are of the same opinion. Standard & Poor’s response to Basel’s third consultative paper was very plain: “Banks that substantially reduce their capital on the basis of [Basel II] as a result of metrics with which S&P does not agree, could be downgraded.”

Second, will Basel II’s new measurement method (plus the addition of a new capital requirement in respect of operational risk) give results that are markedly different from those under the previous regime? The accord is already the product of compromise between conflicting national requirements, each one aimed at preserving particular positions. For example, Germany wants to ensure that the effect of Basel II is not to starve the Mittelstand of credit. By the time Basel II is implemented, the capital measurement process will be more complicated and more transparent but will the end results be so different from Basel I?

For all this, while Basel II’s impact on banks’ Tier 1 capital requirements may turn out to be slight, the accord’s approach and philosophy is likely to affect banks significantly in other but more subtle ways.

Equity is the real thing

Today banks have a wide range of tools with which to manage their capital positions. For example, they can manage assets using securitisation, loan participations and sales and credit derivatives. Their equity capital can be supplemented with Tier 2 subordinated debt and boosted by Tier 1 hybrid instruments.

There are many ingenious solutions to banks’ capital needs but it must not be forgotten that the first step anyone takes when analysing a bank’s capital ratios is to adjust for the non-equity capital. Equity is still the ‘real thing’ and is the basis of a bank’s creditworthiness. Thus, while for 2004 there is unlikely to be a sector wide trend for equity capital raising (indeed higher dividends and/or buybacks are likely to be a feature of the market), ECM bankers will continue to be active in optimising Tier 1 capital.

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