Melvyn Westlake reports on how the bank capital market is facing an uncertain future due to an anticipated slowdown and continuing debate among regulators, accountants and rating agencies.
The restless market for innovative bank capital has not been so agitated since its controversial beginnings in the US some six years ago. After the heady spree that has seen the market in Europe climb to e50bn from almost nothing in the late-1990s, a distinct slowdown is now in prospect. Some analysts even suggest that annual issuance may have passed its peak as it increasingly bumps up against regulatory limits in some countries.
On top of this, the actions of accountants and regulators are introducing new uncertainty. Britain's accountancy profession has startled the market with a ruling that appears to undermine the purpose of some cutting-edge instruments designed to be part of a bank's most valuable source of capital - Tier 1. And, before the end of the year, Britain's all-powerful regulator, the Financial Services Authority (FSA), will issue guidelines in an attempt to keep up with the financial engineers forever creating instruments with new features challenging accepted rules.
It is the continuous state of flux in some Tier 1 capital that makes it such a contentious subject, with no less than four separate bodies outside the market - the regulators, the tax authorities, accountants and credit rating agencies - applying different suitability tests.
As Tier 1 capital is the first line of defence for a bank that runs into difficulties, it is chiefly supposed to comprise retained earnings, and common equity, which has no fixed maturity and can absorb losses through cancellation of dividends. In Britain, and some other European countries, Tier 1 has also included perpetual preferred shares, which are something of a hybrid instrument, having both equity and debt features.
But, as the issuance of debt capital has tax advantages for a bank, which equity issuance does not, the financial innovators have built a raft of hybrid instruments that simultaneously qualify as Tier 1 regulatory capital and capture tax benefits. With the banks anxious to keep down their funding costs, it is this so-called innovative capital, restricted by regulators to 15% of total Tier 1, that has been booming in Europe.
US innovation
The trend started in the US, when bank-holding companies - which are not defined as banks or subject to the same regulatory limitations - began issuing instruments called trust preferred securities, through special purpose vehicles (SPVs) registered in Delaware. The Federal Reserve's approval of such instruments as Tier 1 capital in October 1996 caused howls of anguish in Europe and elsewhere, because the tax advantages of such instruments gave US banks cheaper capital and an unfair advantage over their rivals. "Since then, Tier 1 bank capital has been a world of turmoil," says John Gillbe, London-based head of group capital funds at Lloyds TSB, which has made three hybrid issues in the past two years.
"The level playing field was suddenly and dramatically tilted [by this US move]," he says. "Things have never settled down." Although both the Basel Committee on Banking Supervision and the European Commission have attempted to restore equality by establishing new rules of eligibility for hybrid instruments, these are still open to differing interpretations by national regulators. The various tax and regulatory jurisdictions, particularly in Europe, have resulted in differing criteria for tax deductibility and what constitutes innovative capital for the purposes of the 15% cap.
The mergers and acquisition boom really pushed the market forward, with European banks sharply boosting the volume of Tier 1 capital issues. The amount of innovative Tier 1 capital raised by European banks in 2001 was the equivalent of e16.5bn (excluding private placements), according to analysts at Morgan Stanley, a leading deal arranger. This was down some 27% from the peak-2000 level, although still the second highest issuance level.
Playing it safe
Demand for other, less controversial types of bank capital has also been strong. Issuance of vanilla lower Tier 2 debt rose around 8%, to reach the equivalent of e33bn in 2001, while the rather neglected upper Tier 2 and Tier 3 categories also saw some increase in activity last year, although at a much more modest level.
Investors, meanwhile, have seen bank Tier 1 instruments outperform most other asset classes, on a risk-adjusted basis, with credit spreads (over benchmark yields) narrowing by 60 basis points for double-A-rated banks last year; and by as much as 140 basis points for single-A-rated banks.
Few market participants expect such a good result this year. A fall of around 30% in Tier 1 capital issuance by European banks is widely predicted for 2002, in an environment of slower bank business activity and less encouraging takeover and merger conditions. Some of the more optimistic dealmakers are calculating that banks will find other reasons to come to market: to refinance maturing debt, repair balance sheets (if loan losses start rising), or simply to manage their balance sheets in the most tax-efficient way.
However, the accountancy and regulatory factors look likely to inject an element of caution into the market, at least in Britain, where banks have been especially active in raising hybrid capital.
A new ruling in late-January by the Accountancy Standards Board (ASB) in the UK has particularly provoked the ire of some bankers, who believe many accountants have an inflexible and excessively theological view of dynamic markets and instruments.
The heart of the matter is the attempt by bankers to achieve two contradictory objectives when raising hybrid capital. On the one hand, they want to convince the regulators that such instruments are akin to equity and qualify for Tier 1. That is, the instruments are perpetual, and interest coupons are deferrable and non-cumulative, and therefore carry no contractual obligation or liability. On the other hand, the bankers want to persuade the Inland Revenue that the instruments are akin to debt, because they are tax deductible in Britain only if the coupons are cumulative, and must eventually be paid.
The offshore option
The way that banks have chiefly squared this circle is by setting up SPVs registered offshore. A bank then issues cumulative debt to the SPV that, in turn, issues non-cumulative preferred shares to investors. Often such instruments also have call options after five years, or step-up features after 10 years, whereby the bank has a choice either of increasing the coupon to shareholders or calling the instrument, effectively making them redeemable rather than perpetual.
Complexity is the big disadvantage of such highly structured arrangements. And, in a pioneering move that stunned the market two years ago, Barclays Capital arranged an issue for its parent bank that side-stepped the SPV approach. Instead, it offered e850m of securities, christened reserve capital instruments (RCIs), directly into the market. Since then, several other banks have made direct issues, either RCIs, or closely-related instruments known as PROs (perpetual regulatory Tier 1 securities).
The RCIs, which are senior only to equity, qualify for Tier 1 inclusion and tax deduction. In the event that coupons are deferred, no dividend is allowed to be paid on ordinary shares. If the deferred coupons are paid eventually, the necessary money must be raised by the sale of additional ordinary shares. It is a very simple, elegant structure, says an analyst at another bank. The structure is applauded and criticised in equal measure.
ASB's preliminary findings
Crucially, the Urgent Issues Task Force of the ASB, which has been examining the distinction between equity and liabilities for UK companies in general, reached a preliminary view last October that would result in RCIs being classed as liabilities rather than shareholders' funds. This is because the obligation to issue shares to the value of a specific amount, in effect, constituted an economic transfer, say the accountants. It is a view that is set to be incorporated in a definitive ASB ruling (a public announcement was due as The Banker went to press).
To underscore the point, Morgan Stanley issued a research note entitled RCIs - Rest in Peace? suggesting that the FSA would have to accept the accountants' ruling and forbid future issues of the hybrid instruments. But David Lyon, head of financial institutions, debt capital markets, at Barclays Capital in London, and the person who invented RCIs, asserts: "Much of the commentary about these instruments is just plain wrong."
Absorbing losses
Whether RCIs are liabilities or shareholders' funds does not actually matter, Mr Lyon says. The important point is that these instruments are designed to be loss absorbing. They are also perpetual. And the issuer has an "absolute and unfettered ability to vary the timing and amount of payments", on them. "There is absolutely no obligation to pay anything ever," he says emphatically. This makes them more flexible than hybrid instruments issued via SPVs. Taking a swipe at certain tendencies of the accountancy profession, Mr Lyon says that because RCIs are not equity, the accountants decree that the only thing it can be is a liability, "irrespective of what the terms of the security actually say".
It is difficult to see who is supporting the ASB's ruling, as accountancy firm Ernst & Young was adviser to Barclays Capital during the development of RCIs; Pricewaterhouse-Coopers has approved Barclays Bank's accounts; and KPMG and Deloitte & Touche have, respectively, approved the accounts of Bank of Scotland and Abbey National, both of which have raised directly issued hybrid capital. On this basis, Mr Lyon says: "The market now has approval from the three key bodies - the FSA, the Inland Revenue and the accountants. It is a full house." He hints that he expects to be arranging further issues of RCIs during the course of this year.
Mr Lyon's confidence that the FSA will not rule against inclusion of such instruments in banks' Tier 1 capital seems justified. The authority's review is intended to provide greater clarity to this vexed area, but the new guidelines are not expected to contain any surprises when they are issued this autumn. Some bankers argue that it would not be possible to rule against RCIs without also bringing into question the eligibility of hybrid instruments issued through SPVs. The RCIs at least have the virtue of being much simpler and more transparent.
The Financial Services Authority, situated almost across the road from Barclays Capital, at Canary Wharf, in London's rejuvenated Docklands, says the way the accountants treat these innovative products does not necessarily dictate the regulator's policy. Compliance with EU Directives is the chief determinant of FSA policy.
EU Directives state that innovative capital cannot form part of a bank's minimum, 4% capital adequacy ratio for Tier 1. That part of bank capital has to be held in the purest form - equity and retained earnings (and genuinely perpetual, non-tax deductible preference shares). In fact, RCIs can be issued only by banks with capital adequacy ratios above 6%. (This does not pose a problem for most British banks, whose ratios range broadly between 7% and 10%.)
Rating agencies' dilemma
It is not just the regulators and accountancy profession, however, that are tussling with the concepts of hybrid capital. The rating agencies, which deploy their own stringent methodologies for assessing the quality of bank capital, are becoming increasingly uncomfortable at the growth of hybrid capital. The question is not the relative merits of directly issued RCIs versus preference shares indirectly issued through SPVs, but the growing reliance of some banks on all such kinds of lower-quality capital, say the agencies.
In a special report, prepared in May 2000, bank analysts at Fitch expressed concern at the trend growth of hybrid capital, indicating that if it continued "to any great extent", it could result in a reassessment of bank credit ratings."The factor that makes bank preference shares - and hybrid instruments dressed up as preference shares - look like debt is that if they do not pay a dividend this will be seen as a sign of weakness by the market and possibly lead to a run on the bank," says David Andrews, head of Fitch's financial institutions division in London. Dividend deferment may be allowed under the terms of the prospectus, but "it will seem almost like a default, even if it is not legally one", he adds. Fitch would treat it as tantamount to default.
Breaching the levels
Referring pejoratively to "Lower Tier 1 capital" - a term not formally used by regulators - Mr Andrews argues that traditional preference and innovative hybrid shares could pose a potential threat if, together, they start to exceed 25% of bank Tier 1 capital. In the case of at least one British bank (the Royal Bank of Scotland) and some Spanish and Dutch banks, this level has already been breached. For some Iberian banks, these instruments now account for a significantly higher proportion of Tier 1 capital than pure common equity, according to Fitch. For stronger banks - A-minus and above - the agency rates preference and hybrid shares one notch lower than senior debt.
Rating agency Standard & Poor's (S&P) is even more conservative, typically rating these instruments two notches below senior debt, in the case of the stronger bank (and three or four notches down for some weaker banks).
Caution ahead
Although there have been no problems yet concerning hybrid issues, the economic environment until recently has been supportive, and most of the instruments have been issued by stronger banks, cautions an S&P bank analyst. Like Fitch, if coupons or dividends are not paid on these instruments, the S&P rating goes straight to "D" for default, even though it is not legally one.
This may be logical from the perspective of the investor - the principal constituency of the rating agencies - but it sits uncomfortably with claims that hybrid instruments are designed to be loss absorbing in a stress situation. In fact, in the event of a stress situation, a deferment of preference or hybrid share dividends will result in those instruments being deemed by the rating agencies to be in default, damaging creditor confidence and possibly making a bad situation worse.
Such concerns are largely shrugged off by banks and their investment bank advisers in the face of shareholder pressure to maximise value. The investment bankers are still busily pitching deals across Europe. In a handful of countries, such as Greece and Denmark, the tax authorities have not yet granted tax concessions on hybrid instruments. If they do, banks from those countries will be potential new clients for the underwriters of innovative products. Other countries, such as France, are said to be considering whether to allow direct issues. There are not, though, a lot of new countries left to join the European market for innovative capital, as in 1999 and 2000. Many banks are getting close to their 15% ceiling for this kind of capital.
David Marks, head of bank relationships at JP Morgan in London, estimates that, on average, Europe's banks have filled about two-thirds of their 15% allowance for innovative capital. British banks have around e25bn in outstanding Tier 1 issuance, and have the capacity to raise another e10bn before reaching the ceiling, according to Morgan Stanley calculations. For Europe as a whole, banks have the capacity to raise a further e45bn of innovative capital, on top of the e50bn already outstanding.
In some countries, such as Italy, where there is still scope for some further bank consolidation, this could help drive issuance. Mr Lyon of Barclays says banks should consider raising hybrid Tier 1 capital in excess of the 15% limit and parking the additional sum temporarily in Upper Tier 2, until the expansion in the bank's business creates the requirement - and the headroom - to migrate it back to Tier 1. It makes economic sense (certainly for sterling issuers) because credit spreads for Tier 1 issues are at the lowest they have ever been and the spread differential between Tier 1 and Upper Tier 2 is the tightest for two years. This, Mr Lyon predicts, is unlikely to last.
Little room for expansion
Yet, despite such arguments for boosting market activity in the short term, some investment bankers concede that the scope for expansion in the medium term is distinctly circumscribed, at least as long as the present regulatory rules are in place. "You can see the end game," says one banker.
"The new Holy Grail," he says, "is to design a Tier 1 security that is tax deductible and falls outside the 15% limit." JP Morgan's David Marks adds: "Product developers will try to structure a true perpetual that does not have the step-up or call feature. Broadly speaking, it is possible in Europe to have up to 25% of Tier 1 capital in hybrid instruments if they do not include such synthetic maturity features [on securities above the 15% sub-limit]." That means the traditional non-tax deductible preference share, and equates to the 25% ceiling used by rating agencies, for all instruments that are not pure bank equity.