Innovative hybrid capital is no longer the first choice for banks when it comes to capital issuance, as the growth in non-step-up securities clearly illustrates, reports Alan McNee.

The Financial Institutions Group (FIG) is playing an important role as banks focus on strategies for raising capital. But a period of innovation in hybrid capital is now giving way to a relatively standardised, mature market. Paradoxically, much innovation on the part of bank issuers is now driven by the need to avoid their hybrid capital being classified as ‘innovative’ by regulators.

The growth of non-step-up securities (with no step-up in interest payments on the call date, such securities avoid the innovative tag) has been the most obvious example of this.

The motives for capital issuance vary between individual banks and countries, but certain factors are common – foremost among them, the need to bolster capital to fuel either balance sheet growth or acquisitions with ‘non-dilutive’ (in other words, non-equity) capital. Keeping as low an equity base as possible is vital to delivering good return on equity (ROE) figures, and the relative cost of issuing Tier 1 capital is very low compared to the cost of equity.

Anthony Fane, co-head of FIG debt capital markets at BNP Paribas (BNPP), says that although issuing Tier 1 capital has become more expensive recently, it remains very cheap in historical terms. “In 1999, when the first hybrid deal was done it was at above 200 basis points over Libor, whereas in early March this year it was down to around 50 over Libor,” he says. “This sort of issuance is cheap, in strong demand, and tax-deductible, and AA-rated banks receive satisfactory ratings agency treatment for small amounts of hybrid capital.”

Growing Tier 1 capital

Hybrid capital – an instrument incorporating characteristics of both debt and equity – is popular with banks because it doesn’t dilute equity, and also because servicing costs can be paid out of pre-tax earnings, thus reducing the banks’ tax bill.

Matthew Carter, managing director and head of syndicate, primary markets at Royal Bank of Scotland, says that an important spur for hybrid issuance was the 1999 EU directive which allowed banks to raise up to 15% of Tier 1 capital in tax-deductible hybrids. “From this point onwards, hybrid capital in the form of preference shares became the cheapest way to grow Tier 1 capital,” says Mr Carter. From 1999 onwards, European banks began issuing significant volumes of preference shares to raise hybrid capital.

Mr Carter says one of the other main drivers has been M&A. “A bank takes a big goodwill hit when it carries out a takeover, and this has to be funded by a combination of equity and capital.”

Both M&A and more organic balance sheet growth have played their part in capital issuance, although with a few exceptions – such as RBS’s acquisition of NatWest – there has been relatively little large-scale M&A activity in recent years. (This may be about to change, however, as suggested by the HVB/UniCredit deal.) Instead, banks have enjoyed a period of organic growth, with steady GDP growth in Europe resulting in balance sheet growth that needs to be financed.

Different perceptions

Regulators, ratings agencies and the perceptions of the equity markets are also important factors. Bert Piedra, managing director and head of FIG at Bank of America, says that when financial institutions look at raising capital, they are balancing the demands and perceptions of equity analysts, the ratings agencies and the regulators. “The desire to address an interest by one or all of these parties is what drives capital issuance patterns,” says Mr Piedra. “Equity analysts, for example, may be looking at the impact on share capital, share price and return on equity, while ratings agencies will be looking at ability to service debt.”

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Bert Piedra: institutions must balance demands of equity analysts, ratings agencies and regulators

Of the three – regulators, ratings agencies and equity analysts – regulators have perhaps been the most vital in influencing bank capital issuance patterns. Rules by the UK’s Financial Services Authority (FSA), for example, restricting to 15% the amount of Tier 1 capital which can be composed of ‘innovative’ hybrids, have helped boost issuance of non-step-up securities (in other jurisdictions, more than 15% of Tier 1 can be held as hybrids, but above 15% they become taxable).

Michelle Brennan, director in the financial services ratings group at Standard & Poor’s, says the regulatory treatment of capital is a key factor for banks and insurance companies when deciding how much hybrid capital to issue, or what the structure of the instruments should be. “You have to take into account both IFRS (international financial reporting standards) and Basel II when thinking about bank’s plans for capital issuance,” she says.

“Both have implications for how capital instruments might be considered. Some areas of banks’ business, such as retail and mortgage lending, might require less capital under Basel II, but this could be balanced out by higher requirements in other business lines. IFRS is still a work in progress, as the impact of IFRS on regulatory capital has still to be finalised in many countries. Some instruments currently classified as equity may be reclassified as debt under IFRS, and vice versa, so institutions may choose to structure future instruments in a way that takes this into account.”

Dictates of demand

Capital issuance is also influenced by the demand side of the equation. Spiro Pappas, managing director and head of EMEA bank coverage at ABN AMRO, says that perhaps the most important factor is the question of what investors will actually buy. “Issuers that had a free ride last year are now having to face up to the fact that spreads on bank capital are no longer a one-way bet. We’re increasingly finding that we have to address a wide range of potential investors, both retail and institutional, and execute on a range of markets. The key is flexibility.”

The growth of an institutional bid – in other words, consistent institutional appetite and liquidity – for non-step-up securities has been a key factor recently, says Anthony Fane of BNPP. “Another key development has been the rise of the retail bid; again, this has been crucial for non-step-up securities,” he adds.

However, Benjamin Katz, head of structured capital solutions for Europe at Lehman Brothers, is more sceptical about the novelty of retail investor interest. “I wouldn’t necessarily say retail investors have recently become more important as buyers of hybrid securities,” he argues. “It’s more accurate to say that we see a swing backwards and forwards between retail and institutional buyers, depending on market conditions. The two types of buyer have very different needs. Retail investors want coupon, and unlike institutional buyers are not concerned about credit spreads.”

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Benjamin Katz: retail investors not necessarily more important as buyers of hybrid securities

There has also been an expansion of the investor base for bank capital, from a broad pool who would traditionally buy lower Tier 2, to a pool that has moved down the capital structure and is now comfortable buying Tier 1. “Alternative investors – a category which includes structured investment vehicles (SIVs), and proprietary trading desks as well as hedge funds – are an increasingly important segment of the investor base. The SIVs are probably the biggest investors in the floating rate lower Tier 2 market. Hedge funds and other alternative investors have become very important across the credit spectrum,” says Mr Carter of RBS.

Non-step-up on rise

Whether sold to retail, institutional or alternative investors, the trend for Tier 1 issuance seems to be towards non-step-up preference shares. Richard Boath, head of FIG Europe at Barclays Capital, explains that hybrid capital is sold to fixed income investors at a spread to swaps, generally with a step-up in margin if not called. In the past six months, however, Barclays has issued €2.4bn of preference shares which have no step-up in margin if not called.

“Obviously, investors require a higher margin to buy these instruments, but from the issuer’s point of view these instruments have the advantage that they do not count as hybrids for regulatory purposes,” says Mr Boath. “If you are at your maximum of 15% of Tier 1 capital as hybrids, you are presented with three choices. You can issue equity, at a weighted average cost of 10% or so, which will dilute your ROE; you can deleverage your balance sheet, which is often unappealing; or you can do what Barclays did, by issuing a 4.75% coupon in euros. The latter is obviously the most preferable option.”

Mr Piedra of Bank of America echoes the view that since banks have been aggressive in putting in place efficient capital structures, they have typically already used up the 15% of Tier 1 capital which regulators allow to comprise innovative hybrid capital. “Regulators and ratings agencies tend to disapprove of step-up,” says Mr Piedra, “so the real innovation has been in how banks can issue non-innovative Tier 1 without step-up, while making the product as close to a fixed income security as possible.” The trend towards non-step-up structures seems likely to continue.

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