European banks have given up waiting for clarity on the final form of capital regulations, and began issuing new Tier 2 hybrid bonds to strengthen their capital structures. Asian high-net-worth individuals proved a fertile source of investment, and UBS was able to combine its Asian presence and private banking expertise to exploit the opportunity.

European banks have finally tired of waiting for regulatory clarity on their future capital requirements, and they have been bringing forward capital securities issues in greater numbers. A popular tactic has been to target the well-heeled end of the retail market, with a particular eye on Asia. That plays to UBS’s strategic preoccupation with wealth management as well as its investment banking skills, and the bank’s debt capital markets (DCM) team has led a goodly proportion of these recent deals.

The financial crisis exposed the weaknesses in the role of banks’ hybrid debt capital, supposed to absorb losses but designed to work in a bankruptcy court rather than a global meltdown. When it came to the biggest banks, the too-big-to-fail institutions, either the subordinated debt did not absorb the losses because the bank was bailed out or it did so in an ad hoc way. In a few cases, it was simply too late because the bank failed. So at the behest of the Basel Committee on Banking Supervision, regulators have been addressing this issue along with all the others arising from the crisis.

US, Japanese and Swiss regulators have rewritten their rules to ensure that, in the future, subordinated debt capital does the job it should, stepping in before the taxpayer has to. In Europe, however, where bureaucracy is further complicated by a multiplicity of institutions and interests, the wheels are still grinding. In August it became clear that adoption of the Capital Requirements Directive IV (CRD IV), delayed once already, was not going to happen as promised by the beginning of 2013.

European banks, like most, have been under pressure to strengthen their capital base. Until now, many have been holding back in the hope that they could issue against clearly defined regulations.

“Banks knew they needed more capital,” says Barry Donlon, UBS head of corporate and capital syndicate, DCM, for Europe, the Middle East and Africa (EMEA), “but they lacked clarity as to what form that capital should take.”

Time to move

Once it became obvious that the wait was far from over, some institutions lost patience and pressed on with transactions, structuring them as best they could. The attractions of hybrid debt capital are plain to see. “These instruments are more cost-efficient than equity,” says Johan Eriksson, head of DCM capital solutions EMEA at UBS. He points out that equity costs anything from 12% to 15% after tax, compared with less than half of that before tax for a relatively simple Tier 2 – which is tax deductible. As they redeem existing dated securities, banks have been made even more conscious of the need to replenish capital.

“The regulatory uncertainty means many issuers were redeeming their outstanding capital deals as they reached their call or maturity dates without replacing them,” says Robert Ellison, head of financial institutions group DCM, EMEA, at UBS. “So capital has been drained from the system, which is rather ironic given what the regulators are trying to achieve.”

If all the necessary elements for supply were starting to line up for hybrid capital securities, so too were conditions for investors. They had been seeing a considerable amount of their high-yielding investments mature, without comparable volumes of equivalent issuance to take its place.

Now there is a much healthier realisation that they are there to capitalise the bank, not to fund it. The risks are better defined, and the returns are higher

Barry Donlon

The result was something of a tipping point, as issuer impatience coincided with an uptick in demand, at least from wealth management investors. That was a welcome development, since Tier 2 securities had not been in favour with traditional fixed-income investors. Holders had a torrid time during the crisis, and the instruments’ extreme volatility left a bad taste in many institutional mouths, making them difficult to own.

“There is no audience among traditional equity investors for what essentially remains a debt product and the past three years saw a narrowing of the mandates among many traditional fixed-income investors,” says Mr Ellison. “This trend has started to reverse, but in the meantime, these products are getting a particularly strong reception with ultra-high-net-worth investors who have more flexible mandates.”

Change of perception

There was also a sense that the perception of Tier 1 and Tier 2 paper had changed. “Pre-crisis, they were sold as bonds, and the risks were less well understood as we went into the crisis,” says Mr Donlon. “Now there is a much healthier realisation that they are there to capitalise the bank, not to fund it. The risks are better defined, and the returns are higher.”

The depth of retail appetite was demonstrated in July when Russia’s VTB issued $1bn in unrated perpetual Tier 1 notes, paying 9.5%. With Citi, UBS and VTB Capital as joint leads, this was the first ever Russian perpetual transaction. It was designed in forward-looking fashion to comply with Basel III (not yet implemented in Russia), and was the first ever deal to build in an automatic capital buffer, at the point of introduction, of ‘going concern’ principal loss absorption. A full 77% went to retail investors, with half of that share going to Asia and Switzerland combined.

Once the penny had dropped over CRD IV, ABN Amro elected to follow up a euro-denominated 10-year bullet Tier 2 issued in July and aimed at institutional investors, with a dollar Tier 2 targeting Asian private banking clients. This was a $1.5bn 10 non-call five deal, its first US dollar capital transaction since its precursor was acquired in 2007.

In the absence of European legislation, one potentially problematic area is documentation of the ‘point of non-viability’ (PONV), the point at which the regulator triggers loss absorption. “Either PONV relies on a statutory regime, or you need contractual terms,” Mr Eriksson explains. “ABN Amro decided to address PONV through reference to a statutory regime.”

Investors seemed fairly comfortable with that, judging from the order book of $6.4bn, allowing the coupon to be set at 6.25%, inside the original guidance of ‘mid to high 6%’. Private banks took 88% of the issue, with 69% going to Asia and another 17% to Switzerland – UBS itself had the largest private banking allocation in the book.

Erste Group Bank followed with an inaugural US dollar capital deal and the first capital transaction from an Austrian bank in more than 15 months. This was a 10.5 non-call 5.5 structure which took advantage of the prevailing Asian appetite, roadshowing in Hong Kong and Singapore, as well as London and Switzerland. Even though Erste is not a particularly recognisable brand name in Asia, the deal attracted a $1.6bn order book and the issuer was able to price $500m at a coupon inside guidance of 6.375%. Here too, private banks accounted for 84% of the issue, with 60% from Asia and another 14% from Switzerland.

Denmark’s Danske Bank also decided to target Asia, for the first time, with a US dollar 25 non-call five Tier 2 issue. It wanted more than regulatory capital, however. “Danske also wanted to add support to its ratings,” says Mr Eriksson. In order to be fully credited as equity by Standard & Poor’s, which it was, the issue featured optional coupon deferral as well as its long final maturity. With demand of nearly $8bn, the issue was sized at $1bn with a 7.125% coupon. Private banks bought 68% of the deal, while Asia-Pacific investors accounted for 58%.

More to come

On a global basis, this year UBS has led seven of the 15 bank capital transactions aimed at Asian private bank markets. Narrow that down to European (including Switzerland and Russia) issuers and its record is five out of eight. It anticipates more Tier 2 business in the near future, as the emphasis shifts from mere regulatory compliance to ratings.

“In the past, banks have gone for minimum cost structures with Tier 2,” says Mr Eriksson. “But with the normalisation of the market and of issuers’ priorities, rating capital has become more of a topic. For credit rating purposes, there’s not much difference between Tier 1 and longer-dated Tier 2 with deferrable coupons. So we are expecting to see more Tier 2 issuance.”

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