The question of capital is becoming a big headache for banks. Subprime and structured product write-downs, and to a lesser extent Basel II, are compelling them to raise more capital.
While a number have decided to sell equity stakes to sovereign wealth funds to boost their Tier 1 ratios, and others might be forced to follow Société Générale (SocGen) and launch rescue rights issues, resorting to equity markets will be only part of the remedy. Many bankers and analysts in Europe and the US believe that Tier 1 hybrid issues, and also to a lesser extent Tier 2 issues, are set to increase despite the costs.
Favoured route
Analysts at credit research provider CreditSights said in January that, given the outlook for further write-downs and provisions, “the five to seven biggest US banks alone could look to raise about $20bn to $25bn of Tier 1 capital to address the asset write-down impact on their regulatory capital, with hybrid securities likely to be favoured for this funding purpose”.
In 2007, US financials issued about $46bn of hybrid securities, itself a significant increase on 2006 and 2005. But Credit Sights estimates that for 2008 the biggest US banks have an additional “issuance capacity” of about $50bn, with the broader banking sector taking that figure to nearly $62bn. But, it warns, “demand disruption” means that the market could probably take no more than 30% to 50% of this extra issuance.
CreditSights forecasts a total high-grade fixed rate issuance of $385bn-$400bn for the US, compared with about $320bn in 2007.
European banks might step up issuance, too, say some analysts, even though they issued about $62bn of Tier 1 hybrids in 2007.
“We’re expecting a lot of hybrid supply to hit the market this year and we’re forecasting the market to see up to a 5% increase on 2007. Hybrid issues are cheaper than equity and non-dilutive,” says Jackie Ineke, head of European financials in fixed income research at Morgan Stanley.
Expensive hybrids
The start of the year is usually quiet, although groups such as SocGen (before its rogue trader scandal), UBS and Storebrand are testing the market, and it is already clear that hybrid securities will be expensive for banks. Spreads are typically running at 250 to 350 basis points, and at the time of writing the Kaupthing and Landsbanki issues were at more than 700 bp. Overall, it is now more expensive for European banks to finance themselves in the debt markets than for their corporate clients – a state of affairs that is rare and that most analysts believe is a temporary anomaly that should be corrected later this year. However, this will be worrying for banks considering going to market, and is affecting supply. Some observers say spreads might tighten slightly but Ms Ineke disagrees. “Investors are expecting plenty of supply and are happy to wait,” she says.
Other bankers point out that, although some investors held back last year, the investor base has shrunk since the first half of last year, with special investment vehicles, for example, all but out of the picture. Analysts also point out that investors are becoming more keenly aware of the risks they bear, especially as in recent years some offerings have allowed banks to extend indefinitely the maturity of their hybrid securities or to defer payments if they are in difficulty.
The wide spreads will hit their net interest margin, but banks could be left with no choice except to access the market, probably in the period from March to July after the reporting season. They are unlikely to leave it until what is regarded as the final window in the year, in September-October, for fear of spreads widening even further.
| “Banks will have to raise capital or their lending will slow down, something that would be damaging for their corporate and consumer businesses,” says David Soanes, head of debt capital markets in the European financial institutions group at UBS. “And there is no shortage of investors in proven franchises. There will be an appetite for hybrids. Many investors have stood aside recently but, as spreads widen, they will come back. Issuers will include European banks, for many of which core earnings power has held up well.” |
Liquidity ratios
| David Marks, head of FIG DCM in Europe at JPMorgan, agrees. “For many banks there is no alternative except to raise more capital,” he says. “Regulators have been quite explicit in telling banks that they need to raise capital or else they will have to stop growing their balance sheets. |
Hybrid issuance will increase, despite the spreads, as many banks will be reluctant to access the equity markets and as there is a backlog from the second half of 2007. This higher cost of capital will not undermine anyone’s business model – the cost of liquidity might, however.”
Mr Marks and others believe that liquidity ratios will be as important as capital because banks have had to take an estimated $450bn on to their balance sheets from conduits, special investment vehicles and so on.
Not everyone agrees that banks will push up hybrid issuance, though: they could be forced to take more drastic steps to raise capital. Paul Fenner-Leitao, a director in investment grade research at Barclays Capital, says: “I don’t see European banks coming forward with a truckload of hybrid issues. We expect similar levels of new issue to 2007 and 2006.
“There will be some, and when supply comes it might feel like a lot because the window will probably be tight. But most of the big banks are near their maximum headroom for their non-equity portion of Tier 1. If they want to raise big-ticket, quality capital they will go to the equity or equity-linked market, as has already happened,” he says.
Challenging markets
Others also believe that market conditions will be too difficult, deterring banks from launching issues. Tiina Lee, head of northern Europe in the FIG team at Deutsche Bank, says: “The senior market, as well as the unsecured and the covered bonds markets, will be difficult. Investors are likely to prefer non-financials.”
Ms Lee’s colleague at Deutsche, global head of syndicate Geoff Tarrant, adds: “There will be a market for hybrids, though not at the levels we have previously seen, as smaller banks in particular will have difficulty accessing the market. Even though some of them have been holding fire since last year, bigger banks too will be reluctant at such wide spreads. They will at least wait until after the reporting season.”
Bankers are also expecting a modest increase in Tier 2 issuance but it is not a trend that is stirring any great interest. “A dramatic increase in lower Tier 2 issues is unlikely,” says JPMorgan’s Mr Marks. “Replacing senior debt with dated subordinated may be possible for some banks through their retail network and, at the end of the day, this is ‘gone’ concern capital not ‘going’ concern, so is less critical.”
Deutsche believes that some banks might prefer to sell off non-core assets or to change their dividend policies. The implications of not raising any capital, or raising very little, would be serious for banks. Slow or zero balance sheet growth could throw into doubt their very existence, so weak banks that are unable to attract investments from sovereign wealth funds could become takeover targets. “M&A is a favoured means of addressing financial system stress,” noted CreditSights in January.
But it is not all bad news for banks. For US institutions in particular, deposit bases have boomed since the second half of 2007 and this could relieve some of the pressure to raise capital. Money has been flowing in from US money market mutual funds, in particular, and as a result, says CreditSights, US commercial banks’ deposit liabilities increased by $423bn between the end of June 2007 and the end of December, a 14% compounded annualised growth rate.
Capital requirements
Another positive, at least partially, is that Basel II will not necessarily raise capital requirements for every bank, as was feared: it might even reduce them for some. “The effects of Basel II on banks’ capital requirements is not completely clear. It’s a mixed picture at this stage,” says Stefan Loesch, head of the EMEA balance sheet advisory team at JPMorgan.
“For example, several northern European banks will see their capital requirements diminished. However, other banks’ capital requirements may increase because of the risk parameters. In these cases, banks will need to have plans in place to raise capital.”
Other analysts, such as Mr Fenner-Leitao at Barclays Capital, believe that Basel II in itself is unlikely to force any bank to raise capital. There might be disagreement about how banks will go about it, but the market seems agreed that they will have to raise more capital in 2008 than they did in 2007. In such challenging market conditions, some casualties can be expected.
