ABN AMRO’s Ronan Donohue charts the progress of hybrid capital and the ever-increasing appeal around the world of this once revolutionary product.
Hybrid capital is not a new concept for most US and European banks but the role it is playing and the structures employed have undergone considerable evolution since the first wave appeared in the US in the mid-to-late 1990s. Driven by a rapidly changing banking landscape, including the impending provisions of the Basel II Accord and IAS accounting, hybrid capital has now entered a new phase.
At its outset, hybrid capital was something of a revolutionary concept. The appeal of a product that enabled banks to raise non-dilutive capital with a tax-deductible servicing cost is clear. By satisfying regulatory capital requirements in a way that enhanced return on equity and avoided the potentially thorny task of approaching existing shareholders with a rights issue, it is not surprising the product found instant support.
Conquering Europe
The trend that began in the US was soon spreading to Europe and in October 1998, following a concerted period of lobbying by banks across the region, the Bank for International Settlements (BIS) issued guidance on the subject. The two-page press release provided clarity as to the nature of securities allowable as Tier 1 capital and sparked the beginning of a new market.
The note endorsed the use of special purpose vehicles for issuing preference shares, which allowed banks to issue Tier 1 capital in tax-deductible form. By on-lending the proceeds from one of these issues to the parent, the servicing cost of the transaction was that of a debt obligation. The consolidated bank received the equity accruing to the vehicle from the preference issue as a minority interest (a recognised form of Tier 1 capital by most regulators) but with the interest payment as an allowable expense.
M&As boost issuance
Although European banks did not issue in any significant volume until mid-to-late 1999, they quickly made up for lost time. The new hybrid capital structures played a key role in the burst of M&A activity in the UK during 2000. British banks led the way and continued to dominate throughout 2000. Issuers included, among others Royal Bank of Scotland at the time of the NatWest acquisition and a multi-tranche issue from HSBC.
Whereas the initial period following regulatory and tax clarity was dominated by banks rushing to fill the allowable percentage buckets, in many cases to underpin acquisitions, coupled with a degree of “me too” mentality, the game quickly changed to pushing the structural barriers. The logic behind the next phase was to get beyond the 15% of total Tier 1 restriction, imposed by the Basel Committee on instruments classified as “innovative”. In the UK, this was initially interpreted as structures issued indirectly and/or with a step-up in interest if not redeemed at the call date. Because the UK authorities interpreted the BIS requirements more onerously than their continental European counterparts, where indirect issuance was not a defining feature of the innovative bucket, it was no accident that the UK became the cradle of innovation.
The next generation
The year 2000 saw Barclays successfully approach Euro investors with a tax-deductible direct issue called a Reserve Capital Instrument (RCI). The RCI allowed banks to take the tax deduction in the country where they have the most tax capacity but its issuance was still limited to 15% of Tier 1 as it included a step-up. By removing the step-up and making certain other modifications, the RCI gave way to a new wave of securities that had all the same benefits but qualified for inclusion in Tier 1 capital beyond the 15% limit.
The flurry of activity that surrounded these new direct deals in time proved to be their undoing. Aggressive marketing of equivalent structures throughout Europe brought them to the attention of the BIS, which tested them against the “spirit” of the 1998 press release. The conclusions of a sub-committee of the BIS that the structures under consideration fell short of the characteristics it expected to see in non-innovative capital were communicated to national regulators in a hastily convened meeting in February 2003. A top-and-tail review commenced in certain countries, most notably the UK, where the Financial Services Authority (FSA) recently concluded that the appropriate test for innovative versus non-innovative Tier 1 should be insolvency law. Although it was not the stated objective of the FSA, in essence the test went back to the accounting treatment, where both the Accounting Standards Board in the UK and IAS accounting principles recognise these securities as liabilities. In the future, where a security is a liability, or a prospective or contingent liability, it cannot be used as a component of core Tier 1 but only as innovative Tier 1 or Upper Tier Two. For core capital, issues now must be recognised as share capital under the Companies Act 1985 in the UK, which includes perpetual non-cumulative preference shares.
The decision to turn the spotlight on the UK structures by the BIS proved highly significant as it was coupled with a strong recommendation for greater communication between national regulators. As a result, the conservative stance adopted by the FSA influenced the regulatory thinking elsewhere in other jurisdictions.
Back to equity
Having travelled a considerable distance through several generations of product development, hybrid capital has to some extent come full circle back towards the equity end of the spectrum in the UK. But the UK is not the only country with a leaning in this direction. In Italy, we have seen the emergence of minimum Tier 1 capital requirements to be calculated net of any hybrid already issued. Mandatory convertibles, which had a brief moment of acceptance in the second quarter of 2002 when Fortis issued its Floating-rate, Equity-linked, Subordinated Hybrid Securities (FRESH) transaction, are being targeted as an alternative means of raising core Tier 1 in this market. While the BIS has left the ultimate decisions on allowable securities to rest with national regulators for now, it has promised to revisit the definition of capital just as soon as its commitments on the new Capital Accord are complete, currently scheduled to be by mid-2004.
Elsewhere in Europe we are seeing legislative changes supportive of bank capital issuance. In France a new law has been passed, which for the first time enables banks to issue debt securities at a level of subordination sufficient to satisfy the regulator that it qualifies as Tier 1. In Spain, new legislation has emerged providing for the issuance of equity certificates as a means of obtaining regulatory capital for mutual savings banks. The structures are non-voting but with a variable return linked to profitability.
Asia catches up
And then there is Asia. If Europe and the US are mature markets, Asia is currently in a developmental stage. A late entrant to the hybrid capital game, Asia is now significantly moving up the curve with numerous Tier 2 deals and a handful of Tier 1 issues having been completed. Unlike most Western banks, which have had aggressive shareholders demanding the highest return on equity, Asian banks have a history of family ownership or influence and greater government involvement, a factor that supported capital adequacy ratios well in excess of what shareholders would tolerate in Europe and the US. The trend is now firmly in the opposite direction, which has sparked a change in thinking, not just on hybrid capital, but economic capital and its allocation within the business mix. Although many Asian banks are still struggling with the implementation of the first Basel Accord, developments under the new Accord are nevertheless exerting an influence. As in the West, the Basel II process has influenced the way would-be issuers view hybrid capital and close attention is now being paid to the full range of alternatives.
Insurance changes
If the changes taking place in the banking world are not enough, insurance companies, more used to issuing Upper Tier 2 equivalent instruments, have recently entered the structuring frame. As in the banking field, the structural innovation is taking place in the UK, where in the summer of 2003 the FSA clarified the rules by which insurance companies could issue in a Tier 1 format. The new structures are a concession to enhanced capital requirements shortly to be imposed in the UK as part of the FSA’s new risk-based capital framework. The first structures to emerge from Prudential and Friends Provident were built on technology initially used by bank issuers. We are now seeing significant interest from continental European insurers, which are expecting to see a similar concept endorsed under the Solvency II initiative.
Critical examination
But the new Capital Accord is not just an obstacle that must be overcome before we can get a better definition of the liability side of the balance sheet; it is the very engine that has banks throughout the world examining their fundamental approach to balance sheet management. With its emphasis on economic capital and an attempt to better align regulatory capital with the true risks that banks are undertaking, the Basel II process lies at the very heart of this new thinking. Not only has it introduced an entirely new calibration methodology for capital, it has given banks several brand new areas to be thinking about on a day-to-day basis. These include the requirement to set aside capital for operational risk, as well as an enhanced role for the regulator and the greater disclosure requirements under Pillars II and III, respectively. Leaving aside its target implementation date of January 2007, changes are taking place now, at the very least in the nature of boardroom conversations.
“How well will we be positioned vis-ŕ-vis our peer group in the new regime?” “Will we become a target for acquisition by perhaps a larger bank capable of wringing greater returns for each unit of capital employed?” “Should we change our asset mix?” Such concerns are increasingly commonplace among banks contemplating life after Basel II.
In this changed environment, it is no longer enough for hybrid structures to stay one step ahead of the regulator, while being compliant with the taxman’s definition of debt, hybrid capital must now compete against a growing range of solutions focused on the asset side of the balance sheet. Various versions of synthetic and cash securitisation, as well as simple changes in the asset mix, are all on the table in any capital discussion.
The harsh treatment of securitisation in the current draft of the New Accord, where the cost of providing credit enhancement is set to increase, is also focusing attention on alternative ways to grow and finance new business. Rather than merely recycling capital to support growth, cheaper sources of funding such as covered bonds are enjoying considerable attention at the moment. Whereas in the past, extremely positive spread conditions may have been enough to tempt banks constrained by capital into the market, now the decision to issue will come only after several additional boxes have been ticked. In the rapidly changing and highly competitive world of hybrid capital, a new frontier of competition has opened up.
Far from finished
Changed though the world may be, nobody should assume hybrid capital has had its day. In fact, by quite a few measures it is firmly in the ascendancy. Issuance of hybrid Tier 1 capital by European banks alone (and others issuing into the Euro market) has totalled E19.6bn in 2003, significantly higher than the E13.8bn recorded for 2002. Using the same sample of banks, total subordinated debt (which captures Upper and Lower Tier 2 also) has so far ratcheted up a whopping E63bn, also comfortably ahead of last year’s E55bn. Nevertheless, the profile of the issuers and markets has adapted to changed circumstances. While total issuance from UK banks was constrained during much of 2003, principally owing to a regulatory impasse on allowable structures outside the 15% constraint, we saw significant participation from continental European banks in the hybrid market, much of it targeted at retail investors. In 2004, the Euro retail market is set to play a significant role in bank capital issuance.
Hybrid capital is nothing if not resilient. As an evolutionary product, it has proven itself to be remarkably adept at side-stepping many of the regulatory and tax obstacles it has encountered along the way. Even now with the international regulatory framework trending towards a conservative stance, it remains a vibrant market with brisk primary and secondary market activity. However, with the entire banking sector on the precipice of monumental change, the product is now having to compete with a growing range of alternative solutions in order to remain relevant. On past performance, the outlook is positive.
Ronan Donohue is director hybrid capital – financial markets advisory at ABN AMRO
