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October 2010 | ifr special report | 13 FIG


2.5% counter-cyclical buffer is expected to be composed of hybrids or contingent capital instruments.


Others prefer to concentrate on the too big to fail buffer. “The counter-cyclical buffer is getting more airtime at the moment because it is being announced before the too big to fail buffer. But we should remember that it’s going to be zero for a long time because of the current deleveraging trend in the market,” said one. “The too big to fail buffer could be in the order of 3% or 4%, but what can you put in it? Will it be totally composed of hybrid and contingent capital instruments? Probably not, but if it was 50/50 between those assets and core, and the buffer is 3% or 4%, you’re adding another 2% to the 1.5% required in the total Tier 1 ratio. So banks could be operating with 8% or 9% of core and 3% to 4% of hybrids. That is a feasible capital structure and that is before you strap on the non-viability gone concern contingent capital instruments we’re also going to see.”


Whither now for issuance?


What does this mean for issuance? Certain CEOs are likely to want to make a statement by not relying on the transition- al phase-in of the new requirements. Many market participants predict that most sys- temically important banks will be fully compliant with Basel III on 1 January 2013. While it might make sense to beat the rush and have instruments set aside for the counter-cyclical buffer, institutions are unlikely to pre-fund for that. Not only is a situation of excessive loan growth some way off, equity analysts and regulators might not take a kind view of banks future- proofing themselves for it. As one banker put it, “It wouldn’t be the wisest statement of intent.”


One important aspect is leverage ratio management. While the Basel timetable envisages that leverage ratio provisions will be implemented in 2018, disclosures


start in 2015 and a parallel run in 2013. “This should be done with the cheapest form of capital, hybrid Tier 1,” said a DCM banker. “So that format definitely has value, especially if it becomes loss-absorbing on a going concern basis.”


Of course it is not just a question of how issuers manage new regulatory demands. Fixed income investors must decide what works for them and what does not, although they are going to have to accept that loss-absorption and uncertainty about conversion are going to be a fact of life. While this seems onerous, the positive side of the new landscape for them is that the enhanced equity base will put them in a much better position than they have been in hitherto. They might feel more exposed to losses by the new structures, but the enhanced focus on core Tier 1 will in itself be a protection.


In the absence of step-ups and with


conversion to equity a likely component of future hybrid Tier 1 transactions, there are concerns that fixed-income investors that are currently not permitted to hold equities will no longer be enthusiastic about the format. “A significant proportion will worry about their mandates but they may very well change their mandates,” said one syndicate official. “The key question is the level of supply. In a low interest rate environment like the one we’re in now, few instruments offer the yield the Tier 1 does. Hedge funds are also likely to become a bigger player, as with loss- absorbing and equity converging instruments, there will definitely be a play on dividend income to manage through. The institutional investor base will shrink initially but my suspicion is that mandates will gradually change to a point where you have a normalisation. There will also be greater reliance on retail and private banking money for a market of non-step capital instruments.”


Achieving consistency


A bigger and more pressing problem than questions about demand is the absence of certainty about what new deals will look like. “Once you clarify the waterfall for an investor there will be a price,” said one DCM banker. “The resolution regime is critical, and to add to the uncertainty you have different countries implementing different rules already. Will those that have gone out already revise their rules to conform with the others? Will they be happy to subject their local issuers to a regulatory arbitrage?”


The most important constituent for issuers at the moment is the EU, which will have its discussion on the form of hybrid instruments in the first quarter of next year. The draft of the capital requirement directive’s fourth incarnation is expected before the end of March and while market participants expect a process similar to the Basel consultation, bankers hope it will be swifter than that exercise. The hope is that there should be signifi- cantly more clarity by the end of the first half of 2011.


“In the meantime some issuers will manage to current regulatory capital requirements, others to economic capital, but supply is likely to be a drip feed until there is more clarity,” said one banker. “Overall issuance in fixed income will be much higher when you look at hybrid Tier 1, Tier 2 and contingent capital combined. The latest release from Basel was about core, but things will pick up when we know more about the second phase.” Intesa Sanpaolo brought a deal recently with the express intention of complying as closely as currently possible with the demands of the Basel Committee, demonstrating that some issuers – and investors – are willing to brave the market even in the face of uncertainty. The ball remains in local and international regulators’ court.


“The too big to fail buffer could be in the order of 3% or 4%, but what can you put in it? Will it be totally composed of hybrid and contingent capital instruments? Probably not, but if it was 50/50 between those assets and core, and the buffer is 3% or 4%, you’re adding another 2% to the 1.5% required in the total Tier 1 ratio. So banks could be operating with 8% or 9% of core and 3% to 4% of hybrids.


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