insto - Australian financial markets

The UK banks have a thing or two to teach our financial players when it comes to boosting regulatory capital, writes Elizabeth Fry.

Who said plain vanilla was the only flavour of 2009? Investment banks are always trying to come up with new and innovative ways of structuring deals.

The global financial crisis has hit banks with a double whammy by both increasing the need for them to improve their capital position and making it difficult for them to raise new capital.

This is the problem Lloyds TSB and its adviser UBS faced earlier this year after Lloyds TSB acquired HBOS. Lloyds TSB solved the problem by opting to shore up its capital base by swapping a number of Lloyds and HBOS Upper Tier 2 securities for new Innovative Tier 1 securities in a deal worth £8.5 billion.

Stepping up a Tier or 2

Called regulatory capital swaps – which is when banks exchange one type of their regulatory capital for another type – this unusual transaction was completed in January, when both regulatory and investor attention was firmly focused on Tier 1 capital levels.

The Lloyds/HBOS deal was the very first hybrid to hybrid exchange ever done anywhere.

Since then RBS has also swapped out of subordinated bonds at a big discount.

This method of managing maturing liabilities was recently adopted by Singapore-based OCBC which exchanged Upper Tier 2 securities for Lower Tier 2 securities when the Upper Tier 2 securities were about to mature.

Being well capitalised, the bank didn’t need to increase Tier 1 capital.

According to Vinod Vasan, one of UBS’s London team which acted for Lloyds, the new regulatory capital swap deal was positive for all involved.

“It provided investors with a higher, market rate and a change of issuer from HBOS to Lloyds Bank. This was preferred by many investors. Lloyds was able to strengthen its balance sheet and to book some profit in the process as the exchange occurred at less than book value,” he said.

The margin boosting deal

Lloyds Tier 2 note holders were holding paper that was trading below par. The margins had been priced years previously and were facing an enormous loss. “Investors could switch into a new security that is paying a non market margin for one that had a market margin.”

Under the offer, Tier 2 note holders were offered the equivalent of about a 9.50 per cent discount yield across the curve representing a +350bps pick-up to the new issue. The new securities had a 13 per cent margin compared to the old one priced at 5 per cent.

“Although you are offering investors a higher rate, rolling the existing security into another security the bank is able to achieve a buy-back discount which is easier and, arguably, cheaper than trying to issue new tier 1 today,” he said.

RBS has also completed a deal to swap subordinated bonds at big discounts as part of efforts to improve its capital strength.

Domestic outlook for Australia

Although regulatory capital swaps haven’t appeared yet in Australia, to date banks have boosted Tier 1 capital by raising equity and used the money to pay down the lower quality capital. It is only a matter of time before this type of security makes its way to Australia, according to Brian Johnson, banking analyst at CLSA.

While Johnson argues these new securities are not really swaps but a way of redeeming subordinated debt and issuing a new instrument as a single transaction he says instruments of this kind would help solve the Aussie banks’ maturing subordinated debt issue.

“By redeeming subordinated debt and issuing a new security the bank’s capital ratios don’t deteriorate and the investor doesn’t get slugged with a step up of maturing subordinated debt,” he said

“The important thing about tier 2 debt is that it disappears over time from a capital perspective. Subordinated debt issuance spreads are so wide that issuing these hybrids is better value.”

It is understood though that at least two of the major banks are considering these swaps over the next 18 months, as Australian banks’ total capital ratio becomes a constraint, as has happened in Europe and the US.

An APRA spokesperson said: “We have no in-principle objection to a capital swap, but any proposal to buy back, redeem or swap a capital instrument ahead of maturity requires APRA’s approval. We consider applications against the entity's capital forecasts, and all approvals depend on the details of the transaction itself and the entity concerned.”

Insurance companies take note

In his speech to the Association of British Insurers on bank capital instruments, Paul Tucker, Deputy Governor for Financial Stability and a member of the Bank’s Monetary Policy Committee told insurance companies they should seek out opportunities to swap their holdings of subordinated bank debt into equity or, at a discount, into senior unsecured debt.

He argued that disposing of their subordinate debt was necessary to support the health of the bank system.

“It won’t do for banks to be able to leverage up on subordinated debt (or other forms of hybrid capital) if, just when it matters, the holders do not suffer because the authorities cannot let the banks concerned be liquidated without bringing system collapse down on us all,” he said.

He also argued the case for only equity counting as regulatory capital for banks in the medium term.

Unlike their Australian counterparts, most European insurers are big investors in subordinate debt and swapping it for senior debt or equity would result in them realising significant losses.

According to Johnson, the UK is seeing the subordinated debt issue early and it will emerge here as an issue. “It’s a global phenomenon and if regulators worldwide are looking at subordinated notes, ours will follow suit,” he said.

“Australian banks have responded by issuing ten year non-core subordinated notes and, if you look at each them in 18 months, for capital purposes significant values of these notes will amortise at around $3bn each for ANZ, CBA and Westpac and $6bn for NAB.”

“Either the refinancing of this debt will have a significant impact on earnings, or the non financing will have an impact on total capital ratios of somewhere between 1 and 2 per cent,” he said.