Banks' rocky road to redemption (part two)
A Q&A in which we demystify the changing regulatory landscape facing lenders
Banks’ securities have been plagued in recent weeks by exceptionally high volatility. For instance, the Bloomberg European bank equity index fell 17% in the first six weeks of the year while the Markit iTraxx European senior financial credit default swap index – a measure of default risk – rose over 80% over the same period. While prices have recovered rapidly since, market conditions remain skittish.
Lenders’ riskiest debt was among the hardest hit, amid uncertainty about just how new regulations – designed to avert a repeat of the Global Financial Crisis (GFC) – would operate. That recently prompted European regulators to review the way these new securities work to potentially reduce the likelihood of investors facing a surprise loss of interest payments.
In light of these events, our financial services credit analyst Oliver Judd explains what is going on in a two-part question and answer session. Having in the previous article examined the factors behind the sell-off at the start of the year, here Oliver attempts to demystify the changing regulatory environment.
There’s been a lot of talk about the regulatory landscape. What’s changed?
Since the GFC regulators have been working to avoid having banks that are ‘too big to fail’. They have done this by firstly making individual institutions safer. On top of this, they have established a framework to contain the impact of a bank failure on both the rest of the financial system and taxpayers.
Regulators have forced banks to strengthen their balance sheets by: reducing or eliminating the riskiest forms of lending and business activities; recalculating the way in which they measure the riskiness of their assets; and increasing capital buffers.
The crisis was preceded by weak lending standards, most famously to US sub-prime mortgagors. The problem was exacerbated by exponential growth in the market for asset-backed securities, which enabled banks to keep these loans off their balance sheets and unaccounted for in their risk budgets. Lending criteria are far more stringent now while risk-management systems have been significantly enhanced, with clear regulatory guidelines that limit exposure. On top of this, banks’ ability to make speculative investments has been severely curtailed.
As regulated entities, banks have always been required to adhere to specific capital requirements in order to protect depositors from loss and ensure the stability of the financial system. Since the crisis, regulators around the world have been forcing banks to hold more capital, either in the form of common equity or ‘subordinated’ debt.
Furthermore, during the financial crisis it became apparent the terms and conditions of subordinated debt issues did not allow for a write-down of principal. Investors were by and large repaid in full, with taxpayers left footing the bill after several banks failed.
While legacy subordinated debt securities continue to be protected from a loss of principal, any new subordinated bond must clearly state that it is ‘loss absorbing’ for a bank to be allowed to include it in its capital buffer. Furthermore, those losses are not simply imposed in the event a bank fails. They start to kick in as and when the issuer begins to come under stress.
These instruments are popularly known as contingent convertible securities, or ‘cocos’. In some instances these bonds are convertible into equity, while in others the debt is simply written off altogether.
‘Stress events’ which result in bondholders having to take losses are determined by (a) regulatory capital triggers specifically referred to in the new instrument’s terms, (b) revised statutory frameworks under which banks operate, or (c) at the direction of the regulator.
So just what is additional Tier 1 debt, and what gave rise to this new asset class?
The danger of permitting debt to be included in Tier 1 capital was all too clearly demonstrated during the GFC. The fact the debt used for this purpose was not ‘loss absorbing’ meant that governments had to step in.
In light of the extreme events of 2008, when lenders incurred huge losses, regulators decided banks’ Tier 1 capital ratios had been telling them very little about institutions’ financial strength, and they decided to tighten up the rules.
Banks can still include a relatively small amount of debt – up to two per cent of their risk-weighted assets – in their Tier 1 capital. But regulators, in order to try to avoid a repeat of the financial crisis, now insist that this so-called additional Tier 1 (AT1) debt must be loss absorbing in order for it to qualify for this purpose.
On top of this, since the financial crisis regulators have insisted banks’ build up their capital base to strengthen their position. With banks’ cost of equity financing currently close to 11 per cent, more and more lenders have been raising capital by issuing AT1 debt. The explanation: it’s cheaper for them to do so. This debt tends to carry a coupon of between seven and eight per cent. And furthermore, the interest cost is tax deductible meaning the effective cost to the bank is actually closer to six per cent.
Deutsche Bank reassured investors that it would be paying coupons on its AT1 debt. Do we fear non-payment of coupons on any of our investments and what is our view on this riskiest debt in the capital structure?
It was worrying that the bank deemed it necessary to make an announcement but that just indicates the severity of the weakness in sentiment at that time. Credit investing over recent years has been about a hunt for yield. With respect to Deutsche Bank it can be argued that investors didn’t realise the risk they were taking on. While the coupons on AT1 debt can look attractive superficially, that’s only so long as they continue to be paid. We focus on debt issued by banks with high levels of distributable reserves.
In light of the market sell-off, have regulators done anything to help?
While there have clearly been significant changes already, the regulatory landscape continues to evolve. For example, following the sell-off in AT1 securities at the start of the year and the questions over whether Deutsche Bank could service its own AT1 debt, one measure European authorities are reviewing is the discretionary nature of such coupons. In other words, should bondholders be treated equally to shareholders or should AT1 coupons rank ahead of dividends? We – and the market – await the outcome of the review.
What does the investment universe look like?
To date around 40 banks have between them issued approximately 80 AT1 debt instruments, enough to allow us to express strong, specific views via those we like most. There are a number of different types of structures and we prefer those with an equity conversion option because in the worst-case scenario we are at least left with something. However, many are not considered investment-grade, so they are not always appropriate for our portfolios. But we manage a lot of different portfolios that allow us to take views across banks’ entire capital structure.
Are there certain parts of banks’ capital structure we like more than others?
We especially like Tier 2 (T2) debt from well-capitalised, high-quality institutions. Although our portfolios can express views all the way from covered bonds and other asset-backed structures to the newer AT1 instruments, T2 debt, which sits below senior and above T1 debt, is in a ‘sweet spot’.
For a start, banks have significantly more capital than before the crisis. So there is now a much bigger buffer to absorb losses beneath T2 debt. That means it is less vulnerable to the type of shift in sentiment we saw at the start of the year.
While regulatory changes mean all bank debt can absorb losses, we also like T2 debt because their terms and conditions essentially remain unchanged.
This is in sharp contrast to AT1 and senior unsecured debt whose terms and conditions have become more complicated in recent years. The added uncertainty this has created has made these types of bonds comparatively less attractive.
Finally we also like T2 debt because we expect banks to issue less of it compared with AT1 and senior debt. As ‘old’ T2 continues to count as ‘new’ T2, there is limited need to issue new debt instruments to conform to the new loss-absorbing rules.
Will these new regulations help us avoid bank failures in the future?
I don’t think any set of rules can completely extinguish the possibility of this happening. However regulators have made strenuous efforts to prevent the collapse of a single bank from spreading through the system and to ensure that taxpayers are not left to foot the bill in the event a bank does fail. This means imposing the losses on investors in an orderly and pre-determined fashion when a bank cannot repay them in full. Clearly the devil is in the detail and we won’t know if the restructuring we’ve seen will work until the system actually comes under pressure. But it’s important to remember the regulatory landscape remains focused on preventing the next crisis - regulators have identified 30 globally significant institutions and have imposed special capital requirements on them.
Higher regulatory capital requirements may be good for debt holders, but what happens when revenues do begin to fall?
We are unlikely to see widespread bank defaults, even if global growth slows and we end up in a recession. Equity investors would definitely feel the pain (even more so than now). But we remain positive on bank debt, especially relative to non-financial debt. The securities that we thought looked attractive a few weeks ago look even more attractive now.