Asia: Momentum builds as regulations evolve

As issuance volumes in Asia gain momentum, Fitch Ratings explores some recent developments and likely future trends relating to Basel III capital securities in three key markets: China, India and South Korea.

China: Basel III capital issues may test market appetite

“Planned issuance of Basel III capital securities by China’s largest commercial banks through to the end of 2014 could be sizeable and, as a result, may face a challenging market,” says Grace Wu, head of Fitch’s China team.

The large volume of issuance relative to the size of the market could test investor appetite when there are persisting uncertainties surrounding slowing profitability growth, rising non-performing loans (NPLs) and concerns about the state of the property market.

Issuance in China this year has reached around $41bn (CNY251bn) to date, including $12bn issued in offshore markets and denominated in foreign currencies. The majority of these issues were Tier 2 instruments and were mostly used to refinance legacy subordinated bonds.

There is only one AT1 issue in China thus far, by Bank of China (BOC), which amounted to $6.65bn in October. Based on the announced figures by the five state-owned commercial banks, there are around $36bn worth of AT1 instruments pending issuance before the end of 2015 from Industrial & Commercial Bank of China (ICBC), BOC and Agricultural Bank of China (ABC).

The issuance of capital securities by Chinese banks will provide a supportive buffer as economic conditions become more challenging. Raising this form of capital is part of the Chinese authorities’ plans to fortify balance sheets of systemically important banks amid potential asset quality risks, rising off-balance sheet exposures, tightening profit margins owing to the forthcoming liberalisation of interest rates, and liquidity volatility. Further, this will also better position Chinese banks for ongoing asset growth.

The likely further $36bn in issuance of capital securities by end-2015 by the big five banks is equivalent to just 3.5% of end-September capital and 0.3% of total assets. While new capital securities may boost confidence in the system, the size of issuance will be small relative to existing capital and assets, and is no substitute for common equity. Chinese banks have lower equity to asset ratios than emerging market peers, and this is before factoring in potential off-balance sheet risks emanating from the shadow banking system in China. As such, the capital raisings alone should only be modestly credit supportive.

An additional challenge for international investors will be the uncertainties around how China will address the point of non-viability (PONV) for banks. Previous international Basel III issuance by Chinese banks has been completed through their Hong Kong-based subsidiaries, which are regulated by the Hong Kong Monetary Authority. In China, the China Banking Regulatory Commission (CBRC) has discretion to determine PONV for Tier 2, but the People’s Bank of China (PBOC) and State Council may also play influential roles in determining PONV, particularly when it comes to public sector capital injections. However, for the large, systemic banks, the Chinese government will likely seek to avoid triggering PONV as this would indicate a systemic bank failure.

While Fitch expects all of the big five state banks to issue capital securities, because the final amount to be raised remains unknown it is too early to determine to what extent these issues will offset pressures in the system and have a positive influence on bank standalone strength, reflected by the Viability Ratings (VRs). Fitch’s main measure of capital when assessing bank capital strength, Fitch Core Capital, will not be strengthened by these issues.

Korean Basel III terms become more creditor friendly

In South Korea Fitch believes recent modifications to the terms and conditions (T&Cs) of commercial banks’ Basel III-compliant capital securities have reduced the likelihood of non-performance risk — particularly for Basel III Tier 2 instruments — and are therefore positive for instrument ratings. As a result of these changes, for banks issuing Tier 2 instruments, the agency will consider notching off the higher of the Support Rating Floor and Viability Rating (VR).

The agency understands that the motive behind these changes is to deepen the pool of investors for capital securities to support a rising trend of issuance.

“For investors, the new instruments are potentially of lower risk relative to earlier Basel III Tier 2 instruments” says Heakyu Chang of Fitch’s team in Seoul. “From a quality of capital perspective, these changes make these instruments more like the legacy Basel II instruments and — as a consequence — less likely to absorb losses (and less capital-like) compared with instruments issued in markets where PONV is triggered at an earlier stage of a bank’s deterioration in financial position.”

The key change to the T&Cs is the removal of a management improvement order (MIO) received from the regulator as one of two PONV triggers. The other trigger — when the bank becomes insolvent — remains. Where instruments have only an insolvency PONV trigger and where support is factored into the Issuer Default Rating (IDR), Fitch would consider using the support-driven IDR or the VR (whichever is higher) as the anchor rating for systemically important banks because we expect pre-emptive support to be provided to avoid insolvency. Upon hitting the PONV, the Tier 2 instruments are to be fully and permanently written off, hence Fitch will continue to notch ratings on these instruments twice from the anchor rating to reflect loss severity (i.e. poor recovery prospects).

A similar change has been made for the write-down of Additional Tier 1 (AT1) instruments. This, however, does not change, in our view, the risk of coupon cancellation, which is still linked to a management improvement recommendation (MIR) or the discretion of the issuing bank. An MIR is usually the first timely corrective action that regulators would activate, for example, in a scenario where the total capital ratio falls below 8%. The bank may decide not to pay the coupon, typically when the bank is unable to pay dividends to its shareholders. Given that skipping a coupon payment is central to our assessment of non-performance risk, we will continue to notch ratings on AT1s five times from the VR (where the anchor rating is investment grade).

The definition of insolvency is less subjective than an MIO, which the authorities have a significant degree of latitude in deciding when to issue. An MIO event is also supposed to be activated when a bank’s total capital adequacy ratio falls below 2% (or if the Tier 1 capital ratio drops below 1.5% or common equity Tier 1 capital ratio is below 1.2%). The MIO trigger is more comprehensive and would practically be the first trigger to be hit if both triggers are applicable. This was a factor behind the agency’s previous decision to assume that the VR would be the anchor rating.

Fitch expects the revised single PONV trigger (i.e. insolvency trigger only) to be the standard for future Basel III Tier 2 issues by Korean banks. Fitch notes that the Korean authorities have approved a number of proposed Tier 2 and AT1 issues in recent weeks.

South Korea’s only offshore Basel III-compliant Tier 2 security, issued in April 2014 by Woori Bank (A-/Stable/bbb), had the two above-mentioned PONV triggers. Had Fitch rated that instrument, the bank’s VR would have been used as the anchor rating. In the case of Woori, its IDR is two notches higher than its VR.

In total, $3bn (KRW3tr) of capital securities have been issued since April 2014, with $1.6bn in foreign currency and one deal being AT1. The relatively weak capital positions of banks resulting from recent and planned M&A activities have been driving them to issue new securities or refinance maturing legacy bank capital securities. Some policy banks (e.g. Korea Development Bank (KDB) and Industrial Bank of Korea (IBK)) are also under pressure to issue securities to supplement their Tier 2 capital positions. Their capital positions have been under pressure due to their policy role of extending loans and their limited internal capital generation capacity. We estimate the potential supply between now and end-2015 to amount about $5bn.

India: AT1 Changes May Help Reduce Basel III Capital Gap

“In India recent investor-friendly changes to Additional Tier 1 (AT1) instruments may help the banks to partly fill the sector’s large $200bn Basel III capital needs,” says Saswata Guha in Fitch’s Mumbai office. “But the Indian bank AT1 market remains untested, and the new features may introduce retail investors to a riskier asset class.”

The capital requirement also builds in expectations of a pick-up in economic growth, following the advent of a new government with a clear electoral mandate and focus on policy reforms. Banks are still the dominant credit intermediaries in India, and would therefore need to raise capital to support the process of economic recovery. We forecast real GDP to grow by 5.6% in 2015 and 6.5% in 2016.

Large private banks are potentially the best positioned to take advantage of an economic recovery, given their scale, lower funding costs and higher capital levels. They need only 15% of the Basel III capital requirements, and could better fulfil these needs because of stronger internal capital generation and access to equity capital. Public-sector banks would also benefit from a cyclical recovery, but to a lesser extent — in light of their high exposure to structurally weak sectors. State Bank of India and Bank of Baroda are the best placed among the state-owned banks.

Saswata notes that state-owned banks, which represent close to 85% of the capital gap and suffer from weak valuations, would find the capital requirements more challenging. Asset quality pressures and declining profitability have hurt internal capital generation, thus raising their dependence on state capital. We believe AT1 securities would be likely to have to fill state-owned banks’ capital needs in the near term — until improvement is evident in asset quality, profits and their ability to raise core capital.

The Reserve Bank of India’s (RBI) amendments to Basel III capital norms include allowing AT1s to have a shorter maturity of up to five years, be temporarily written down at a pre-specified trigger point, and sold to retail investors. These features are more creditor-friendly, and would be likely to draw investor appetite for loss-absorbing capital instruments. But they may introduce moral hazard risk, as the RBI may be forced to bail out retail investors should there be a need to impose losses.

The recent changes would probably lead the banks to switch to the domestic market for issuance of bank capital instruments, though its ability to fulfil the entire AT1 requirements is still uncertain. So far, only two state-owned banks — Bank of India and IDBI Bank (BBB/Stable/bb) — have accessed domestic markets, with each raising INR25bn in AT1 capital in the second half of 2015. In dollar terms, the combined sum ($830m) constituted only about 5% of the combined AT1 requirement expected over 2015 and 2016, implying that a large part of this significant gap is yet to be filled. Steady issuances of AT1 capital will allow banks to bridge near term capital needs, but they may have to tap overseas markets eventually. Simultaneously, banks will also need to raise core equity, which constitutes another 40% of the total capital requirement.

Early signs of asset quality stability are emerging at some large state-owned banks, which should be boosted by a pick-up in economic growth. We expect Indian banks’ stressed assets to peak by the financial year ending March 2015, led mainly by cyclical recovery. However, improvements will be slow as it will take time to resolve the large stock of problem loans, particularly in the infrastructure sector.