Municipality Finance: Bridge to the future

Finland’s Municipality Finance on 24 September sold the first Additional Tier 1 instrument from an SSA issuer, a Eu350m 4.5% perpetual non-call 2022 BBB+ deal that had the lowest coupon and highest rating of any AT1. Esa Kallio, executive vice president, deputy to the CEO and head of capital markets, Municipality Finance, discusses the rationale for the landmark.

What was the rationale for your Additional Tier 1 transaction?

There was one reason behind it and that is the leverage ratio. If you look at all the regulatory burdens facing financial institutions in general, we don’t have problems complying with them — with the exception of the leverage ratio. And there, it is simply because unfortunately the leverage ratio doesn’t look at the level of risk you are running on your balance sheet.

If you look at our business model, there are key differences between ourselves and a traditional bank: our only source of income is the margin we are able to make on top of our average funding cost — we don’t have any kind of fee income — and meanwhile our customer base is very, very restricted. So the level of risk of our asset base is completely different to what you can see on a typical bank balance sheet.

How did your thinking evolve in how you would address this capital need? Did you have alternative options?

Here we have to rewind back as far as 2009 to 2010, because that was when the authorities gave their first indications as to the new regulations that would be coming up, and then it became clear that we would have to comply with all of them, the leverage ratio included.

At that time, in 2010, our leverage ratio was below 1% — somewhere around 0.8%-0.9%. Yet by that time it was quite widely discussed that the required leverage ratio would probably be 3%. Since then, in terms of the necessary levels, we have heard very little on the regulatory side and nothing will be set before 2017, so we have been working with the 3% as a target. And in reality you have to reach a leverage ratio of 3% before 2017-2018 because investors, rating agencies and others who are monitoring your business will most probably expect institutions to have a really good plan as to how they can be sure they will comply with the set level if and when it is finally set.

Regarding the question of what alternatives we had, in our case there were only two options in 2010: either continuing with the very low margin business we had been doing until then and going to our shareholders some time in 2015-2016 to request a substantial amount of fresh capital; or raising our lending margins quite significantly and then starting to grow our equity base through organic profitability.

AT1-type instruments were available, but at that time you had to have this so-called equity conversion clause included in your instrument and in our case that would not have worked, the reason being that our shareholders are restricted to being either Finnish municipalities or some other operators in the Finnish public sector that need to be individually approved by our board. So AT1 was not any kind of option for us. Then last year, in early 2014, we discovered that regulations changed to allow more flexibility whereby you can also use either temporary or permanent write-down features. This meant that AT1 potentially became an alternative way for us to increase our equity base.

Did you need to come up with any new structural elements to reflect your atypical business model?

No. Indeed during our roadshow we didn’t even go through the structure because it is a very straightforward, standard structure that was used by banks in many previous AT1 transactions in the past year. So there was nothing special in the structure itself.

It is the first AT1 transaction from the SSA sector. How did this affect the preparations?

It was really challenging. First of all, this was not only the first AT1 issued by an SSA; it was at the same time the first AT1 issued by anybody out of Finland. So it wasn’t only investors that we had to communicate with, but the local regulators and authorities, too. While the structure was nothing special in itself, it was new to our regulator and also the whole concept was something completely new for our tax authorities.

Then the second part was who the suitable investors were. This came down to finding, with the help of the banks we had chosen, the right type of investors. In the AT1 world these are slightly different to who we were used to through our usual issuance.

What were the key messages you were trying to get across to these investors?

The main messages were really that although we are a financial institution — i.e. we have to comply with all the regulatory burdens in the market — we are different, and that we are very low risk to start with. Honestly speaking, from our business perspective the fact is that we don’t need this capital; this is only to comply a leverage ratio that is not appropriate for us in the first place. The parameters that we should be monitored against are therefore quite different to what investors have been used to when investing in previous AT1s issued by various banks. So it was a question of making it very clear how much we differ from other banks.

How did you find an appropriate price in light of this?

That was also a really challenging exercise, the reason being that, as you mentioned, we are the first SSA issuer. Also, if you look at the rating of this transaction, it is the best you can find in the whole marketplace, i.e. there was no reference point whatsoever. We did try to use the ratings as a kind of starting point and at the end of the day there were a couple of different models that were used but which all landed in the same ballpark.

Are you happy with where you ended up?

Yes, even if you can always argue over what the correct price is. Whenever we are issuing in any market we try to be fair, meaning something that is a good price for us but which is also a good price for the investors. The secondary market is quite a good indicator in this respect, meaning there should be a healthy development with a little tightening, but not too much, and indeed the performance of our issue demonstrated this, in the first couple of days, at least. It could be seen as having been quite tightly priced, since we were able to tighten the level through the execution process, with the book being huge, but there was still this positive development in the secondary market. That tells me that it was a good price for everybody.

How did you go about allocations with such a big order book?

As you can imagine, that was also really challenging because we were nearly three times oversubscribed, meaning that we had to use certain parameters when allocating the bonds. We tried, once again, to be as fair as possible and to do our best to satisfy everyone, even if this was difficult.

The order book was also of a really good quality. I have heard that in those AT1 transactions where there has been huge oversubscription the main driver has been more or less inflated orders, but we didn’t see that much in our transaction.

Why did you choose the maturity?

It was really for ALM reasons. As I already mentioned, our original decision was to try to grow our equity base through organic profitability, and that’s exactly what we will be doing in the future. We have run various calculations as to how our balance sheet will grow under this scenario and they show that we will easily be able to grow our CET1 figure sufficiently high so as to comfortably comply with a 3% leverage ratio plus an internal buffer after five years on this basis, meaning that we will be able to pay down this transaction.

That’s the simple reason behind it and internally we have been speaking about this as a transaction that is only necessary to bridge our capital needs over time. This is the first and only AT1 that we are planning to issue provided that the required leverage ratio will be set at the level of 3%.

Other SSAs may be looking at similar transactions — what advice would you give them?

There are always rumours flying around in the capital markets and naturally I have heard some names who might be looking at the market. Really, the only advice I am able to give is: first of all, put aside enough time to do your homework in terms of your local authorities, tax authorities, and the rating agencies; and secondly, make sure you refine your story so that investors can easily see how you are different from typical banks — that’s the only way to explain the also different price, and to help investors find a fair value for your transaction.