Roundtable: Team UK
The UK has led the way in new-style bank capital instruments and sterling issuance has found its way into investors’ portfolios, but the pace of regulatory change has brought with it uncertainty. A difficult summer has meanwhile thrown up many questions about the asset class. Leading players gathered in London on 2 September to discuss the latest developments.
Michael Benyaya, DCM Solutions, Crédit Agricole CIB Aravind Chandrasekaran, senior analyst, Camares Pascal Decque, financials credit analyst, Crédit Agricole CIB Scott Forrest, head of capital strategy, Royal Bank of Scotland Grégoire Pesques, head of global credit, Amundi UK Sebastiano Pirro, senior portfolio manager, Algebris Investments Vishal Savadia, head of capital issuance and strategy, Lloyds Christian Scarafia, senior director, FI team, Fitch Ratings Richard Staff, senior manager, capital management, Standard Chartered Bank Amreetpal Summan, credit financials trader, Crédit Agricole CIB Matthew Williams, senior portfolio manager, head of financials, Carmignac Moderator: Neil Day, managing editor, Bank+Insurance Hybrid Capital (BIHC)
Neil Day, Bank+Insurance Hybrid Capital: How has supply from UK banks panned out versus expectations?
Pascal Decque, Crédit Agricole CIB: What we can say is that UK banks were among the first movers in the AT1 market, back in late 2013 with Barclays first issuances. Since then, including the exchanges that Lloyds and Barclays made, plus issues from Coventry and Nationwide, we can say that in the last 12 months UK supply has been around 30%-40% of the whole market. They have been first movers and big contributors to the market.
Regarding expectations, it’s a trickier question, because the market did not have a very good view at the start of the year of how the market would grow. I would say that globally supply has been more or less in line with our expectations. Breaking it down on a name by name is much more difficult — although Barclays has always made clear that they want to issue at least 1.5% of risk weighted assets.
On top of that I would say that the icing on the cake was the announcement of HSBC’s Additional Tier 1. Meanwhile Royal Bank of Scotland, if I’m not wrong, has made clear on their side that is not a topic for them in the short term.
Christian Scarafia, Fitch: Yes, there was strong supply in the first half of this year. We rated upwards of £10bn of UK AT1 instruments — and there was also sizeable issuance from other European countries and emerging markets. The incentive remains there for banks to fill up the 1.5 percentage point buffer, so we would expect further issuance. The other thing we saw in the first half was certain medium-sized institutions issuing in the UK, the building societies and some smaller issuers as well.
Day, BIHC: Has the UK proven an interesting area of supply for investors?
Sebastiano Pirro, Algebris Investment Management: Yes, it has been very interesting for us. We have dedicated money that we only invest in bank capital, which we gradually shifted to Basel III-compliant securities along with the new issuance. Barclays and Lloyds were first-movers in terms of announcing deals. We expected big supply out of UK banks, and we still foresee significant issuance from UK banks in the future.
Day, BIHC: Has it been an advantage for UK banks coming first, or is it more of a challenge?
Vishal Savadia, Lloyds (pictured below): If you think back to the turn of the year, a lot of work was being done by issuers with investors on AT1 instruments, and it was uncertain how the market would grow as we went into 2014. From a UK issuer standpoint, we saw a number of pieces align as we came into 2014, particularly on the regulatory side, and I think that gave issuers the confidence to then go out and access the market. It has been positive to see the depth of demand.
It’s hard to say if there is a first-mover advantage or not. If you looked at the market six weeks ago you’d say that the guys who issued in the first part of the year did well. It’ll be interesting to see how the market develops and as a broader issuer base accesses the market.
From our perspective at least, we’ve gone out with a trade that filled our AT1 bucket. We’ve now got 2% of AT1 in our capital structure, which has largely taken AT1 off the table for us in the medium term, and positions us well in my mind in what I think is the next regulatory debate — developments with regards to total capital planning, bail-in and recovery and resolution.
Scott Forrest, RBS: In terms of our plans, we had AT1 issuance pencilled in not for 2014 but for 2015, so we have been comfortable with our plans and the trajectory of our capital position. Your ability to issue AT1 instruments is, to some extent, dictated by the distance to your trigger levels as well, so those two things can go hand in hand — as our CET1 position builds up then we can plan for the issuance of AT1.
The only thing that I would add in terms of early-mover perspective is, if you look at the likes of Nationwide or Coventry, they issued instruments that they thought would count in totality towards their leverage position, but given that we are now in a changing environment it is questionable whether they will get the full value for those instruments.
Richard Staff, Standard Chartered Bank (SCB): AT1 makes sense for all UK banks to issue given the regulatory incentive attached to meeting CRR minimums with the appropriate tier of capital. As an institution we had no intention of being a first-mover regarding AT1 and have continued issuing Tier 2 capital. I think the FPC leverage consultation paper released over the summer has made UK issuers take a hard look at the value of AT1 and the value of being early to the market.
Aravind Chandrasekaran, Camares: I would argue that the first-mover advantage has actually been for the investors if you look at how the earlier deals priced versus how these new deals are pricing. Even from a structural perspective, generically we tend to prefer the older generation of higher coupon higher resets. And to the extent that you see evolution in Europe towards higher triggers, you’re better off holding the 5.125% triggers. So I’d say it’s the exact opposite.
Matthew Williams, Carmignac: I agree that with the asset class being new and the investor base as yet undetermined, new issuers had to pay up to attract investors to these instruments. That evolution may now be behind us, but we’ll see. So I think the first mover advantage was for investors to get in first, rather than for issuers to issue first.
Grégoire Pesques, Amundi: In general you have a first-mover advantage. However, for this particular asset class, when there is no identifiable bias, you can have prices that vary very significantly from what you consider fair value. So then you can have behaviour that you were not expecting even if you are well aware of all the different covenants and specificities of each particular bond. So I’m a bit more, I would say, cautious. You have the idea of your fair value, but given that it remains relatively untested as an asset class — with no natural buyers so far — maybe the buyers at the very beginning were not the same as now, and the technicals of this asset class may stay quite volatile. So I think it’s true for if you have a long term investment horizon, but in the short term you can have some discrepancies that you were not, I would say, expecting, just for technical reasons.
Day, BIHC: In the UK, which is one of the more mature sectors, we’ve seen issuers beyond the national champions come to market. Do people expect there to be more supply from and investor interest in the mid-sized names?
Amreetpal Summan, Crédit Agricole CIB: I think there won’t be as much supply in mid-size UK banks. The cost of issuing an AT1 for some of these smaller banks is going to be fairly expensive given the profitability of the business — they are run with very tight margins — and most of these guys are actually pre-empting the leverage ratio, more than anything else. Everyone expected Barclays, Lloyds and so on to be issuing, but I think everyone was quite surprised when the mutuals began to issue, especially with them finding solutions with the CCDS, which has actually made it even more interesting for the investors. A lot of investors prefer the CCDS over the AT1. So yes, I agree with you, many customers I speak to would love to have these kinds of securities but opportunities will be limited. We believe the recent issuance was driven by the fear that the leverage ratio would increase from 3% to 4%. At the same time, most of these deals will be in sterling, thus limiting your investor base and given the smaller issue size they will be very well held.
Michael Benyaya, Crédit Agricole CIB: A CCDS qualifies as CET1 and is definitely very specific to the UK market and also specific to some issuers. When the CCDS came onto the market earlier this year there was a kind of debate as to whether it was closer to equity or to fixed income instruments. But it was mainly placed towards the fixed income investors, which was, I believe, an overall positive signal for the development of capital instruments for smaller issuers.
Day, BIHC: We have seen three markets clearly open — euros and dollars as well as sterling. What are the differences? You did different currencies in your ECN exchange at Lloyds.
Savadia, Lloyds: For a business like Lloyds with a largely sterling balance sheet, issuance in sterling is preferable. That was very much in mind as we structured the exchange. AT1 instruments have accounting complexities attached to them which make in some certain instances foreign currency issuance slightly more challenging from a balance sheet management perspective.
That said, I think it is positive to see demand across currencies, and we’ve launched AT1 across sterling, euros and US dollars. Going back to some of the points raised earlier, there is a finite demand for sterling AT1, and so in that respect you are going see to issuers looking outside their core currency as evaluate access to the market.
Day, BIHC: Scott, are you encouraged by how the different currency markets have evolved?
Forrest, RBS. Yes. From our perspective, from any issuer’s perspective, you’re looking at where the strength and depth of the market is and what’s going to be cost effective for you to issue. We all have CFOs that we have got to report into, and they’ve all got a focus on the pennies. It’ll be encouraging to see even more development in terms of the sterling market. I think it’s there for longer duration capital instruments, and depending on how you want to build out your capital profile and maturity buckets, then sterling could play a role there, but it’s not as strong and it’s not as deep as other markets such as dollars.
Staff, SCB: The ability to issue to as diverse an investor base as possible is clearly useful. That said, the challenge of hedging this particular asset class makes it more challenging to look outside of US dollars for Standard Chartered.
Benyaya, CACIB: The accounting angle is important, because the AT1 are accounted for as equity under IFRS, so it cannot be hedged, so the choice of currency to some extent reflects the businesses of the issuer.
Pirro, Algebris: We are generally agnostic towards currencies — we can invest in all of them.
In 2014 we have been focusing more on euros, which was a less developed asset class in the AT1 space and offered compelling value opportunities, both in terms of spread and yield. Right now, we have a balanced allocation towards euros and dollars. The sterling market is and will probably remain a smaller asset class for the space.
Pesques, Amundi (pictured below): At Amundi in London we are mostly managing global portfolios, which means that we like to have the choice between the different currencies. And it’s all the more important for this particular asset class: you can have a yield approach or a spread approach, or at least relative value opportunities between the different tranches. So, yes, we like to have multiple currencies, but we were there for some smaller issuers who for reasons of hedging or liability management just issue in their domestic currency, whether it is sterling or for some other issuers euros.
Forrest, RBS: It’s great to hear that everyone around this table buys the asset class, but there is a group there in terms of the insurers who struggle to buy AT1 instruments, just because of the impact on Solvency II. I think that if that group were able to buy the instrument, then you’d see a new class of investors come in. They may have difficulties buying it directly, but perhaps they could buy into active funds of funds.
Summan, CACIB: We have recently seen sellers of CoCos from Asian life insurers. There was recently a ruling that Taiwanese life insurers could not hold CoCos and following that we saw a few Chinese and regional life insurance companies sell down holdings in RAC Tier 2s and AT1s. This could become a theme across Europe as well, where insurance companies are effectively restricted from buying CoCos. As you said, under Solvency II it is very punitive to hold CoCo and equity on the books. So that’s one of the big hurdles in terms of investor base.
Pesques, Amundi: There are many countries where insurance companies can’t, in their own mandate or dedicated funds, invest in CoCos. For significant numbers of our mandates for insurance companies, at least in Europe, we can’t invest in CoCos and according to them it is the regulator.
Day, BIHC: The UK PRA has its one year hold on selling CoCos to retail in place. Does anyone have any views on the wisdom of that, and how that might restrict demand?
Forrest, RBS: To a certain degree I find it quite curious because if you pick up an offering circular it is plastered with health warnings all the way through it to its very core. So there are restrictions for retail investors from buying those instruments, but they can go out and buy equity, which is more subordinated, more junior, without having the same warnings.
But I can see what they’re getting at, namely is this an instrument that should be in retail hands, or is it something that should be in institutional hands?
Decque, CACIB: But nevertheless both the Bank of England and the FCA hit the market in the summer — although it was caught up in the BES issue, which was affecting the market at the same time. The Bank of England mentioned in its Financial Stability Report that investors potentially haven’t a full understanding of all the risks of potential triggers on this type of instrument. And on top of that the FCA issued its circular — although if I’m not wrong they excluded high net worth individuals from the retail investor base. This is strange behaviour given that at the same time they are requiring that banks meet very, very high capital ratios and to meet these the banks are forced to issue this type of instrument.
Summan, CACIB: I don’t think it had too much of an impact, because most UK private investors were not involved, because a lot of the banks were probably too scared to even sell it to them. Litigation risk remains high, with retail banks constantly in the spotlight following the PPI scandal, so there is a fear of further mis-selling headlines. So I think it was never really a concern.
The only real private investors were in Asia, and that was on the initial dollar deals, some of which were actually promoted as retail deals. Recent flows have shifted away from retail/private wealth investors and towards more institutional accounts. So unless this ban spreads — maybe into Asia, let’s say — I don’t really see too much of an impact.
Most of the move in the summer was not necessarily the FCA ban but more from the changes in the Merrill Lynch index and the general market tone. Investors jumped on that bandwagon and pushed bonds lower. But in terms of effect from the UK retail ban on CoCos, it should not really have an impact.
Day, BIHC: How much of an impact might the BAML index change have?
Chandrasekaran, Camares: For us, it makes little difference as we don’t track a benchmark. But I don’t really have a sense that many people were following it.
It wasn’t the case that all AT1s were included in there, and I also think it had both dated and undated instruments together in the index. So it wasn’t the cleanest index to follow to begin with. So I’m not sure it’s that big of a deal, really.
Pirro, Algebris: I think it is irrelevant in the long term, but it did have some consequences in the short term. We estimated a direct impact of 1%-1.5% of the high yield mandates, which is negligible. It nevertheless did have an influence and added a catalyst to sell back in July — when a series of negative events all came together. I don’t think we’ll see technical pressure when this comes through in late September, but it may remove some of the hype in the primary markets that we saw in the first half of 2014.
Pirro: Yes, there is enormous value compared to high yield in most of these trades.
Pesques: This is the perfect situation for a high yield portfolio manager, when you have a restricted benchmark but you have the ability to use some CoCos to beat the benchmark, to add some beta, to add some alpha. So high yield portfolio managers are quite keen on that sort of news.
Chandrasekaran, Camares: Yes, the existing high yield investor base that can already buy CoCos is arguably incentivised for it not to be in the index.
Day, BIHC: Switching back to the UK authorities’ approach to these instruments: UK issuers have been at the forefront of issuing while other countries still faced hurdles, with tax issues, for example. Have the authorities been supportive in getting the market going?
Savadia, Lloyds: To date they have been supportive. As you say, we’ve had regulatory clarity on structure, we’ve had clarity from the tax side, and that gave us the pieces of the puzzle we needed to issue.
However, there still remains ongoing regulatory discussions at the moment, for example on the leverage side which the PRA has recently been consulting on. That still needs to play out but will be an important additional consideration going forward.
To date, we have had a generally good market backdrop, we’ve had the investor base for this asset class grow, with a search for yield that has supported it. But we shouldn’t get carried away that the market’s going to stay like this forever, and I think that’s one thing that the regulators do need to be mindful of as they move ahead with further regulation that impacts the market backdrop for these instruments.
Forrest, RBS (pictured below): Also we’ve not had a common approach in terms of CRD IV, which is driving issues of AT1. We’ve got the PRA’s view in the UK, but the other national regulators have their own views on appropriate levels for trigger levels, etc. So there is still some divergence amongst national regulators.
Coming out with the tax position was a massive help. I imagine some of our Dutch peers are chomping at the bit to get the tax situation in the Netherlands resolved.
Staff, SCB: The early resolution of the tax treatment on AT1 in the UK was helpful, but to some extent it would have been more helpful to have a consistent view across national regulators on the structure of AT1. We have developed a market with transitional triggers versus fully-loaded triggers and low versus high trigger securities, which I think has hindered the appetite for these securities
Scarafia, Fitch: What we see when we are rating these instruments is there’s still some uncertainty in terms of the final capital structure of the banks, also in the context of GLAC and MREL. This means that further adjustments of target capitalisation is likely, but we expect the regulator to give the banks time to adjust to new capital requirements and our ratings of these instruments are based on our expectation that this should be doable.
Chandrasekaran, Camares: To that point, sometimes you wonder if they move too much, too quickly. Take ECNs, for example, or Barclays Lower Tier 2 CoCos. It’s hard to say whether two years from now UK AT1s will look vastly different or not, but in the last five years you have had two huge pockets of issuance that are effectively somewhat meaningless at this point.
Day, BIHC: If we can switch tack to something that has nevertheless come up a few times already: what has happened over the summer and the market reopening. Obviously things got ugly around BES. To what extent does BES and its impact have more than an immediate effect on the market?
Pesques, Amundi: BES is more a specific event. Over the summer you also had a lot of different stories, with Russia, overall weakness, and more negative macro figures. Of course it has some impact. It’s very clear for me that senior remains something that is very strong until the bail-in, and we have some good years still in terms of the valuation of senior paper. The impact on Tier 2 was not a surprise. What really remains to be seen is what the impact of a coupon pass on an AT1 would be, in terms of price impact on the specific bond and the asset class as a whole. That’s something that will enable us to really assess how strong this asset class is and the potential impact on a particular bond. I saw a survey recently where people were expecting that any coupon pass would trigger a fall of more than 24% in the price of the particular bond. So that’s something that will be a real test for the CoCo market. I would not say that I want it, but that would be a real test.
Decque, CACIB: It was specific to one name, for sure, but it was a violent reminder for the market and investors that banks are still black boxes, and you can have nasty surprises on the balance sheet or the structure. We often mention national champions compared to the others, but BES was the national champion.
Pesques, Amundi: You are right, but it’s also very close to a situation more or less like Parmalat.
We have also this summer seen how the different pieces in the capital structure have changed, Lower Tier 2, equity, AT1. We had a good test.
It also gives us some clues about liquidity. At one point, when the Crossover was trading at 300, if you had a Eu50m position on an AT1 and you wanted to sell, it was not possible, or you would have a big discount.
Summan, CACIB: The key word is “confidence”. The market has lost its confidence in some of the structures. Post-BES any sort of knee-jerk reaction will be very fast. BES’s Tier 1 ratio was at 11.4% and then with additional provisioning they were down to 5% at 2Q14. Apply that to any mid-size bank in the UK and they would be severely impacted. People will become very wary of the sudden change in core capital and that can exacerbate moves on periphery and second tier banks. But, yes, I agree with everyone that BES is a specific story, it had a very messy structure.
At the same time, there are fund managers looking for opportunities in underperforming periphery capital.
Day, BIHC: It has been noted here that the AT1 market is off its highs whereas the corporate market is back at its highs. Is now a good time to be getting involved in the market, to be picking up stuff that other people aren’t as confident in?
Chandrasekaran, Camares: On the AT1 versus corporate hybrids point, corporate hybrids have outperformed in terms of cash price, but on a spread basis they have actually underperformed. That’s a function of the fact that AT1s still trade as a total return yield product and corporate hybrids trade as spread products. But coming back to your point, generically we still tend to like where some of these AT1 bonds are versus where high yield deals are pricing. Yes, it’s at the tight end of the range, but on a relative value basis it can still be attractive.
Pesques, Amundi: I do not find the asset class very attractive for the moment. It is a bit expensive, particularly because, as you said, the big difference — particularly if you make a comparison with corporate hybrids — is that this asset class is trading more on a yield basis, and yields are too low. That’s the reason why you can see an amazing situation where the spread curve can even be inverted. So for long term investors, at least, it doesn’t make a lot of sense currently. Looking at dividend yield is also very important for assessing relative value.
Williams, Carmignac: There’s a seemingly 100% certainty of calls, given the way these are being valued on a yield to call basis, and I’m not sure that in call cases you should put a 100% probability of call.
Day, BIHC: Do UK names trade at the right kind of level?
Williams, Carmagnac: My big picture view is that I find the PRA one of the faster moving but also unpredictable and opaque regulators. And businesses are changing, too, with respect to various restructuring plans, etc. So my view is that they trade roughly fair. They don’t stand out as outstandingly cheap on a pure relative value basis vis-à-vis the Continent.
Chandrasekaran, Camares: I think it’s difficult. The UK is the only one to have the 7% fully-loaded trigger so far. You kind of need to see the Scandinavians or others come with similar structures. Their business models are also pretty different, whether it’s Barclays or Lloyds, so I don’t really have a strong generic UK view versus Europe.
Summan, CACIB: Following on from what Matthew was saying with regards to the PRA being a little bit unpredictable, that’s affecting the market’s pricing, because we don’t know if they’ll add on another buffer and a buffer on top of that. That’s why the UK banks trade wider than some of the European banks. But at the same time, the UK regulator is effectively leading the way and on the back of that you could see the rest of Europe follow suit, and thus over time a convergence between the two. But given the fact, again, because they’re just so unpredictable, you’re kind of pricing that in, with Barclays, for example, trading wider than some of their European peers.
Decque, CACIB (pictured below): I do agree that the analysis is difficult given the change in business models, in reporting, the deleveraging or refocusing, and over the short term it is quite difficult. From Q1 through to Q3 we have a different set of reporting and numbers, and that’s not very easy and I can understand that investors do not like that.
I do agree on the PRA. I don’t know if they are a leader, or if they will be followed by others, or if they will remain on top of the rest, like the Swiss. Then there is the potential arrival of the Nordics with yet another standard. We are all looking for harmonisation, but we already have the low and high triggers and we will have a super-high trigger, 8%, in the Nordics. I’m not sure that will help.
Looking at UK banks going forward, I would just repeat what we see in the numbers and what the rating agencies said recently when changing the outlook. The improvement on the macro and the operating side will be offset by the lasting deep uncertainties and potential impact of litigation risk, misconduct and related costs.
Savadia, Lloyds: If we take a step back, one thing you can say about the UK — and where we are compared with some of our European counterparts — is that when it comes to legacy risk or charges, UK bank balance sheets are so much more well prepared to absorb these charges now. We’ve seen a fairly long derisking programme from the UK banks, strengthening their core capital base, working to a slightly higher standard than some of their European counterparts on an accelerated timeline. So I take the points around possible regulatory uncertainty, but from a UK standpoint I hope to see that we will get some benefit around derisking, around the simplification of our business models, which makes the analysis of our capital instruments slightly easier from an investor perspective. It’s not just a case of looking at buffer to trigger, for example, but increasingly investors are hopefully doing a lot of work around the earnings volatility of the businesses and looking at the organic capital generation banks will look to create over the next few years and the defence that provides on coupons for those investors. Hopefully we see the positive impact of this come through further as investors review UK issuers.
Day, BIHC: What did you make of the timing of Moody’s going negative on the UK banking sector outlook recently?
Savadia, Lloyds: All agencies are currently looking at the removal of sovereign support notching for banks. However, this comes back to my earlier point around the introduction of recovery and resolution regimes, and the focus on the UK regulator in that respect. As part of this you also need to consider the strengthening of capital levels at UK banks. So if any ratings change is driven by a broader market dynamic, the question is, how do you expect UK banks to fare relative to their global counterparts? I think it’s difficult to pull up the UK on its own in that respect.
Scarafia, Fitch: I would agree with that. The removal of support is something that will affect most countries in Europe and the US. We have a slightly different approach in our ratings, but we changed the outlooks of most issuer ratings that are based on sovereign support in the affected countries to negative earlier this year. There will be no impact on the hybrid ratings, though, as we already do not assume support for those instruments.
We’ve also seen the UK regulator setting high requirements and expectations, and banks being able to meet them, by changing business models and/or by raising capital if necessary. And if you look at the targets, that the UK but also the Swiss have, and which some other countries have, they are significantly higher. It’s normal to see CET1 targets well above 10%.
Forrest, RBS: Just look across to the continent, where BNP had $9bn or $10bn of fines. They were able to absorb that without the blink of an eye because they’ve got the higher capital levels.
Summan, CACIB: A lot of people thought that HSBC was not going to issue an AT1 anytime soon. Now there is chatter that BNP and similar high quality banks will potentially issue AT1s just in case their local regulator demands higher capital buffers.
Yes, you have these kinds of shock events which they can absorb, but I would not be surprised if they will look to issue AT1s to develop a credit curve for themselves. They still have the ability to issue at a reasonable level given the strong investor appetite for the name, so I wouldn’t be surprised if they come to the market.
Chandrasekaran, Camares: It’ll be interesting when we see some of the upcoming deals being investment grade, and how that reprices the market. I’m not sure from a mandate perspective whether IG will really see much more demand than what we’ve seen so far given it’s an equity-like product, and whether that has a secondary impact on where existing non-IG bonds are trading.
Summan, CACIB: When Danske Bank was upgraded and thus their AT1s became IG rated, they jumped up 1.5 points. Bonds were originally traded with non-domestic accounts and post-upgrade we saw a surge in demand from regional long term investors — pension funds, etc. This helps to stabilise and improve holdings of the paper.
Day, BIHC: How does Fitch approach the “8%” bail-in rule? Can banks achieve higher ratings to reflect strong buffers in the form of subordinated or bail-in-able debt?
Scarafia, Fitch (pictured below): First of all, it’s quite important to be clear that the 8% rule only applies if you want to use resolution funds. Only in that case do you have to bail-in 8% of total liabilities. What it shows is that the liability structure in general has become much more important.
Our general approach is that we assign Viability Ratings that look at the standalone strength of a bank and Support Rating Floors that look at the support that we expect a bank to receive. The Issuer Default Rating is then generally the higher of the two ratings, and senior debt is usually rated at the same level as the Issuer Default Rating. Since January, when we updated our criteria, we said there could be situations where we can rate the Issuer Default Rating above the Viability Rating if we believe that there is sufficient junior debt available that in fact protects the senior creditor. So the idea is a bank would fail and that the bail-in of the junior debt is sufficient to fix the problem such that the senior debt doesn’t default. We give some indication in our criteria on what the amount would have to be, and we say that it should be sufficient to recapitalise the balance sheet to a minimum requirement, which probably in the UK would be the Pillar 1 requirements, say 8%. That’s the sort of level when we would start looking at it.
So far we haven’t done it, and I think one of the reasons is that we would want to see some steady state in the liability structure of the bank, and with GLAC and MREL coming in, we expect some more clarity on that after Brisbane. Once we see that, that could be the case.
And I think that’s the right way to do it because in a way you take away state support or implicit government support for senior creditors and you replace it with loss absorbing instruments that are there to protect senior creditors.
There have been some cases where we had the Issuer Default Rating above the Viability Rating, but those were very low rated banks when you could have visibility on how the stress scenario was really affecting the credit and its various debt levels. The Cooperative Bank was an example, where the Viability Rating went to the lowest levels but the Issuer Default Rating, when there was clarity that senior creditors would not suffer losses, was kept slightly above. And we say that if we do rate the Issuer Default Rating above the Viability Rating for reasons of large buffers of subordinated debt it will be only one or maximum two notches above, so it is still a very close link.
Day, BIHC: Is it a challenge keeping your rating methodology up to date given the changes in regulation?
Scarafia, Fitch: We have to review them annually, in any case. Regarding hybrids, the latest review was in January, and the changes were reasonably limited — there wasn’t any impact on ratings. What is clear is that there is uncertainty on buffers and all the topics in the UK. But what we’ve seen so far is that, particularly for highly rated institutions, there is financial flexibility to reach targets and that we expect the regulator to give sufficient time to meet them. When you assign ratings or when we affirm them, one of the sensitivities of the ratings that we put out is sudden shifts in regulatory requirements or expectations, or in management of capital, which could lead to a change of rating. So, yes, ratings could change, for instance, if the leverage ratio requirement is moving from a backstop towards a more binding ratio with additional buffers — we would have to see how the banks respond to that, how they manage their capital stack.
But we acknowledge that there are changes and some uncertainties, but so far we see that they have been managed pretty well by the banks.
Day, BIHC: How have the issuers found their dealings with the rating agencies?
Forrest, RBS: They’ve got their views. We appreciate the approach when there is a consultation that comes out, that gives you the opportunity to provide an input to the process and changes. These things evolve, and the agencies were heavily criticised for being behind the curve going into the crisis, and in a similar tone to the approach the PRA has taken, they are seeking to be more at the forefront of developments. From an issuer’s perspective, we welcome clarity and dialogue on GLAC, TLAC, MREL and any other abbreviation you want to throw in there. The sooner we have clarity on these things, the sooner it enables us to plan effectively for what our capital stack is going to look like.
Savadia, Lloyds: I agree. We welcome the dialogue. We understand that there are challenges and uncertainty; however, we will continue to actively work with the agencies to understand where they are going with their assessments of balance sheets, and it’s a valuable discussion to have. It is also positive that investors are doing their own independent work.
Staff, SCB: Broadly speaking, the relationship we have with all three agencies is good, but the repeated review of methodologies over the last 12-18 months has been challenging for all market participants. However I think investors have adopted a more pro-active approach and rely less on ratings than previously.
Day, BIHC: Do the investors pay much attention to the rating agencies, beyond technical aspects like index eligibility, for example?
Pesques, Amundi: They are very important, if you look at what happened to the corporate hybrids after the changes in methodology. This asset class suffered a lot from this uncertainty. With AT1, you still have uncertainty about the regulatory regime and uncertainties regarding how stable the rating methodologies are. So if the regulators and issuers do want AT1 to really become an established asset class, you need all this to be clear and fixed, otherwise it could remain something really uncertain, with a lot of primary market activity for sixth months and then a rating change or a new buffer that stops that. In this asset class, the regulator is very important and the rating agencies, too, and they need to make things clear and stable so that investors can take a long term view.
Transparency is also key: buffers, distributable items are not always easily accessible.
Day, BIHC: Do you fear AQR, or will it be a non-event given the long run-up to it?
Pirro, Algebris: A few bad outcomes are expected, mainly from smaller German and Italian unlisted institutions. In general, we do not expect any surprise that might negatively affect the performance of our portfolios. There might be a couple of banks that do not pass and are forced to raise equity — ultimately this will prove to be a very positive outcome for credit holders. The AQR and stress test will be a positive catalyst for bank credit and this should bring spread tightening over time.
Williams, Carmignac: If you look at the structure of the final disclosure, it starts with the 2013 accounts, and I think moves its way through the various scenarios, and then 10 pages in you have the capital and balance sheet actions taken throughout 2014. So I agree with your sentiment. There may be a little bit more to it, where you get a surprise with a name that either fails or comes very close, but where the capital actions that they have taken throughout 2014 mean that everything’s OK.
Decque, CACIB: You could say that most of the AQR has been done so it’s almost a non-story now. What was important is that they have forced banks to make capital increases, a very long list, to sell some non-performing assets or non-core assets, and to increase provisions. And most of the job has been done. The result will be probably quite poor — a few banks probably won’t pass — but it won’t depress the market much.
Pirro, Algebris: And that is going to be positive for the asset class in general. Bank sub capital has been a great trade in the past two years, and that is likely going to continue. Especially because in the coming years the regulator will be more demanding, as we saw with the US banks, and the shift towards higher quality balance sheets and more transparency will go on.
Day, BIHC: What is the biggest risk to performance and/or supply on the horizon, if anything?
Decque, CACIB: The risk we have is that it is a young market, liquidity is scarce, the investor base is not really wide enough yet, and there is high volatility in difficult times, and any BES-like story or geopolitical stress or any unexpected surprise on the AQR would have an impact on one of the names and that could affect the whole sector. But we have seen that the regulator, banks and even investors in their search for yield have a very strong interest in seeing the market develop, and I suspect that it could recover anyway. This a market that is well set for a long time.
Day, BIHC: Aravind — you talked early on about investors having first mover advantage. How do you see the investor base developing? And do you agree with Pascal’s points?
Chandrasekaran, Camares: It’s quite important for market structure that regulation not always be a moving target and that we also have fixed ratings methodologies. If the market structure gets fixed, I think you can start to see a lot more people being involved. It’s still a fairly young asset class, right?
The way we tend to look at these instruments, in addition to relative value versus high yield, is versus equity, versus where dividend yields are trading, versus where cost of equity is, and I think you tend to get different conclusions than just looking at RV on a pure AT1 basis. Sometimes not — but sometimes you get interesting opportunities. And the fact that it’s a young market also presents a lot of opportunities.
Day, BIHC: Scott, 2015 is likely to be in the calendar for you: do you see any risks to your longer term plans panning out?
Forrest, RBS: We are cognisant of the competing supply that may come into the market at this time. You know, you can’t sit in my seat or in Vishal’s seat without a friendly investment bank coming to bang on the doors telling you now’s the time to issue AT1, but fundamentally you have to work to your own plans and find the window that works for you.
