roundtable discussion

2 6 | k a n g a n e w s j u n e 2 0 1 3

Bank tier two capital: lack of clarity causes pricing gap

PartICIPantSn Jai Anderson Head of Long-Term Funding Australia & New Zealand RABOBANK n Michael Bors Portfolio Manager CHALLENGER n Jason Bounassif Head of Markets AMP GROUP n Rupert Daly Managing Director, Head of Hybrid Capital DEUTSCHE BANK n Natasha Feder Senior Credit Analyst COLONIAL FIRST STATE GLOBAL ASSET MANAGEMENT n Jasper Gale Head of Credit Sales DEUTSCHE BANK n John Georgiades Director, Structured Funding & Credit WESTPAC BANKING CORPORATION n David Hanna Division Director, Fixed Income & Currency MACQUARIE INVESTMENT MANAGEMENT n Tricia Ho-Hudson Head of Capital & Regulatory Strategy, Group Treasury COMMONWEALTH BANK OF AUSTRALIA n Bruce Lambert Executive General Manager, Group Capital SUNCORP n Will Manfield Vice President, Australian Pacific Flow Trading DEUTSCHE BANK n John Manning Senior Investment Manager ABERDEEN ASSET MANAGEMENT n Rob Mead Managing Director, Portfolio Manager PIMCO n Mark Mitchell Portfolio Manager, Head of Credit KAPSTREAM CAPITAL n John Needham Head of Structured Funding ANZ BANKING GROUP n Helen Pericleous Senior Portfolio Manager, Credit Markets, Fixed Income AMP CAPITAL n Matt Price Head of Group Capital Management, Group Treasury NATIONAL AUSTRALIA BANK

Moderatorn Laurence Davison Managing Editor KANGANEWS

ssuers and investors continue to work their way through new

regulatory rules covering bank tier two capital. At a May roundtable

hosted in Sydney by Deutsche Bank and KangaNews, Australian bank

issuers and fund managers discussed the challenges that will have to be dealt with

to make the asset class work as an institutional product.

i

CHANGING MODEL

davison Rupert daly, conceptually what are the main differences between old- and new-style tier-two debt so far as you see them?n daly Old-style lower tier two was effectively a simple, subordinated debt instrument with mandatory coupons. There was a technical point about not having to pay coupons if doing so would make a bank insolvent, but to my mind that was a point-in-time test and therefore practically if the bank didn’t pay it was probably already insolvent. As such tier two was really a ‘gone concern’ instrument – at the point payments ceased the

issuing bank or insurance company would be insolvent, and investors would wait in line to see what they would recover from insolvency proceedings.

Basel III follows the overlay from the financial crisis of having banks saved by government money, in the sense that it is looking for ways to both protect depositors and save governments from having to step in at any future point.

Point of non-viability (PoNV) has now been added to tier two. This is defined as being when the regulator – the Australian Prudential Regulation Authority (APRA) – notifies a bank or insurance company, in writing, that it believes the institution will become non-viable unless its additional

“I would hope non-viability in Australia would be triggered before things were so bad that the only option was to bail in old-style lower tier two instruments as well as the new ones.”d a v I d H a n n a M a c q u a R i e i n v e s t M e n t M a n a g e M e n t

2 7

tier one and tier two instruments are either written off or converted to equity, or the institution will become non-viable in the absence of a public sector injection of capital or other equivalent support.

To my mind the main difference between Basel II-styled tier two and Basel III-styled tier two is a change from being a gone-concern instrument to effectively a going-concern instrument. If an Australian bank or insurance company is critical to the functioning of the financial markets or wider economy, my view is that APRA would step in before the institution fails. Therefore, something will always happen in an attempt to keep the bank or insurance company on its feet – in future it won’t be a case of waiting in line to see what the payout is from a subordinated instrument post-liquidation.

In terms of what it is that happens at PoNV, investors will know when they buy an instrument. The terms will specificy whether they will get written off or – I suspect more likely in the initial phase – converted to equity.

n needHaM I would add two additional points. One is that it isn’t necessarily the case that all an institution’s tier-two debt will be written off: APRA will determine the amount of tier-one instruments that need to be written off and then, if necessary, how much tier two. It’s not necessarily a binary outcome.

The other point is that old-style tier two was subject to the requirements of the Banking Act, under which APRA has very wide-ranging powers including being able to direct banks not to make payment on any instrument – including equity, debt securities and deposits. The powers APRA now has to some extent already existed under the Banking Act, and applied to old-style tier two.n Mead The important thing to recognise is that we have moved from a bail-out world into a burden-sharing world, and this move has been a strategic one in terms of re-regulation. Only after acknowledging the new regime we are all living in should we start to look at individual security characteristics – because they are migrating to reflect this new regime.

“We look at the issues in the context of the regulatory environment in which banks operate. We take confidence from regulatory environments as much as we do from the clarity of disclosure and the language in security documentation.”M a r k M I t C H e l l k a p s t R e a M c a p i t a l

roundtable discussion

2 8 | k a n g a n e w s j u n e 2 0 1 3

value and, we believe, low extension risk. In the new world we are taking a wait-and-see approach, though we think there will be a place for tier two in our portfolios – certainly more than there is for tier one.n PerICleouS We have also been a fan of old-style lower tier two. It has been appealing from a relative value standpoint and we have generally been happy to invest

down the capital structure in issuers we like. We have also seen a lot of value in foreign-currency issuance from Australia, for example US dollar deals from domestic majors. For new-style instruments the jury is still out on whether investors will be adequately compensated – we will see.n Feder Pricing has certainly been attractive on old-style instruments – I agree with the comments about relative value. Going forward there are quite a few challenges to overcome, in terms of structure as well as the intention of regulators.n borS We were very selective about the range of issuers on which we would take subordinated and call risk, and I wouldn’t necessarily say we would be a buyer at today’s spreads – though we were a buyer of old-style tier two when relative value was better. It is informative that even in the past six months there have been a number of global issuers that have decided not to call notes when funding markets have been operating smoothly.

However, we have been comfortable with the core risk of the biggest domestic issuers in Australia and some select offshore banks, because of their increased capital and expanded liquidity. With the last of the old-style issuance in December last year we took the opportunity to top up our holdings.

Regarding new-style issuance, I would describe us as having been an interested observer for some time. I note the fact that early ‘CoCo’ issuance by European banks initially struggled to perform even as the rest of the market rallied. I suspect that is based on an expectation of a lot of supply of new-style tier two, which already appears to be transpiring.n MannIng We have been very positive about old-style tier-two instruments for some time – they have been an important part of our portfolios and continue to be so. Going forward

davison How has old-style tier two performed in the secondary market since the advent of the new regime? in particular, does there appear to be any premium for the legacy notes – are they a kind of de facto ‘tier three’?n ManFIeld There has been significant spread compression across the board in the past 12 months but tier two has traded well, over and above this. There are a few factors at play here. As well as the general spread compression in the market I think the main one, however, is scarcity value. People know these instruments have a set lifespan and aren’t being issued anymore, so they are held very closely.

davison How active were fund managers as participants in the old-style tier-two market – and to what extent will the conceptual change in tier-two securities’ role likely affect that?n Mead In the old world the initial response to bank problems from governments and regulators across the globe was to bolster the bank’s capital base and guarantee funding sources. Pimco’s view was that, in this type of regime, investing down the capital structure made a lot of sense – the structure of deposit protection meant there was an expectation of equity injection below tier two. For us tier two was a very attractive asset class, and we think old-style securities from the Australian banks will continue to be an attractive hold until they mature or are called.n MItCHell We have been a big fan of old-style tier-two instruments for some time – they have accounted for a meaningful portion of our portfolios. They offer good relative

Rupert Daly Will ManfieldJasper Gale

“We have to ask why we are playing in the middle part of the capital structure at all if, in the worst-case scenario, we are effectively treated like equity holders.”r o b M e a d p i M c o

deutsche Bank participants

2 9

we have less of an attraction for offshore issuers and we will heighten our focus on domestic issuance, particularly from the four majors. There is more opacity around new-style structures and until we see more transparency we will likely hold fire on investing.n Hanna Our approach is fairly consistent with what the other investors have said. We were a buyer of old-style lower tier two – it formed a component of our investment strategies – and we continue to have demand for old-style paper especially as it appears to be developing scarcity value. Also, it seems the new-style issuance may help support the old-style instruments.

Like everyone else we are currently researching new-style instruments. I note John Needham’s comment about APRA always having had the power to take action over old-style tier two, however investors participated in those deals on the basis that this was not an expected outcome. With new-style instruments we would be investing with our eyes open to the fact that regulators are more likely to act.

NON-VIABILITY VISIBILITY

bounassif do investors believe that if there was a capital call on new-style tier two there wouldn’t also be one on old-style notes?n MannIng I think the question is really one of understanding PoNV. Once we can ascertain what the real risk is we can make a decision about whether or not that risk is acceptable and, if it is, how it should be priced. That’s certainly the way we are approaching it.n Hanna In terms of APRA writing off lots of instruments not explicitly covered by new rules, we certainly hope that wouldn’t happen. It can’t be ruled out, but it would do serious damage to investor confidence – which is exactly what a bank does not need.n needHaM There are examples in offshore jurisdictions, though – for instance in Ireland and what happened with SNS Bank (SNS) in Holland. In both cases the burden of non-viability was also applied to investors in old-style instruments. In Australia the law at the time those securities were issued allowed a similar thing to occur.n Hanna I would hope non-viability in Australia would be triggered before a situation became so bad that the only option was to bail in a bank’s old-style lower tier-two instruments as well as the new ones.

n needHaM I think this comes down to John Manning’s point – what exactly is the PoNV? All we have is the statements in prudential standards, which are necessarily drawn very widely.n Feder The problem we have is that non-viability has different meanings in different offshore jurisdictions, and in Australia we would have to witness non-viability in order to understand what APRA would do. That is obviously not an ideal situation, so we need to continually assess the risk of what non-viability is, when it could occur and what the regulator thinks about it.

davison investors obviously want clarity around what is considered non-viability, but it also seems to be accepted that apRa needs interpretative scope to allow it to guide banks through the specific circumstances of difficulties. How clear should the regulator be about what it will consider to be non-viability?n laMbert I don’t think APRA is going to give any detail whatsoever – it has made it very clear that it needs to be able to trigger non-viability under a whole range of circumstances and if it starts to list what those are it will feel boxed in. Doing so might produce more certainty, but I can’t see APRA going down that road.

The best way of assessing non-viability will, unfortunately, either be when it occurs or when it could occur but doesn’t. I don’t expect APRA will be definitive about what it will consider, and I don’t even think it will be definitive about what it won’t consider.n MannIng Historically there have been structured failures of smaller banks, for instance State Bank of Victoria and State Bank of South Australia, and arguably even Adelaide Bank and Bankwest. In the new tier-one and tier-two paradigm the question is whether that type of event will continue. In contrast to the smaller banks, should one of the four majors find itself in a situation where the regulator was concerned about it, non-viability could be used as a pre-emptive strike. I think that is very possible.

It is the lack of transparency that is the concern. But I also agree that the regulator must have absolute flexibility to react at any time, because its role is to preserve the stability of the banking system. From an investor’s perspective the question is whether it is a risk I am prepared to assume.n borS The worst-case scenario from an investor perspective would be something like a second-tier Australian institution

“As an issuer we are seeing additional volatility added to our capital structure by virtue of having all our tier two issuance convertible – and this is not very helpful.”J o H n n e e d H a M a n Z B a n k i n g g R o u p

roundtable discussion

3 0 | k a n g a n e w s j u n e 2 0 1 3

having its tier-two debt written off then the next day merging with a major bank. That possibility would certainly limit our appetite for issuance from non-major banks.n anderSon Investors will have to evaluate the risks of each institution’s issuance at any point in time, and regional bank risk premia will clearly be different from majors’. But the question is also about making a judgement on future regulatory responses, and how treatment of systemically important banks may differ from treatment of those that are not systemically important.

In Holland, for instance, SNS was the fourth-largest bank and considered systemically important, so the regulator considered it necessary to ensure the bank survived and therefore triggered non-viability. Yet there are situations with smaller banks – such as with Friesland Bank, which Rabobank took on in 2012 – where non-viability was not enforced.n needHaM Looking at this issue in an international context is important, because APRA hasn’t gone into a room and come up with this idea on its own. It is being imposed as part of the

davISon Some offshore investors – specifically Asian private banks – have in the past been very keen to buy higher-yielding instruments from issuers they favour. Was that sector interested in the recent Suncorp Group deal?

laMbert There was interest, and it was pretty much unsolicited – we didn’t market or otherwise push the deal offshore. I wouldn’t say the demand we encountered was of a quantum that

international angle adds intRicaciesThere is likely to be significant offshore demand for Australian-origin tier-two debt, even if pricing may not yet work for issuers. Cross-border tier-two markets carry unique challenges, though – not least of which is the question of making judgement calls on how foreign regulators will treat non-viability.

“When A bAnk Is IntegrAl to An economy We Were AlWAys tAkIng both regulAtory And sovereIgn rIsk – thAt contInues todAy And Is lIkely to contInue In future.”n a t a S H a F e d e r c o l o n i a l F i R s t s t a t e g l o B a l a s s e t M a n a g e M e n t

“When We look At Any offshore bAnk We need to hAve A cleAr understAndIng of WhAt Its regulAtor hAs done In the pAst And to form A vIeW on WhAt It mIght do In future.”J o H n M a n n I n g a B e R d e e n a s s e t M a n a g e M e n t

everyone is still working on the answer to this fundamental relative-value question. Being in Australia I understand non-viability as a very remote prospect. However, Europe has recently confirmed it is going for a statutory non-viability regime – they have given up on a contractual approach – and the US is doing the same. Australia is one of the few jurisdictions going for contractual terms.

The question becomes how will investors think about this. Will they view Australian tier-two issuance as closer to the CoCos issued by some European banks or more akin to tier-two instruments subject to a statutory overlay regime? My view is the comparison should be very much the latter, and that Australian product is completely different from CoCo issuance.

This is on the assumption that the point at which the Australian Prudential Regulation Authority (APRA) would step in and call non-viability is the same point at which a European regulator would step in and call non-viability under a statutory regime. Whether investors offshore agree remains to be seen.

gale Looking back to before the crisis, it’s also interesting that some of the largest

would excite the big four banks. But it was there and I am confident we could have increased it had we needed to.

davISon The level of spread offshore institutional investors appear to want on capital notes – relative to what Australian banks can achieve in the domestic retail market – appears to be a barrier to international deal flow at present. Rupert Daly, how would you characterise offshore demand for Australian-origin product?

daly The majors are undoubtedly still recognised offshore as very strong issuing institutions, and we believe demand for higher-yielding bank product will be very strong. The fundamental issues are price – including where comparable deals are pricing – and how offshore investors should and will look at Australian tier-two issuance versus the other products they buy.

The conversations I have with our syndicate teams in New York and London suggest that

3 1

Basel committee’s burden-sharing approach. It is being applied in various ways, through legislation or contract, but it is coming in all jurisdictions.

The goal is to be able to collapse a bank’s existing capital structure on the hypothetical Sunday night and then recapitalise so it can trade on the Monday. To me that is where non-viability is reached, and to get there all capital-raising opportunities need to have been exhausted – including reducing risk-weighted assets and selling various parts of the operation.

LIQUIDITY TRIGGERS

n Mead That assumes, though, that the PoNV is caused by capital erosion. But, if we go back to the financial crisis, Australian banks had to be guaranteed by the government to secure the funding they needed to survive. Is that a PoNV, and if not what is it? You could certainly argue that a bank not being able to fund itself makes it non-viable.n Ho-HudSon Commonwealth Bank of Australia (CBA)’s view is that the concept of non-viability extends beyond capital, and we have been very clear with both wholesale and retail investors that this is the risk. Investors have to make an assessment not just about how we manage our capital but also how we manage our funding and liquidity.n PerICleouS In that case perhaps what is required, to give investors more comfort, is more disclosure from banks.n Ho-HudSon Yes – and this is something we have done. When we have come to market we have felt the pressure of increased disclosure obligations. However, this is not just a result of the introduction of the concept of non-viability but of the financial crisis generally. Liquidity was not a focus pre-financial crisis, but it is something on which we have increasingly been requested to provide more disclosure.

The problem at present is that the banks are in a state of flux with regard to liquidity. We are still awaiting key details on the proposed Australian liquidity rules, and without those details we obviously cannot provide full information to investors.n MItCHell We look at all these issues in the context of the regulatory environment in which banks operate. In Australia and Singapore, for instance, we think it is highly likely there would be some sort of proactive discussion with regulators, which would encourage raising equity before triggering PoNV clauses in tier-two debt. We take confidence from regulatory environments as much as we do from the clarity of disclosure and the language in security documentation.n Ho-HudSon I agree with that. APRA has had a very strong focus on each of the areas of capital, funding and liquidity. It was already looking at new liquidity rules for Australia before the Basel III committee process began, for instance. So I think concerns about non-viability should be overlaid with a general judgement about how APRA regulates banking in Australia.

davison going back to the point about bank rescues and takeovers in the context of tier-two capital, is there at least an option for apRa to say it won’t declare a ponv until attempts to secure third-party capital injections from the private sector have been exhausted?n laMbert I don’t think there’s any chance of APRA being definitive about PoNV, frankly. APRA will work with a troubled bank across a range of possibilities – including a sale, divestment of assets and non-viability. It won’t trigger non-viability lightly.

buyers of Australian bank tier two at the time – the structured investment vehicles – looked for any margin they could find on tier two. This eventually drove the senior-sub margin right in because those investors did not foresee a scenario in which an Australian bank would be triggered in one and not the other.

ManFIeld In terms of old-style tier-two paper on issue, pricing the trigger is very much a jurisdictional, regulator-specific question. Certainly there are extension-risk and call-risk premia in some markets.

davISon How are offshore investors looking at the issue of, effectively, predicting what a foreign regulator – in this case APRA – will do in terms of pulling the non-viability trigger? Are those investors likely to be able to get comfortable making what will have to be a judgement call about how a remote entity will make those decisions?

daly It is very difficult to answer this question, other than to suggest to investors that there is no real difference between making that judgement call in relation to APRA versus a European regulator. To me they really are the same – no-one knows exactly when a European regulator will step in, either. That said, some insight might be gained from the SNS Bank (SNS) experience.

davISon How are Australian investors thinking about the same issue in reverse – in other words, how would they assess the issue of non-viability calls on a tier-two note issued by a bank where the decision could be made by a foreign regulator?

Hanna It’s an interesting question. It probably comes back to our level of comfort with the major domestic banks, and the fact that we don’t think non-viability is imminent in that sector. We would take a similar approach regarding foreign names – investing would only occur if we had sufficient comfort on the potential of non-viability being triggered. We have a team of analysts who analyse the local banks offshore and try to understand these points.

MannIng The key for us is also tapping into our global network. SNS makes it clear that you are taking, for instance, Dutch regulatory risk. When we look at any offshore bank we need to have a clear understanding of what its regulator has done in the past and form a view on what it might do in future. This is an absolutely critical part of the analysis process for us.

Feder Our view is that nothing has really changed on this score. When a bank is integral to an economy we were always taking both regulatory and sovereign risk – that continues today and is likely to continue in future.

roundtable discussion

3 2 | k a n g a n e w s j u n e 2 0 1 3

I’m not sure I agree that the scenario where a regional bank is bought by another institution means that regional bank tier two is more at risk than major bank issuance. The equivalent situation is a major having to have its capital guaranteed by the government, which I think would pretty clearly be a non-viability event.n Hanna The other factor with PoNV is that investors are much more at the mercy of the market than they were previously. In the financial crisis liquidity issues forced the government to guarantee banks that were otherwise in good shape, and it is easy to imagine that if the market has concerns about a bank it will withhold liquidity from that entity until APRA is forced to trigger non-viability. We don’t want the return of capital we have provided to a bank to be in the hands of the market.

n Feder I agree that this is an issue. When a bank starts to struggle there is a good chance the market will step in and effectively create non-viability. As an investor, because we are one step back from the provision of bank liquidity, we are likely to find out after these events have played out.n daly But it’s not impossible to envisage a scenario, as in the financial crisis, in which the government steps in to guarantee debt but where it would still be an overreaction to call non-viability across the banking sector.n Hanna On the other hand I can see why taxpayers would say they want tier-two debt to be triggered before that type of situation becomes a necessary response.n daly You’re right. Even so, in a situation where global funding markets are frozen I am convinced it would make more sense for the government to step in to provide liquidity

davISon One issue specific to write-down securities is the local tax treatment in Australia, under which issuers may have to recognise a potential tax gain from writing off debt and as a result only be permitted to record capital value for 70 per cent of tier-two issuance. How has this come about?

Ho-HudSon In the finalised Basel III standards for Australia the Australian Prudential Regulation Authority (APRA) says we have to take into consideration, for both

hybrid tier-one and tier-two securities, the fact that when something happens to the securities upon non-viability that may create a gain for tax purposes. Therefore, whenever we issue, APRA says we should allow for that gain upfront and only include the after-tax amount in our capital calculations.

This issue was apparently discussed by the Basel committee, which is why it has been included in Australia’s standards. We are waiting to see what emerges elsewhere but at this stage the issue only seems to appear in the Australian standards.

We discussed the issue with APRA as soon as it appeared, and the regulator decided to give us a concession. That was to say we wouldn’t be required to take a tax haircut if our securities featured a conversion feature. This is generally fine for tier-one issuance and for convertible tier two, but it leaves us with an issue in relation to non-convertible tier two.

It is an issue because we have heard from some investors that they cannot accept convertible tier two. We don’t want to have to effectively over-issue tier two by 30 per cent to get the amount of capital we want. The industry is currently working very hard to resolve this issue with APRA, federal Treasury and the Australian Taxation Office.

davISon In the event that this issue is not resolved, would write-down securities issued for 70 per cent capital treatment be

taxing tiMesFor Australian banks, the decision to sell convertible or write-down style tier-two instruments is not simply one of marrying issuer and investor preferences. A local tax treatment effectively penalises issuers if they plump for write down.

“We don’t WAnt to hAve to effectIvely over-Issue tIer tWo by 30 per cent to get the Amount of cApItAl We WAnt. the Industry Is currently WorkIng very hArd to resolve thIs Issue.”t r I C I a H o - H u d S o n c o M M o n w e a l t H B a n k o F a u s t R a l i a

uneconomical to the point of not being worth doing?

PrICe I can’t see how they could be economically viable on that basis.

davISon Exactly how is the industry going about trying to get the situation changed?

Ho-HudSon We are trying on all fronts – with APRA, in terms of its interpretation of international standards, and with federal Treasury regarding the impact on the Australian banking industry.

The reason this is one of the last issues to be resolved is simply that there was so much to manage in the lead up to January 1 this year that this became a secondary concern. It is one we are actively working on now, though.

laMbert I think the best context I can put around this issue is that tax advice will likely become more prominent in the regulatory conversation around issuance.

bounaSSIF Getting clarity on this issue will also improve speed to market. There has been a lot of back and forth and there is still a process to go through – dealing with this will help the market overall.

3 3

support, of the type we saw in 2008, before APRA writes the letter of non-viability to all the banks in the system.n needHaM There is an enormous gulf that has to be crossed for these kinds of situations to trigger non-viability, even if there is a liquidity event. The system has been built to try to remove those issues, and government-provided liquidity facilities are available, in large volume, as part of the system.n Hanna But are you happy to say that gulf won’t be crossed?n needHaM I don’t want to dig into the causes of Lehman Brothers’ liquidity problems, but when it comes to whether large holdings of mortgage-backed securities that hadn’t been marked to market counts as a capital event or a liquidity event I’d suggest the two are intertwined. Yes there was a liquidity event, which probably caused the failure to occur as quickly as it did, but you can’t say there wasn’t also a major capital problem.n Mead If you look at the Australian banking environment today these all seem like moot points because the system is strong. But you could have argued that about many banking systems five years ago. Investors need to think about their clients in the long term, including what happens if the state of play becomes very different. This means we have to ask why we are playing in the middle part of the capital structure at all if, in the worst-case scenario, we are effectively treated like equity holders.

It has become more acceptable for some banks not to call lower tier two, even in its current form. My fear is that, if another jurisdiction has to trigger non-viability at some point over the next two to five years, the level of acceptance will start to elevate as well. This is a decision under Basel III that is being rolled out globally – it is not reflecting the specific circumstances of the Australian system.n borS At the very least pricing of new instruments needs to reflect an expectation of greater mark-to-market volatility. If there is the slightest sniff of non-viability being triggered there will be a large and fast price move – or no bid at all.

RISK PRICING

needham are investors switching to making judgements based on probability of default rather than loss given default?n MItCHell Our assumption will be 100 per cent loss given default in all cases. So the nuances of how PoNV operates and

how securities are structured are all very well but that is our ultimate expectation if there is an event. n borS I agree – we expect 100 per cent loss given default.

daly How does that 100 per cent loss given default expectation compare with the pre-Basel iii situation?n MItCHell Traditionally we would have factored in around 20 per cent recovery in subordinated debt.

needham How do investors think about the probability of ponv events occurring, relative to the probability there may have been under old-style lower tier two and given the fact that the banks have a lot more common equity?n PerICleouS The probability of default has definitely reduced, but the loss given default has increased at the same time. In the past investors had an expectation that if a large institution got into difficulties it would receive government support. They are now coming to the realisation that this systemic support is no longer there, so investors need to understand the institution they are lending to and price appropriately.

Institutional investors are in a better position to price for that risk than retail investors, and yet we are seeing all the banks issue tier-one securities to retail investors at tight margins – levels that institutional investors will not contemplate. We wonder whether retail investors really understand what they are buying. As a result we also question whether the regulator will be comfortable writing down instruments if those securities are largely held in the retail market.

davison tricia Ho-Hudson has mentioned cBa’s focus on disclosure, especially to retail buyers. How do other issuers approach ensuring retail understands the risks involved in what it is buying?n PrICe National Australia Bank (NAB) has been quite an active issuer over the past 12 months, in both the retail and wholesale spaces, for old-style tier two and tier one. We have a strong focus on being very clear about the risks in securities with our broker and adviser channels. To some extent we are reliant on those networks to disseminate that disclosure, but we have had a clear focus on making it available and treating it in an appropriate manner in documentation.

“the risk of having all our capital securities converting to equity at the same point in time is something we are thinking about. I also agree that there may well be investors offshore who only want to look at write-down structures.”J o H n g e o r g I a d e S w e s t p a c B a n k i n g c o R p o R a t i o n

roundtable discussion

3 4 | k a n g a n e w s j u n e 2 0 1 3

n PerICleouS What confuses me is how retail investors are happy to buy Basel III-compliant instruments offering a spread of around 320 basis points over bank bills, when the old-style major bank offshore wholesale tier-one deals are trading at substantially wider margins.n needHaM I think you need to look at both the forums in which instruments can be traded and all their characteristics. If instruments are listed on the Australian Securities Exchange (ASX) there is clear visibility of their pricing – and those floating-rate, AUD-denominated securities show that tier two clearly trades at a lower margin than tier one.n daly Also, if you look at where the two wholesale tier-two deals done by major banks last year – by ANZ Banking Group and NAB – they are both trading tighter than where those banks’ equivalent ASX-listed instruments are.n PrICe It’s about a 60 basis point difference.n PerICleouS That may be the case. However, relative to old-style offshore lower tier-two and tier-one instruments the domestic new-style tier-one lines issued by Australian banks are mispriced and expensive.

Offshore old-style lower tier two offers an extra 18 basis points over ASX-listed old-style lower tier two. Offshore tier ones offer 45-160 basis points of additional spread. In the event of non-viability, old-style notes rank ahead of new-style instruments, assuming no event of default or legislative application of the non-viability language to old-style tier-one and tier-two instruments. n borS There is an issue of capacity here. My understanding is that the Australian majors are forecast to need around A$20 billion of additional tier-two capital over the next five years, and at some point they may max out the capacity of the local retail market.

When that happens issuers will have to address the institutional market.

n PrICe It’s certainly true that we have a tier-two requirement – perhaps not imminently but in future years.

Mitchell will banks tap out retail issuance before contemplating the institutional market?n PrICe That comes into some of our calculations for tier one, if only because of the role franking credits play in making tier one a largely retail market. There is clearly an issuance cost impact – not being able to issue unfranked tier one into offshore markets is a problem.

CONVERSION AND WRITE OFF

davison it seems that the market is migrating towards conversion rather than write off as the loss-absorbency feature of new-style tier two. is this a challenge for fund managers, given mandate issues with holding equity in fixed income portfolios?n Mead I think the ability of institutional investors to hold convertibles is very mandate-specific and it depends on how close an instrument is to equity – so it’s hard to generalise. As always, it comes down to the appropriate price for taking any level of risk. But at the end of the day most of our mandates would be able to handle either type of issuance – though there would be nuances in some cases.n laMbert This issue was certainly something we considered when we did our recent tier-two deal, because we wanted to make sure the transaction was attractive to as many potential investors as possible. We put a feature in place that allowed even investors who can’t hold equity to buy the instrument: if it converted and the holder had advised us that they didn’t want equity, we would transfer the shares to a trustee and sell them at market rate. Compared with a write off – where you

“Investors will have to evaluate the risks of each institution’s issuance at any point in time, and the risk premium on a regional bank will clearly be different from that for a major. but the question is also about making a judgement on future regulatory responses.”J a I a n d e r S o n R a B o B a n k

“I’m not sure I agree that the scenario where a regional bank is bought by another institution means that regional bank tier two is more at risk than major bank issuance. the equivalent situation is a major having to have its capital guaranteed by the government, which I think would pretty clearly be a non-viability event.”b r u C e l a M b e r t s u n c o R p - M e t w a y

3 5

definitely get nothing – investors have the possibility of getting something back.n MannIng Taking the issue of non-viability out of the equation, there is a price-determination point that comes out of a write-off structure. That is, write off gives a clear pricing point as those notes rank subordinate to common shares. As such, the price point has to start with an issuer’s gross dividend yield.n ManFIeld In the old-style tier-two market pricing was always derived from senior. The question now, in my view, is whether it is more appropriate to derive pricing back from equity – and the extent to which it makes sense to look at senior and old-style lower tier-two spreads at all. My guess is the market will land somewhere in the middle.

Similarly, as much as the relative-value argument comparing AUD with offshore markets is relevant, this dynamic is neither new nor unique. In fact, this pricing disparity has been evident across corporate and financial issuance since the implementation of QEII and the subsequent relatively high optical yields available in the AUD credit market.

Certainly we have seen some fund managers take advantage of this via cross-currency swaps – but the flow in this strategy has not been significant enough to correct the pricing divergence.

I believe it is relevant to analyse the AUD capital structure in isolation – ignoring USD and EUR pricing, as those instruments will be redeemed within three years. Rough and dirty, in AUD investors have a choice to invest in senior debt with a high 3 per cent handle, old-style lower tier two at low 4 per cent, old-style tier one at mid-5 per cent, or equity at a 7 per cent dividend yield. In my mind, therefore, you can roughly estimate a price for new tier two at around 5.5-7 per cent – which is essentially where the retail bonds have been issued.n borS I suspect the institutional market is looking at relative value to CoCo spreads.

n ManFIeld I would guess the basis on which new-style securities is being marketed is a relationship to equity.n needHaM I also don’t necessarily think the market is migrating to conversion rather than write off. We will need to go to international markets and we have yet to see exactly how they will develop. Statutory regimes may effectively be considered to have write off for all US and European issuers, and if so Australian issuance into those markets may well go in that direction. Or we could still see both types.

As an issuer we are seeing additional volatility added to our capital structure by virtue of having all our tier-two issuance convertible – and this is not very helpful. At the point of non-viability we don’t want to have a large overhang of convertible stock at exactly the time when what we need to do to avoid non-viability is a capital raising. By being able to reduce that volatility we make the outcome itself less probable.

davison do other issuers believe there is value in being able to issue tier-two capital that would write down rather than convert?n georgIadeS I think there is. The risk of having all our capital securities converting to equity at the same point in time is something we are thinking about. I also agree that there may well be investors offshore who only want to look at write-down structures. When we get to the point of looking at those markets it would be helpful to be able to choose structures that meet investor demand in each jurisdiction.n PrICe To some extent I think we will end up taking a horses-for-courses approach on what structures we issue, based on what works in different markets. There will likely be pockets of demand around the globe which gravitate to either convertibility or write off and we would like to be able to offer the product they are looking for. On the point about conversion and system stability, having certainty around this

“In the past investors had an expectation that if a large institution got into difficulties it would receive government support. they are now coming to the realisation that this systemic support is no longer there.”H e l e n P e r I C l e o u S a M p c a p i t a l

“there will likely be pockets of demand around the globe which gravitate to either convertibility or write off and we would like to be able to offer the product they are looking for.”M a t t P r I C e n a t i o n a l a u s t R a l i a B a n k

roundtable discussion

3 6 | k a n g a n e w s j u n e 2 0 1 3

in the sense of being able to move forward without having an overhang of stock has a lot of merit.

davison Mark Mitchell suggested earlier that there is a likelihood that loss given default

expectations will be 100 per cent in new tier-two securities. in this context is there any reason for differential pricing between write-off and convertible securities? does equity hold any residual value in a non-viability situation?

davISon Do other issuers expect they will aim to cap out retail tier-one demand before looking to alternative markets for future additional capital issuance?

georgIadeS I think that’s likely. The retail market is a great one for us and I expect we will continue to look first to retail, especially on the tier-one side. There are also tax concerns around the ability to issue tier one offshore in unfranked format, so retail will continue to be the home for tier one at least in the near term.

As and when retail capacity shows signs of fatigue we will look at other opportunities, including for tier two. We, and the other majors, have generally been active issuers over the past 12-18 months, which has bought us some time to assess the new tier-two landscape.

davISon What sense do issuers get about the capacity of domestic retail relative to the banks’ expected need for

additional capital? Is it possible they might never need to address the new-style tier-two market?

georgIadeS It would be good to be able to issue in tier-two format – should it be a reasonably-priced form of capital. But it’s also important to note that banks are generally running with high levels of tier-one capital, which also counts towards total regulatory capital. We don’t have an immediate need to start issuing tier two – we have bought ourselves time to let the market develop.

Ho-HudSon None of our major investors are questioning us about our total capital at present, so there is little or no pressure to look at tier two. If anything the focus now is on common-equity tier one.

The other issue is relative pricing between tier-one and tier-two capital. We would like to issue tier two in both the retail and wholesale markets and to see pricing even out between the two markets. But

offshore wholesale investors are concerned about the concept of non-viability. That is making tier-two pricing higher than we think it should be, to the point that we might as well issue tier one.

bounaSSIF We took the opportunity to issue an old-style tier-two deal late last year, mainly because we knew we would be having discussions like this in 2013.

Our group requirement is for tier one and tier two. Ideally it would be nice to have a mix of retail and wholesale investors in all our deals. But the way things are going suggests to us it will be a predominantly retail market in the short term.

anderSon Rabobank has taken a different approach, and in fact it has already accessed the new-style tier-two market in euros, US dollars and sterling as well as issuing two US dollar, new-style tier-one deals. Therefore, all our trades have been targeted at institutional investors and private banks. Rabobank is

cautious about selling these types of instruments in smaller denominations as we want to make sure that investors have an appropriate level of understanding of these products.

davISon Suncorp Group has issued in Australia under the new rules. Was there any institutional interest in that deal?

laMbert I would summarise the institutional view as ‘wait and see’. As our deal progressed that attitude mellowed a little and we encountered some demand. But as it was, especially given that our transaction incorporated the roll-over of existing securities, retail demand was very strong and we didn’t need to press the institutional angle. In fact we had to wind back what we got.

It was the same with international demand. There was some but we didn’t need it and we didn’t market offshore – we wanted to avoid an issue around substantial oversubscription and, therefore, scaling.

anderSon Institutional investors internationally have been willing to support new-style tier-two transactions. During our investor relations work we have noticed that investors, especially in Asia, have quite advanced understanding of the product. The challenge for issuers is how they should price their deals to attract institutional and retail investors. The retail bid seems to be a little less conversant on price – it tends to be more focused on the name.

tHe Retail first resortAustralian banks have made hay in their domestic retail market in recent times, to the tune of nearly A$12 billion (US$11.7 billion) of tier-one and tier-two issuance from the big four alone since late 2011, according to KangaNews data. Whether the retail market can provide all the additional capital the banks needs is an open question.

“IdeAlly It Would be nIce to hAve A mIx of retAIl And WholesAle Investors In our deAls. but the WAy thIngs Are goIng suggests to us It WIll be A predomInAntly retAIl mArket.”J a S o n b o u n a S S I F a M p g R o u p

3 7

not looking at non-operating holding companies as the issuer. That adds extra elements of subordination to an already-opaque structure. It is another element of complication that has to be worked through and priced. That said, old-style lower tier two remains an attractive asset class for us.n MItCHell Over the next couple of years I don’t think we will be buying – we will just stay long the old-style securities. When they start to roll off, especially if yields and spreads stay where they are now, I expect we will look at higher-yielding product. I suspect tier two will have a place in a way that tier one will not.n gale Across our client base we are not seeing any substantial volume of old-style issuance coming back to us.n ManFIeld That is right – there might be a small amount of switching but there is definitely net demand.n Hanna I absolutely concur with the idea that price is key – and that we are not there yet. Even if we do get there on price I suspect demand for new-style tier two is likely to be weaker in our portfolios. I’d also like to know if the banks believe an issue into the institutional market is something which needs to happen within the next two years.n needHaM The suggestion earlier was that the major banks have a A$20 billion need, which is obviously a very large number. But divided between five years, and then split four ways, means just A$1 billion each per year. That is barely two benchmark-sized transactions, which is reasonably easily executed in a functional market – even as the task grows over time. We don’t need to do anything now, but I think over the next two or three years there will be deals we want to complete.

PoStSCrIPt On May 21 Deutsche Bank launched and priced its first tier-two capital instrument since the European parliament reached agreement in April on the proposed regulatory resolution regime for Eurozone banks. These rules will ultimately subject tier-two capital issued by Deutsche Bank to bail-in provisions not dissimilar to the non-viability regime in operation for capital instruments issued by Australian banks.

According to Deutsche Bank, based on levels of relevant securities in the secondary market, deal pricing suggested little or no premium was charged by US investors for this potential bail-in risk. And, by inference, it also suggests offshore investors may not look to charge a material premium for future Basel III-styled tier-two instruments issued by Australian financial institutions relative to their Basel II equivalents. •

n Ho-HudSon When I speak to investors I tell them they can have the conversion feature for nothing, and since it carries some potential upside they might as well take it. The only argument I have heard against taking it is that some investors have very strict mandate rules. However, the trustee mechanism used in the recent Suncorp and CBA transactions shows this can be managed. Therefore, I am not entirely sure why there should be significant push back on what is a free option.

davison if you are happy to give convertibility away it suggests you are less concerned than john needham is about having a lot of convertible instruments.n Ho-HudSon We differ slightly on this issue, yes. John Needham is technically correct – if we were in difficulty we would not want to have conversion occur at the same time as we were taking other actions to save the bank. But we don’t run the bank in expectation of non-viability – I’m sure none of the other issuers here do either – and on that basis we are able to offer convertibility as a small upside feature today.

FUTURE EXPECTATIONS

davison taking everything into consideration, do investors believe new-style tier two will have a significant place in their portfolios in future?n PerICleouS It will have a place in our funds but it is a question of pricing for risk. With the lack of clarity around non-viability we will have to take a worst-case scenario in determining how we price the new terms of Australian bank Basel III-compliant tier-one and tier-two instruments.n Feder We will continue to look at product as it is issued. But it is very much a wait-and-see at this point.n Mead With such a vague concept around non-viability, price targets from issuers and issuer expectations may never meet. We would have good appetite – at the right price – but at this point I have to question whether both sides will ever line up.n borS Our participation will depend on what other relative-value opportunities are available at the time. But I agree with Rob Mead – there is probably a wide gulf in price between where banks want to issue and our expectations at this stage.n MannIng It is a matter of risk and reward, and we are not there yet. I think it may be easier in the times ahead if we were

“the worst-case scenario from an investor perspective would be something like a second-tier Australian institution having its tier-two debt written off then the next day merging with a major bank.”M I C H a e l b o r S c H a l l e n g e R