Banks race to beat new higher cost capital rules

LONDON (Reuters) - European banks could issue around 25 billion euros ($32 billion) of hybrid bonds in the final quarter of the year as they rush to beat new capital rules that will drive up their costs by billions of dollars.

If current favorable credit market conditions hold, financial borrowers are expected to set a blistering pace of bond issues that count toward Tier 1 and Lower Tier 2 capital and so avoid having to raise capital later, when costs are likely to be higher.

This contrasts starkly with the first nine months of 2010, when the market was repeatedly shut by the sovereign debt crisis and regulatory uncertainty.

"Despite the Basel consultation, the existing rules are still there. None of this (change) has been defined, so in the meantime I think banks will try to slot in additional capital while they can," said one senior European banker.

Italy's Monte dei Paschi di Siena on Thursday, for example, came to market with a Lower Tier 2 subordinated 10-year bond.

The uncertainty around what type of securities will count as capital and how much banks should hold in the future has caused a hiatus in the supply of new hybrid deals this year.

Banks have issued only 46 of these bonds in 2010, raising a relatively meager $39 billion across all currencies, according to Thomson Reuters data.

But they faced redemptions of $67.7 billion this year, according to JP Morgan data. In 2011 the number rises to $85 billion and is a still hefty $76 billion in 2012.

"There is a room for both Tier 2 and hybrid Tier 1 capital classes in the future," said Marc Tempelman, head of debt capital markets for financials at Bank of America Merrill Lynch.

"With every publication that Basel produces, there is increased clarity around what structures will be acceptable in the future," Tempelman said.

HIGHER CAPITAL COSTS

After the credit crisis, the Basel Committee on Banking Supervision is pushing for new hybrid bonds to be built in a way that ensures bond investors share the burden with shareholders and taxpayers of any future bank bail-outs.

Hybrid bonds have equity-like features and can count toward a bank's capital ratios. They are also a cheaper form of capital for banks than true equity, as coupons are tax deductable.

But new-style hybrids will carry more equity risk, will cost banks more to sell to investors and might not be tax deductible.

UK bank Lloyds, for example, last year issued Lower Tier 2 bonds with so-called contingent features that could form part of new-style hybrids once the Basel rules are finalized.

The Lloyds' bonds convert to equity if the bank's core Tier 1 capital ratio falls below 5 percent.

Some of the Lloyds hybrids currently trade with a yield of about 9 percent, about 300 basis points more than the bank's other Lower Tier 2 bonds, traders estimated.

Therefore, the additional yield borrowers face on a $1 billion bond deal amounts to about $300 million over 10 years.

(Editing by Will Waterman)

($1=.7814 Euro)