December 13, 2012 / 2:50 PM / in 5 years

Regulatory rethink spoils bank capital prospects

* European regulators may seek new stop-gap capital rules

* New proposals could erode capital value of existing Tier 2

By Aimee Donnellan and Natalie Harrison

LONDON, Dec 13 (IFR) - European banks hoping to boost capital through issuance of Additional Tier 1 and Tier 2 debt next year could be in store for a blow if market talk that regulators could contractually impose losses on holders of these instruments prove correct.

EU member states and the European Parliament are negotiating tougher bank capital rules on Thursday. The meeting, which began at 0930 GMT in Strasbourg, aims to reach an agreement on how to put the Basel III framework into European Union law and could see banks being required to introduce contractual loss-absorption features from January 1 2013.

Under the Basel guidelines agreed in January 2011, all classes of capital instruments issued by banks need to fully absorb losses at the point of non-viability before taxpayers are exposed to losses.

The Basel Committee agreed that these requirements could be met through a statutory resolution regime as long as it produced an equivalent outcome to a contractual approach.

Bankers had been hoping that the introduction of the European Crisis Management Directive (CMD) in 2015 - which will introduce a European wide resolution regime and thereby capture all outstanding bank capital instruments - would be enough to satisfy the global regulator.

However, a report published in July by the Basel Committee Banking Supervision (BCBS) highlighted Europe as one of the jurisdictions failing to comply with some of Basel’s requirements and it looks like lawmakers are now seeking to remedy this.


Despite the clear Basel guidelines and countries like Canada opting for the contractual instead of statutory route, the response from some bankers to the proposals for contractual loss obligations was apocalyptic.

“The problem with going for a contractual clause is that, should a bank run into trouble before the CMD is implemented, then holders of Tier 2 debt could be hit first and it would be easier to wipe them out,” said a banker.

“This will completely reprice Tier 2 as banks will be forced to re-evaluate their capital levels once again.”

Others bankers, however, said banks should be able to issue new Tier 2 bonds with these required features without onerous premiums.

Investors have already proved their willingness to increase their exposure to riskier instruments, including total loss, high-trigger contingent capital issued like a USD3bn deal issue by Barclays, some pointed out.

“In the near term, yes, there is fractionally more risk. But an investor would not buy Tier 2 bonds from a bank they think is going to go bust in the next couple of years anyway,” one banker said. Even so, such a rule change will have ramifications for European issuers which have raised over USD33.5bn equivalent of Tier 2 debt year-to-date, according to Thomson Reuters data, having grown tired of waiting for regulatory clarity.

The market consensus was that as long Tier 2 bonds complied with all of the Basel requirements with the exception of loss-absorption at the point of non-viability, they would count fully as regulatory capital.

Now those instruments issued up until January 1 2013, which do not include these contractual features, could now be captured in Basel’s transitional arrangements instead.

That effectively means that, overall, they will lose 10% of their capital value per annum - a blow for those banks that bit the bullet.

Should Europe agree on the proposals, it could also put another nail in the coffin for Additional Tier 1 capital, which banks have not felt confident to issue due to unclear regulatory and tax treatment of the capital instruments.

Industry estimates are that over the course of the next few years as much as EUR200bn of Tier 2 debt could potentially hit the market. Once rules governing Additional Tier 1 are clearer, issuance could be as large as EUR150bn.


The new proposals, if implemented, would mean that if a bank reaches the point of non-viability, then the principal either has to be written off or converted into equity.

As that carries significantly higher risks, investors will want to be compensated.

“Investors have been saying that if an instrument were to include a contractual term for a writedown ahead of the statute being introduced then there should be a cost implication for the issuer,” another banking source said.

That extra cost was justified for two main reasons. The first was the likely negative impact on the ratings of the instrument due to the higher loss risks, while there are also question marks about whether the instruments would be deliverable into subordinated CDS contracts, the banker added.

However, unless the premium was too onerous, then issuers would still likely want to issue Tier 2 as they need to raise capital. (Reporting by Aimee Donnellan and Natalie Harrison, Editing by Helene Durand, Sudip Roy)

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