European and US banks are facing the prospect of having to issue much more subordinated debt, and at a much higher cost, as regulators stamp out low leverage ratios and investors demand higher concessions for market volatility. In the US, the Federal Reserve is thought to be considering doubling the leverage ratio for its largest banks to 6 percent, while across the pond, European banks are struggling to meet the minimum 3 percent requirement.
"There are certainly a number of US and European banks that would have to issue hard capital in the form of equity or Additional Tier 1 to meet the new leverage requirements," said Alexandra MacMahon, head of EMEA FIG debt capital markets at Citigroup. "At the moment, there is still a lack of clarity on the tax treatment of Additional Tier 1, which is stalling certain banks from raising this form of capital. Added to that, as volatility returns, investors are flexing their muscles on pricing, which could make issuing subordinated debt more costly."
As it currently stands, US banks Citigroup, J.P. Morgan, Bank of America Merrill Lynch, Goldman Sachs and Morgan Stanley are all comfortably above the minimum 3 percent ratio. But in Europe, BNP Paribas is the only eurozone bank to surpass that minimum requirement. RBS and UK headquartered HSBC have both exceeded the ratio target, according to Barclays research. Despite the discrepancy between US and European banks' capital needs - which some say could damage the latter's competitiveness - bankers seem relatively calm about issuance prospects.
They argue that banks are in general well capitalised and can therefore afford to sit and wait for calmer market conditions. "If markets do stabilise, we could see some deals in September, but I don't think anyone is expecting a big gush," said Daniel Bell, head of EMEA DCM capital products at Bank of America Merrill Lynch.
"No one is in a particular rush to do deals. It's more about how they can optimise their balance sheets and about taking out old structures and putting in new ones, so certainty of treatment - regulatory and tax - is more important at this stage." European banks, however, were given a further push to issue capital on Thursday, when the European Banking Authority (EBA) announced that Tier 1 deals that have passed their call dates and stepped up would not be grandfathered as Tier 2 capital. This means that if banks want to maintain their current capital levels, they will have to issue Additional Tier 1 and Tier 2 debt, adding further pressure at a time when markets remain fragile.
In the US, there is even more of an impetus for financial institutions to get going. This week, the Fed ruled that the banks with over USD250bn in assets cannot, as many had hoped, keep any of their old Tier 1-eligible Trust Preferred Securities (TruPS) as Tier 2 subordinated debt, although smaller banks can. The decision, especially in a rising-rate environment where the biggest banks are battling to safeguard themselves from losses on the billions of dollars of Treasury securities on their books, could spur a new round of extra capital issuance to buffer Tier 1 levels against volatile swings once the new rules are effective.
For banks with less than USD250bn of assets, however, "the Fed's final interpretation of Basel III is better than expected", said Kevin Ryan, co-head of FIG DCM at Morgan Stanley. The smaller banks can continue holding some TruPS as Tier 2. They are also not subject to the higher supplemental leverage ratio rules, and can continue to elect that most elements of 'All Other Comprehensive Income' (AOCI) do not have to be included in regulatory capital calculations.
The biggest US banks, however, have lost their lobbying efforts to keep the gains and losses on tradeable securities cordoned off from regulatory capital. In the US, they are seeking to keep putting Treasuries and other actively traded securities in the 'Available For Sale' bucket, which is counted as AOCI.
"The potential losses (on actively traded securities) in a rising rate environment is a concern, because it could be a direct hit to capital," said one DCM head. "So one thing the G-SIFIs are focused on is the capital implications of that - does it mean the big banks should issue more preferred or subordinated debt to bolster their capital positions? That's something they need to think about."
In Europe, they are calling for further clarity on the tax treatment of AT1 so they can fatten up their capital cushions and meet the leverage ratio while yields are still relatively low. The renewed focus on leverage ratios, and therefore capital, comes at an unfortunate time for European banks. Increasingly risk-averse investors are looking for higher yields to compensate them for perceived higher interest rate risk, which means issuing capital will be a challenge.
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