Swedish banks are expected to fight government plans to clamp down on the favourable tax treatment of subordinated debt, which threaten to push up the cost of issuing and servicing regulatory capital. Finance minister Magdalena Andersson outlined proposals in the Swedish press on Wednesday that could generate SEK1.4bn (US $173m) in revenues by removing the tax deductibility of coupons on Additional Tier 1 and Tier 2 bonds.
The tax change could be implemented as early as 2017 and make it less attractive for Swedish banks to issue this type of debt. "The removal of tax-deductibility would put Swedish banks at a disadvantage versus foreign competitors, making issuance more expensive, and would be out of line with other jurisdictions, although it itself it is not the main reason for banks to issue AT1 and Tier 2 instruments," CreditSights analysts said in a note.
It was not until they had certainty on AT1 coupon tax deductibility that banks in the UK, Germany, and the Netherlands started to issue this type of debt. Swedish banks are expected to push back, particularly given the increased costs would come at a time when the profitability of European banks and net interest margins are already under pressure.
One banker put the saving offered by the tax deductibility at 25%-30%, adding it was "not negligible" and said it was why banks originally pushed for that treatment. "Banks will lobby and it's not a slam dunk," he said. But while pushback is expected, market participants believe the tax change is likely be implemented given the political tailwinds, and the fact that it has been in the works for some time. They also believe that banks will continue to issue this type of debt.
"It would change the tax efficiency of AT1 instruments but I'm not sure it would change the approach. Tax efficiency is only a portion of the economic interest of the instruments, as long as they still remain cheaper than equity," said Julien Brune, co-head of capital structuring at Societe Generale. Coupons on Swedish AT1s are around 5%-6.5%, compared to the approximate 9%-10% cost of equity. "...Swedish bank are waiting for final proposals regarding TLAC/MREL requirements, under which it will probably be advantageous to have a certain level of Tier 2 and AT1 instruments in addition to Common Equity Tier 1 capital," CreditSights analysts added.
Changes to the tax rules could impact outstanding bonds given that tax changes tend to be applied retroactively. Banks could in theory try to call their bonds. That is because the documentation incorporates "Tax Event calls" to redeem the securities at par in the case of a material tax change that was not foreseeable at the time of issuance. But that seems unlikely given banks need to keep building their capital buffers, and because they would need to receive regulatory approval to do so.
"That's not a given. Such discussions have happened in Sweden for a number of years, so one could say it was reasonably foreseeable that such a law would happen," said Brune. Svenska Handelsbanken has already indicated that it would be reluctant to exercise a Tax Event call, according to CreditSights. Investors will be keeping a close watch on the likelihood of early redemption, which limits upside. That is particularly true for Tier 2 bonds which are generally trading better than the AT1s, which have slipped two to five points below par.
"The argument applies to both but will be most visible in Tier 2. This leads to higher spreads, while new issues (presumably without tax call) would trade at a premium, unless banks remove the tax calls from legacy bonds," said one investor. Some argue that the additional costs facing banks are actually fairly minor, pointing out that Swedish banks are already in a relatively strong position. "While it puts banks at a disadvantage from a tax perspective, they are still at an advantage compared to their European peers on many levels, such as funding costs, operating environment and how capital requirements are implemented in Sweden," said another source.
The fact that Sweden has tried to emphasise the role and value of Common Equity Tier 1 (CET1) should help, he added. "The portion of CET1 is quite high in the country, which also means that the cost impact is smaller than it would have been if the focus had been on other forms of capital."