China warning spurs banks over bail-in debt plans

Competing for attention in global TLAC markets could drive up costs for Chinese lenders

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China’s central bank is forecasting that its top four lenders – which are among the world’s largest – will need to start issuing bail-in debt sooner than originally expected, and is warning that capital markets may not be ready to absorb the volumes involved, which may now coincide with large supply from western peers.

Systemically important banks must hold total loss-absorbing capacity (TLAC) equivalent to 16% of risk-weighted assets in 2019, rising to 18% of RWAs in 2022, according to rules drawn up by the Financial Stability Board in 2015. China is exempt from the rules until 2025, with full implementation due in 2028.

This exemption is contingent on the size of China’s corporate bond market: if it hits 55% of gross domestic product before 2022, as measured each November, the country will have three years from the start of the following year to phase in the rules. Reaching the 55% trigger point is meant to indicate that the domestic bond market has attained sufficient depth to absorb the additional TLAC-related issuance.

In its Financial Stability Report published in early November, the People’s Bank of China noted: “Our bond market continues to deepen, with the size of the credit bond market growing relatively fast. The ratio of credit bonds to GDP is likely to hit the 55% trigger point ahead of time.” Credit bond market refers to bond issuances from non-government entities.

Although the central bank did not specify a date that it predicts the market will reach the trigger point, it cited Financial Stability Board statistics showing that the size of the bond market had reached nearly 50% of GDP by the end of 2017. With bond issuance in China forecast to grow and overall economic activity set to weaken, the trigger point could be hit as early as next year. That will bring forward the implementation of TLAC by two years.

The prediction has jolted large domestic banks into reviewing their plans for building up TLAC reserves. Some Chinese banks have already set up teams dedicated to meeting their bail-in debt requirements, says Tim Fang, co-head of debt capital markets for AMTD Group, which provides capital markets and advisory services across mainland China.

“From the conversations I’ve had with the big four banks, some are more advanced in their preparations than others. If you look at which of the big four banks have been the earliest adopters of Basel III compliant capital instruments both onshore and offshore, these are the ones that are more advanced in the internal process,” he says.

“Chinese banks are doing a lot to be prepared,” says Benjamin Weller, vice-president in the capital solutions and sustainable financing team at Deutsche Bank. “Local clients want to know what particular measures Europe, Japan and the US have taken to allow banks to prepare for implementation of TLAC. This is a healthy development.”

The four banks – Agricultural Bank of China, Bank of China, China Construction Bank, and ICBC – will need to raise as much as $402 billion in the coming years to meet the regulation, according to calculations by rating agency Moody’s. But the central bank acknowledges that the existing make-up of the domestic bond market could pose problems for banks looking to issue debt on this scale.

“Our country’s bond market has a homogenous and thin institutional investor base. A large issuance would face a particularly big challenge given that the banks holding each other’s TLAC debt have to deduct this from their capital base,” noted the central bank in its report.

None of the four Chinese banks nor the People’s Bank of China could be reached for comment.

Looking abroad

Given the domestic market’s limited ability to soak up debt issuance, China’s banks recognise they will need to turn to offshore markets. But foreign buyers would come at a cost. By bringing forward their TLAC debt programmes, Chinese banks will be issuing debt at the same time as the big, systemically important banks in Europe and the US – all competing for the same pool of investors. Under the original timeline, Chinese banks would have waited several more years and potentially avoided the global logjam of TLAC issuance.

Between 2010 and 2017, banks outside of China issued nearly $400 billion worth of bonds classed as additional Tier 1 and Tier 2 compared to just under $90 billion of similar bonds sold in the home market, according to data from Moody’s.

Increasing competition in the overseas bond market has affected the price of bail-in debt. Senior non-preferred debt, which qualifies for TLAC, can be between 20 and 60 basis points more expensive than senior preferred debt, depending on the quality of the issuer and the timing of the issuance, Weller says. “In a constructive market environment these spreads can tighten significantly, whereas in a risk-off phase people need to be more vigilant,” he says.

The spread between the domestic and offshore market could be wider given the diverging appetite for such debt between Asian and global investors. Regional bond buyers essentially see the big four banks as risk free and would take a much more “aggressive” pricing approach, Fang says.

“Given cost differentials between domestic and international placement, it makes sense to see what is feasible on the domestic side first and then look at what is to be done in the international market,” says Pramod Shenoi, regional head of debt capital markets for Mizuho, based in Singapore. “There is no doubt that a fair amount of TLAC debt will have to be issued in the international market and so issuers will have to ensure they are cultivating different investor bases in order to maximise the opportunity in terms of placing their bonds.”

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Bank of China tower in Hong Kong: BOC is one of China’s ‘big four’

To complicate matters further, the Chinese authorities have yet to clarify exactly what type of debt is eligible for TLAC. A release from regulators in January promised to look at ways to broaden the number of domestic investors for such paper and called on banks to explore innovative ways of issuing debt instruments, but it lacked specific guidance. The longer the uncertainty persists, the shorter the issuance window for banks to complete the required debt placements.

“In order for banks to set up a strategy to meet TLAC requirements they need to know which instruments are available to qualify as bail-in regulatory capital and we do not know yet what these instruments will look like,” Weller says. “For the moment their hands are tied.”

But some bankers believe the overall TLAC shortfall may turn out lower than current predictions. Bail-in debt is measured against risk-weighted assets, and moves to curb past financial excesses could help lower the overall level of RWAs held by lenders.

“Whilst there are large numbers floating about as to how much TLAC Chinese banks may need, one mustn’t forget that there are a lot of unknowns in determining what the actual shortfall might be. We could see the shortfall number drop quite significantly in the coming years,” Weller says.

Authorities could further ease the strain of issuance by allowing China’s deposit insurance scheme to meet much of the TLAC need. The scheme was launched in 2015 and will gradually ramp up to full capacity. The Japanese authorities allow reserves held in its own deposit insurance scheme to be considered as “credible ex-ante commitments to recapitalise” a failed bank, equivalent to 3.5% of RWAs for the purposes of meeting the 18% TLAC requirement. If the Chinese authorities allow similar relief, the TLAC shortfall could drop to just $30 billion–40 billion, “which is a far cry from the market rumours of $400 billion–500 billion”, Weller says.

In Asia, three lenders from Japan and four from China have so far been categorised as global systemically important banks, or G-Sibs – the class of bank that must meet the TLAC rules. National regulators around the region may choose to impose TLAC rules on domestic systemically important banks (D-Sibs). Japan’s banking regulator, for example, has chosen to impose the bail-in rules on Nomura, a D-Sib, from 2021.

More could join the ranks of G-Sibs in China. Shanghai-based Bank of Communications, China’s fifth-largest bank, in next in line to reach the threshold for G-Sib status and has been keeping abreast of the latest global rules, according to people familiar with the bank’s thinking. No new Chinese banks were included on the Financial Stability Board’s latest list of G-Sibs, published in November, but once they do they will have three years to meet their full TLAC obligations, assuming the country has exceeded the 55% bond market threshold.

The banks could already have taken the first steps. Since 2014, Chinese banks have been able to issue preference shares which, depending on the final shape of the country’s bail-in regime, could go some way towards meeting their TLAC shortfall. The big four banks had collectively issued a little more than $45 billion in preference shares by the end of last year, with just under a third issued offshore and the rest onshore (see chart).

Editing by Alex Krohn

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