Asia’s banks move to meet new capital and liquidity rules

Financial institutions have a raft of new capital and liquidity rules to meet during the next several years. What tools are available to help treasurers and capital planners to meet these challenges? Viren Vaghela reports

Bankers in Asia Pacific are quick to point out that financial institutions in the region emerged from the financial crisis relatively unscathed compared with their European and US counterparts, some of which are still struggling to restore their reputations following government bail-outs. There is also a consensus that Asian banks are well capitalised compared to many of their peers around the world.

Nevertheless, many banks are taking advantage of a window of opportunity open until January 1, 2013 that lets them issue old-style Tier II capital. Already this year, Woori Bank, United Overseas Bank (UOB) and Macquarie Bank have issued lower Tier II instruments, and bankers foresee further issuance during the next 18 months as banks seek to make the most of transitional provisions issued by the Basel Committee on Banking Supervision in January.

“Overall in most Asian markets [banks] have very high capital levels, but I recommend that they take advantage of this window and raise additional capital,” says Brian McCullough, a managing director in the financial institutions group at Citi in Hong Kong. “Because of a rising interest rate environment and various securities rolling off, or being able to be called, institutions are starting to come to the market. Also, they know that other banks are going to come, which will probably increase market volatility.”

Woori Bank issued $500 million in 10-year bonds in April, while UOB issued S$1 billion ($793 million) in lower Tier II bonds in March. Towards the end of last year, Oversea-Chinese Banking Corporation (OCBC) in Singapore issued $500 million in lower Tier II subordinated bonds with a maturity date of 2022 and a callable option in 2017. The OCBC issue was the first-ever, non-step-up, callable lower Tier II issuance in the international markets, according to RBS, the joint book runner for the deal.
Under the terms of new Basel III rules, step-ups will not be permitted and new-style Tier II instruments will also require non-viability conversion or write-down, which bankers believe will be more expensive for banks and investors. This means the contractual terms of the capital instruments will allow regulatory authorities to write off or convert the instrument to common shares in the event that a bank is unable to support itself in the private market in the absence of such conversions.

“Basel III instruments have a significantly higher financing cost. They are stringent in terms of loss absorption, conversion into equity at the point of non-viability or contingency,” says Kenneth Tang, regional head of financial institutions for the Asia Pacific region at RBS in Hong Kong, who worked on the OCBC deal. “As a result, the cost required by investors for Basel III instruments are very high compared with Basel II instruments, but there’s room for Asian issuers from now until the end of 2012 to issue more Basel II paper and increase the headroom for amortisation when it comes to 2013. These types of paper can also be issued at a competitive cost.”

Juggling Tiers
Macquarie Bank also completed an old-style Tier II transaction with the issue of $1 billion in 10-year subordinated notes at the end of March with a coupon of 6.625% to mature in 2021. Part of the rationale was to fill existing Tier II capacity following redemptions last year and the transaction also benefited from favourable ‘grandfathering’ rules. This involves phasing out instruments over a 10-year period, beginning on January 1, 2013. The base will be fixed at the nominal amount of such instruments outstanding on January 1, 2013 and will decline by 10 percentage points each subsequent year. Consequently, recognition of such instruments will be fully phased out by January 1, 2022.

Old-style Tier II instruments issued before the window closes can be grandfathered during a 10-year period. This means they can be issued without the Basel III non-viability conversion or write down mechanism and still qualify for grandfathering.

“A large proportion of Tier II will roll off in the region between now and the end of 2012, approximately $12-14 billion, and the banks will need to replace that with various forms [of debt],” says McCullough at Citi. “Given the cost uncertainties around refinancing with new-style Tier II, they will probably in the near term use old-style Tier II with grandfathering under Basel III to optimise their Tier II base, and move the duration of the aggregated amortisations out as well.”

However, supervisors in some jurisdictions are considering limiting the amount of old-style Tier II instruments that can be issued. “Regulators in different countries are still making up their minds on how much old-style Tier II to allow banks to issue. The window is there but, depending on their view of the preparedness of the local banking sector, regulators may push for early adoption of Basel III and say you need to focus on Tier I and core equity, and lessen the percentage of Tier II in your capital structure,” says Aniruddh Gupta, global head of capital markets solutions at Standard Chartered in Hong Kong. “Everyone is liaising with regulators right now, and in different jurisdictions the situation is slightly different.”

Hong Kong, for example, may take a tough line on the issuance of Tier II capital, according to a written response from the Hong Kong Monetary Authority (HKMA): “The HKMA is certainly not encouraging banks to issue old-style Tier II capital instruments in the transitional period. On the contrary, we have written to banks in January 2010 saying that ‘the HKMA expects local banks to have regard to the revised definition of regulatory capital in their capital issuance planning during the interim period up to January 1, 2013’.”

Notwithstanding the HKMA’s stance on old-style Tier II, some regulators in the region are weighing whether to introduce a statutory resolution regime to facilitate the new Basel III capital structures or follow a contractual approach. The latter would require banks to include non-viability wording on a transaction-by-transaction basis, whereas a statutory resolution regime would standardise the process.

“On a jurisdiction-by-jurisdiction basis there is debate about whether banks will deal with loss-absorption at the point of non-viability by using statutory resolution regimes or whether they will have to go down a contractual approach,” says Bob Herbert, executive director in the capital markets group at Morgan Stanley in Sydney. “There is a general view that if you follow the contractual approach and a similar bank in another jurisdiction uses the statutory resolution approach, then there’s a danger that two similar credits might be priced differently by the market.

Consequently, banks can take advantage of the window until 2013 and hold off until [receiving] clarity from regulators about which is the preferred route.”
Peter McInnes, an executive director of structured solutions at JP Morgan in Sydney, believe there are tentative signs of banks trialing some of the new Basel III, non-viability structures. “We are starting to see issuers explore potential structures... ABN Amro issued a [Tier II] transaction that contains a credit non-viability concept. But there is still some uncertainty about what is required from regulators so we are not expecting a flurry of issuance until greater clarity is provided by individual regulators, and ultimate size of issuance is dependent on receptivity of investors to the required form of the new structures,” he says.

First to fall
Arthur Yuen, deputy chief executive of the HKMA, was critical of the way subordinated debt holders incurred limited losses due to taxpayer bail-outs of big banks during the financial crisis when speaking at a Basel III training seminar organised by Asia Risk in Hong Kong on March 29. “If, in the judgement of regulators, the bank is no longer viable then some of these non-common equity instruments – in order to quality as regulatory capital – either have to convert to common equity or be written off at that point in time,” he said. “The idea is to avoid moral hazard – in the financial crisis the subordinated debt holders were bailed out by the government. So the government stepped in and subordinated debt holders didn’t pay a single cent of losses, which is perverse as they should be the first to be wiped out of the equation.”

Hong Kong–based Dah Sing Bank is a typical example of a mid-sized local bank that is generally well capitalised. In November 2010 it had a rights issue to raise HK$1 billion ($130 million) in equity to prepare for higher Basel III standards. Speaking about Tier II capital, Dah Sing Bank’s finance director, Gary Wang, says he is waiting to see how Basel III standards are translated into national rules as well as for regulatory timetables from the HKMA. “After the rights issue we are in excess of 11% in capital and we will be able to generate additional capital by profit retention in the coming years,” says Wang.

Malaysia-based Maybank, meanwhile, has a targeted plan to deal with ongoing capital requirements under Basel III. “We have implemented the dividend reinvestment plan as part of our strategy to preserve equity capital ahead of Basel III as well as to grow our business whilst providing shareholders with an opportunity to reinvest their dividends into Maybank,” says John Lee, group chief risk officer at Maybank in Kuala Lumpur.

As a further example of the capital composition of Asia’s banks, Bangkok Bank’s total Tier I capital ratio, according to its latest financial statements, stood at 13.2%, well above the Basel III minimum of 6%.

Since Asian banks are, in the main, well capitalised, industry experts say they may be in the enviable position of being able to refinance at competitive rates. “More important for Asia Pacific banks is how do you transition into Basel III at the most competitive financing, capital and funding costs. That’s the key question to address,” says a Hong Kong-based banker.

Coco, anyone?
In Europe, meanwhile, new debt instruments such as contingent convertibles (cocos) are viewed as debt structures that could meet new regulatory requirements that in the event that a bank gets into financial difficulties debt holders should suffer losses before taxpayer money is used. Cocos convert debt into equity at a specific strike price once a company’s share price breaches a pre-defined level.
But within the Asia-Pacific region, cocos are viewed with a degree of suspicion, especially as many banks may not have a requirement for them. “Cocos are expensive now but they may come down in cost. It’s a question of what do investors think about the fully developed product and how is it priced, as well as which banks are they relevant for – probably ‘sifis’,” says McCullough at Citi, referring to systemically important financial institutions that will likely have to meet tougher capital standards due to their pivotal role in local and international markets.

“If you have gone through a least-cost, capital-planning exercise and in doing so you are able to add another slug of growth capital, albeit at a higher cost but your overall cost of capital is still optimised, it may make sense to do that,” says McCullough. “But I think it’s too early to determine that as, outside of Switzerland, no-one has come up with specific requirements for that instrument.”

The HKMA’s stance on contingent capital is still not clear: “Traditionally the HKMA tends to have favoured common equity for its simplicity, permanence and certainty of loss absorption. Meanwhile, we are still considering our position on contingent capital and monitoring relevant international supervisory policy and market developments,” says a spokesman at the regulator in Hong Kong.

Of more significance to Asia, is liquidity and although implementation of the liquidity coverage ratio (LCR) does not commence until 2015, several treasurers and risk managers have started to consider their options.

To meet the LCR, Lee at Maybank says he has intensified risk management capabilities for Basel III by developing a liquidity road map. This includes Maybank participating actively in primary auctions and secondary market trading, holding a well-diversified stock of corporate and government securities and conducting rigorous stress tests. The Malaysian bank is also aiming to hold diversified liabilities to avoid over reliance on short-term funding. This is monitored by looking at the medium-term funds to core-asset ratio among other indicators.

Lee says Maybank is also looking at funding with non-callable features or non-callable clauses subject to approval from its regulator, Bank Negara Malaysia. Maybank is also granting credit lines more selectively, as a high volume of undrawn committed credit facilities will attract higher outflows under the LCR. The bank is imposing stringent lending requirements to ensure high-quality liquid assets are posted as collateral by customers. It is also increasing deposit-gathering efforts with a focus on retail over corporate deposits as they are less volatile.

Race for deposits
Many banks around the world have recognised that deposits will be more precious under Basel III. They are an excellent source of funds that comply with the Basel Committee’s definition of high-quality liquid assets constituting the LCR, whereby government bonds and cash are judged the best forms of liquidity. As a result there is a race to secure more deposits in a number of markets in the Asia Pacific region.

Lee Kok Kwan, deputy chief executive at CIMB in Kuala Lumpur, explains that due to higher savings rates in Asia, there is a lower reliance by banks on other types of funding. “The savings rate in Malaysia is 33% of GDP and in Singapore 46% of GDP, which is much higher than the equivalent rates in the US,” says Lee. “Our balance sheet is funded in local currency. From the Asian crisis in 1997/98 it was clear that reliance on foreign currency funding is toxic for both the sovereign and corporates.”

Nonetheless, the costs associated with deposits are increasing, according to some bankers. “Savings rates are rising and there’s more competition for deposits, so it’s costing banks more to get them,” says Duncan Beattie, an executive director for debt capital markets at JP Morgan in Sydney. “Although there have been increases in interest rates due to the strength of the economy, banks have also increased loan rates above official rates rises reflecting the additional cost.”

The right term
Replacing shorter term funding with longer term funding – described as ‘terming out’ – is also happening, which may lead to a widening of spreads even if market sentiment is strong. Indian banks have come to the debt markets frequently this year and spreads have moved wider during the past three or four months as more banks try to issue debt, according to Gupta at Standard Chartered: “More banks will try to term out funding as they can’t rely on short-term funding from banks as much under Basel III. This is creating liquidity pressures in the wider market especially in the syndicated loans market, for example, where liquidity for loans is getting tighter.”

Gupta adds that banks are also trying to meet risk-weighted return asset targets, leading to a slow down in asset growth and a change in the mix of assets. “Banks are trying to put on shorter-dated assets so they don’t have to pay so much for the liquidity premium and going wider on credit spreads to make returns and lending less. There is pressure to not bloat the balance sheet so asset growth will be slower,” he says.

Gupta adds that regulators in some jurisdictions such as Hong Kong and Singapore have taken steps to ensure banks rein in lending to the property sector. This has resulted, for example, in the maximum loan-to-value (LTV) ratio for property purchases in Hong Kong and Singapore being cut to 60%, which means property buyers need to put up 40% of the asking price in cash.

In China too, banks have been directed to reduce lending to the real estate sector so on-shore liquidity in China is now tight. However, relatively low interest rates and easy access to funding at low spreads has resulted in property values continuing to rise.

Singapore, meanwhile, on January 14, 2011 announced a 16% tax on any real estate sale that takes place within one year of buying a property to discourage speculation. Regulators are hoping to stop real estate prices from reaching bubble territory, but nevertheless, prices have continued to rise slowly upwards.

Meanwhile, under Basel III LCR rules, corporate bonds are a level 2 asset, which means that they can only comprise up to 40% of the LCR quota and they are also subject to a 15% haircut. Despite these restrictions and because of a contraction in the loan market, corporate bond issuance is rising.

“In Asia there is always this interplay between the loan and bond market and as conditions get tighter on the loan front, you are seeing many more corporates come into the bond market and CNH [offshore renminbi] market, so that trend will continue as long as liquidity remains tight,” says Gupta. “That said, the majority of corporates in Asia have historically relied on the bank market for funding, so that process will be slower than one would expect. But we are also seeing a lot of corporates who are coming to the bond market for the first time this year, and a lot of that is to do with what is happening in the bank market.”

However, the dynamics are different in some markets. For example, there is generally a greater reliance on offshore markets such as the US for Australian institutions. “Corporates who used to borrow from the banks rather than capital markets are now bypassing Australia totally and going offshore and sometimes with very competitive pricing, which is one of the reasons why we aren’t seeing such strong RWA [risk-weighted assets] growth at the major banks. The typical growth they may have seen from corporates is actually a decrease from corporates, which has been picked up to a lesser extent through the retail mortgages,” says McInnes at JP Morgan.

“In the Australian context, true return on an economic capital point-of-view has driven the major banks for the last decade,” McInnes adds. “Now they will have to overlay regulatory capital over economic capital. This is following through in re-pricing in business loans and mortgage loans. But as corporates can access capital markets at a competitive price, banks can’t just increase their prices to get a better return.”