October 10, 2017

How global regulation has created brand new investment classes already approaching $2 trillion in value

Jonathan Zenios

The introduction of the Basel 3 reforms has resulted in significant changes to the way banks fund themselves including the types of instruments issued. Why should markets care and what does this mean? As a result of these regulations entirely new asset classes have emerged known as Additional Tier 1 (AT1 or so called ‘CoCos’) and Tier 2. These instruments are subordinated to senior bank debt providing a yield pick-up but are senior to common equity allowing for lower volatility.

Currently there are over $1.8 trillion in instruments outstanding globally – double what was outstanding in 2013 when the reforms came into force and 10x pre-crisis levels in 2006 when total issuance was just under $160 billion. In comparison there is around $8 trillion currently outstanding in publicly traded common equity from banks. End state for a typical well capitalized bank is c. 8-10% equity, 1-2% AT1, 2-3% Tier 2 and issuance levels reflect banks getting to this as BIS fully loaded ratios come into force.

A tenfold increase in the amount of securities issued since the crisis hasn’t gone unnoticed. More and more investors are looking at AT1 and Tier 2 instruments for diversification, a Morgan Stanley survey of European investors outlined that 63% of respondents described their AT1 holdings as a core part of other long-term holdings[1]. This also isn’t just CoCo or pref share funds, over 60% of AT1 volume holders in the survey are asset managers – most of which are not primarily HY focused.

This result shouldn’t be surprising, financials are arguably better capitalized than ever[2]. The deleveraging of banks will continue as capital requirements are phased in at fully loaded levels – further reducing balance sheet sizes which should also be good for debt investors. Whilst the low interest rate environment has not helped banks achieve their ROE targets, with the exception of some of the weaker or periphery banks this is primarily an issue for equity holders rather than having a meaningful impact on solvency.

In the high yield corporate bond market, subordinated instruments ranked similarly to AT1 and Tier 2 make up around $1.2 trillion outstanding. Interestingly it appears ghosts from 2008 are still in the mind of the market, where there’s a significant yield pick-up for financials – total return levels are c. 2x higher for the European CS CoCo index vs European high yield corporate credit with the same average credit rating[3].

On all measures of risk and liquidity banks are much safer holding substantially more capital on lower risk balance sheets. Regulators are also playing an active role (e.g. in clarifying rules on coupon payment priorities) and are determined to make the new AT1 and Tier 2 asset classes a success. This is resulting in an interesting relative value assessment versus traditional HY corporate and bank equity markets – investors are taking notice.

[1] Morgan Stanley European Banks 2017 AT1 Survey – Results, 5 May 2017.
[2] Bank Capital. Mini-skirts and Maxi-dresses
[3] Credit Suisse, European Banks: Attractive Relative Value, 06 September 2017.
General: market data from Bloomberg 26 Sept 2017.

July 31, 2017

Bank Capital: Mini-Skirts and Maxi-Dresses

Jonathan Zenios

When I was at school in the 1980s each time we were set an essay, some bright spark would invariably ask how long should it be. To which the (of course, male) teacher’s response invariably was:

An essay should be like a woman’s skirt – long enough to cover all the essentials but short enough to be interesting.

As for essays of the 80s so for bank capital requirements of the 00s.

Legend has it that this approach to essay writing was taken to its logical extreme in the Oxford University general entrance paper when an aspiring student’s answer to title “What is bravery???? was the one liner “This is???. No doubt this had the desired effect for the first student who used it, but you wouldn’t fancy the chances of the second one to try it.

For the world’s largest banks the extreme point was reached in 2008 when RBS supported a £2.4 trillion balance sheet with a Tier One ratio of 6.1%. Too short to cover anything but certainly interesting if only in a bad way.

While most of us end up feeling nostalgic about our schooldays whether or not we actually enjoyed them at the time, few people miss the financial crisis.

Things have changed a great deal for the world’s largest banks since 2008 and generally in a good way. For starters while still large they are all a lot smaller than they were – RBS’s 2016 balance sheet was one third the size of its 2008 one and its CET1 ratio was over 13%. They also make a lot less money than they used to but are much less likely to lose lots of money in the future (even if some, such as RBS again, are still over a decade later paying the price for past excess).

Regulatory change has forced banks to deleverage, narrow their focus, fund themselves in more stable ways and hold a lot more capital. They are undoubtedly safer and more boring or to put it in a way my English teacher would understand – more maxi-dress than mini-skirt.

  • Note 1: RBS reported figures – 2016 under BIS III; 2007-2008 under BIS II on a proportionally consolidated basis
  • Note 2: FSB study estimates CET1 ratio of 1.97% at end 2007 under BIS III rules