The Basel Committee on Banking Supervision (BCBS) and the G20 recently reaffirmed their commitment to introducing higher mandatory core capital ratios, greater liquidity requirements and a maximum leverage ratio. Furthermore, the BCBS proclaimed that “the predominant form of Tier 1 capital must be common shares and retained earnings”. While there is nothing dramatically new in these statements (see previous blog), their affirmation and the revelation that more definitive proposals will be forthcoming by the end of the year has shifted investors’ focus to how they are likely to affect financial institutions and debt issuance in different jurisdictions.

The impact of the BCBS’ proposals will be felt most keenly by major banks in the eurozone. These lenders have less common equity and more hybrid capital than their counterparts in the US and the UK (see table below). On aggregate, they had lower Tier 1 capital ratios than their rivals at end-2008 and, although they had a slightly higher Tangible Common Equity (TCE) to Total Assets ratio than UK lenders at end-2008 (at 2.5% compared to 2.1%), banks in the US and the UK have subsequently strengthened their equity capital, either through government injections or by converting prefs into common stock. And the imminent introduction of the UK’s Asset Protection Scheme will significantly lower its most troubled lenders’ risk weighted assets (RWAs), leaving them with a robust TCE / RWA ratio. By contrast, governments in the euro area that have recapitalised their banks have tended to do so via purchases of subordinated debt rather than equity, leaving euro area lenders with substantial ground to make up once the BCBS’ proposals come into force, as seems highly likely. The final row of the table shows that banks in the euro area need to raise far more equity capital than their UK and US peers to achieve a leverage ratio of 25x, a level that press speculation suggests is the most likely eventually to be demanded by the BCBS (see article).

Bank equity requirement analysis (end-2008)

Source: IMF, Global Financial Stability Report (April 2009).   *Denmark, Iceland, Norway, Sweden, Switzerland

We therefore expect equity issuance among euro area financial institutions to increase sharply in 2010 following the BCBS’ announcement of detailed capital reforms at end-2009. And the proposed reforms could also have a significant impact on the financial credit markets. Subordinated debt issuance on the scale seen in the past six months (see chart) is likely to become a thing of the past. We also expect more modest levels of Tier 1 hybrid issuance, while issuance of Tier 2 bonds could decline particularly sharply. Meanwhile, the BCBS’ insistence on greater liquidity is likely to mean that issuance of commercial paper will continue to fall in favour of bonds with a duration greater than one year.

Investment grade European banks’ subordinated debt issuance

Source: Dealogic

However, we do not expect the financial bond markets to experience any sudden change. The current timetable is that the BCBS will announce prospective rule changes by end-2009 and carry out an impact assessment during 2010. In addition, governments are keenly aware that higher capital requirements risks restricting bank lending further and that banks will need time to conform to these new standards. Therefore, capital reforms are likely to be implemented gradually, providing investors in financial bonds – particularly in the euro area – with ample opportunity to adjust to lower levels of hybrid financial issuance in the future.

Nick Smallwood, Credit Research

Disclaimer:

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