Maintaining variation

Author: | Published: 12 Mar 2015
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Richard Johnson of Credit Suisse Group discusses expectations for capital structuring and product development in the coming 12 months.

Credit Suisse Group is well-placed to comment on emerging trends in products that are aimed at meeting capital requirements, particularly under the Swiss regime. Here, Richard Johnson, head of the EMEA debt capital markets, transaction management group, provides the reasoning behind his views on the outlook for product adoption and emergence, having much expertise in regulatory capital.

He also provides an overview of the key European regulatory themes to affect the sector in the coming year to watch out for, particularly in relation to Contingent Convertibles (CoCos).

Switzerland has long pioneered Contingent Convertibles (CoCos) as a way of solving bank capital shortfalls post-crisis. Do you see the asset class growing in 2015–16?

CoCos have now been embedded as a permanent part of banks' capital structures for a while in many regulatory regimes, e.g., the CRD4 European Additional Tier 1 (AT1s), which are required to be CoCos. As such, I would expect this asset class to continue to grow as banks transition their capital structures to the new rules. Additionally, as resolution regimes come online with point of non-viability (PONV) loss absorption and bail-in, it will become clearer that CoCo-like features and risks are embedded in instruments throughout banks' capital structures.

What product developments do you expect to see within AT1 instruments over the next year?

While in many jurisdictions a degree of standardisation is taking place, I expect to see continued use of different trigger levels to reflect different institutions' economic and regulatory capital requirements. I would also expect a continued evolution of the loss absorption mechanisms available to banks, with temporary write-down becoming available in more jurisdictions.

Do you expect a degree of homogeneity ultimately creeping into AT1 documentation as the market develops?

Compared to the world of Basel II, the level of standardisation in Basel III AT1 instruments has increased because the minimum requirements are set out in pan-European legislation, and are no longer set at national level as before. However, the wide range of ownership structures, business models, home jurisdiction requirements, etc., still require issuers to keep some flexibility in order to adapt the structure to their own and to their regulator's needs, particularly with regard to trigger levels, loss absorption mechanism, call options, and to the class of investors who may buy. For instance, several regulators have concerns around sales to retail investors. Also, the documentation will have to continue to reflect variation in corporate and tax law frameworks across the different jurisdictions, ultimately limiting the degree to which true homogeneity can be achieved. Nevertheless, the European Banking Authority, (EBA), has a clear aim to increase the homogeneity of AT1 terms where possible, and systems such as the Single Supervisory Mechanism should help further in that respect.

Post stress tests, do you imagine a new type of more peripheral southern European issuer of AT1 emerge?

Stress tests may potentially accelerate the issuance, but those in need of capital so far have generally preferred to respond by increasing their Common Equity Tier 1 (CET1), in one way or another. Ultimately, all banks are motivated to have AT1 in their capital structure unless they choose to meet this requirement with expensive equity, so while stress tests may impact timing of issuance, they are unlikely to have a material impact on the ultimate issuer universe.

What, if anything, needs to be clarified from a regulatory perspective to encourage the development of AT1s and Tier 2s?

In most jurisdictions there is now sufficient clarity to allow issuance. Key areas for development mainly focus around tax, with some jurisdictions yet to confirm deductibility, and there is still some variability around Europe in the approach to tax issues arising from a write-down. On other structuring issues there remains some variation across jurisdictions, which is not necessarily a bad thing in as much as it reflects national specificities. However it is certainly the case that while there is one rulebook in Europe, it is implemented differently around Europe, with some jurisdictions and bodies applying a principles/policy filter to the basic rules.

At the time of writing, the total loss absorbing capacity (TLAC) proposals are in their consultation phase. What is your view on these proposals?

The aim of TLAC to provide a consistent and credible framework to ensure bail-in is adequately resourced is welcome. The proposals on external TLAC seem broadly appropriate, although some of the rules on qualifying instruments look tough (e.g., maturity cut-offs and exclusion of all structured notes). The decision to impose internal TLAC on material legal entities, represents the first time the Financial Stability Board (FSB) has sought to regulate the distribution of capital within a group. The final rules should ideally be more flexible to better facilitate a proportional distribution of external TLAC to avoid instances of trapped capital and liquidity. It will be interesting to observe how the proposals are applied across a broad range of different banking models, e.g., HoldCo banks vs OpCo banks, and whether this will lead to further changes to statutory legislation or insolvency regimes in certain jurisdictions. UK banks have already started to incorporate contractual recognition of some of the statutory tools into the documentation of their recent issuances, a process we would expect to continue and evolve.

The Swiss Financial Market Supervisory Authority (Finma) has directly implemented Basel III and has been ahead of the curve in terms of post-crisis legislation. Has this pro-active approach surprised you?

No. Switzerland has always taken a pro-active approach to bank regulation, informed in part by the importance of the banking sector to the Swiss economy. As such the Swiss approach to Basel III is best seen as a continuation of its longstanding approach to bank regulation.

What can other countries learn from the Swiss approach to bank capital rule making?

Switzerland has benefited from a clear and transparent process of designing and implementing rules, with an efficient, expert-driven approach.

What regulatory developments do you expect to have the biggest impact on your sector in the coming 12 months?

A couple of themes spring to mind, particularly in financial services regulation where the reform to strengthen and update the EU market abuse regime, which has been in place since 2004, is likely to have a big impact. Also, we have seen various regulators including the European Securities and Markets Authority (Esma), the UK Financial Conduct Authority (FCA), the German Federal Financial Supervisory Authority (BaFin), Danish Finanstilsynet (FSA), Italian Securities and Exchange Commission (Consob) and the Securities and Futures Commission of Hong Kong (SFC) issuing guidance and statements on the distribution of CoCo instruments.

"It will become clearer that CoCo-like features and risks are embedded in instruments throughout banks’ capital structures"

On the first point, most of the provisions of the Market Abuse Regulation (MAR) will come into effect in the middle of 2016, introducing a single directly applicable rulebook governing market abuse. It is broadly the direct replacement to the Market Abuse Directive (MAD), which has been in effect since October 2004, and is intended to reduce regulatory complexity. Among the changes relevant to the sector are the scope (MAR will apply to a wider range of securities and derivatives than MAD) and market soundings. With respect to the latter, MAR does usefully recognise that inside information can be legitimately disclosed to potential investors to gauge interest in a potential transaction or its potential size or pricing. Indeed, MAR will regulate market soundings in some detail, for example by requiring certain steps to be taken prior to conducting a sounding and by imposing detailed record-keeping requirements. In addition, Esma (in a consultation paper on draft technical standards for MAR) has proposed arrangements and procedures for those making the soundings, including rules on who to speak to and when, and the contents of scripts, and they will be separately issuing guidelines for the investors receiving the soundings.

Regarding the discussion on restrictions on the retail distribution of regulatory capital instruments, the major development impacting the markets has been the UK FCA's product intervention, coming hot on the heels of the Esma statement in August 2014. Essentially, the regulators are voicing concern that investors may not have fully considered the risks of CoCos before investing in them and that investors cannot or do not properly understand or evaluate the complexities of, and risks associated with investing in, CoCos. Esma set the details of some of these risks in its statement and, in particular, the unusual features of CoCos that differ from other regulatory capital instruments, whilst the FCA stated that it does not believe that CoCos are appropriate for distribution to the mass retail market: i.e., retail clients who, amongst other criteria, are neither sophisticated nor high-net-worth. These were not unanticipated – for instance, the UK FCA first outlined its concerns in June 2013 and then worked closely with UK issuers to ensure their new capital securities were marketed in a way that minimises the risk of inappropriate investment by ordinary retail investors, largely through voluntary agreement by issuers to issue with high minimum denominations. In light of the continuing regulatory scrutiny, there is ongoing work across the market (via industry bodies, for instance) to ensure that there continues to be a diverse pool of investors for these products, allowing the stabilisation of performance in times of volatility and, hence, continuing to allow banks to raise capital efficiently.

About the contributor

Richard Johnson
Director, Head of EMEA DCM Transaction Management, Credit Suisse

London, UK

Richard Johnson is a lawyer and director in the investment banking division of Credit Suisse. He is based in London, and joined in 2014 to head of EMEA DCM transaction management group. He leads teams and advises on debt capital markets and structured finance transactions, with a particular emphasis on regulatory capital and financial institutions issues.

Prior to joining Credit Suisse, Johnson previously worked for Barclays, Allen & Overy and Norton Rose and has over 10 years in managing bond issues for financial institutions and global corporate issuers, bringing them to both the European and US markets.