February 12, 2016 / 3:54 PM / 2 years ago

Regulatory fog wreaks havoc in ailing AT1 market

LONDON, Feb 12 (IFR) - Regulatory uncertainties are adding to the woes of the Additional Tier 1 market, which has been left reeling by worries over Deutsche Bank's ability to pay upcoming coupons.

The implementation of new rules that could prevent banks making dividend and coupon payments on some of their subordinated debt has unsettled investors, fuelling a sell-off and scuppering lenders' ability to raise further AT1.

"I think as no one really knows what the changes mean, the easiest option is to hit the bid and exit a position," said a hedge fund investor.

"It definitely makes it harder for the weak banks to recapitalise now. The market will be more two-tiered between the good solid names, where people want to play, and the no-goes that I think will struggle."

Banks most vulnerable to the new rules include UniCredit, BNP Paribas and Banco Popular Espanol, which have some of the thinnest capital cushions. But analysts warn that there are plenty of others.

The doubts are a blow to a market that appeared to have a settled regulatory regime - unlike senior and Tier 2 debt, where concerns around changes have weighed on investor appetite in recent months.

Some of the rules were well flagged.

On January 1 came the phasing in of the Combined Buffer Requirement (CBR). A breach of that means a bank has to calculate a Maximum Distributable Amount (MDA). That in effect is a firm's distributable profit, in turn determining how much it can pay out, for example on its AT1s.

EBA SHOCK

But what took the market by surprise was an opinion paper from the European Banking Authority - subsequently endorsed by the ECB - that recommended the hard-wiring of so-called Pillar 2 into banks' capital requirements, narrowing the distance to the MDA.

Pillar 2 allows authorities to tackle various idiosyncratic risks such as legal and concentration risks not taken into account by minimum capital requirements under Pillar 1.

"Regulations were silent on Pillar 2 positioning and most issuers, if not all, as well as investors, were under the opinion that it would sit above the CBR and not impact the ability to make AT1 coupon payments," said Roberto Henriques, European credit analyst at JP Morgan.

"However, by positioning it under the CBR, the buffer that protected AT1 investors from coupon deferral has been materially reduced."

Although banks can choose to prioritise AT1 over shares, for example, this has created confusion in the market.

Furthermore, while Pillar 2 requirements were once a private matter between a bank and its regulator, the number has become public under the ECB Supervisory Review and Evaluation Process (SREP).

"While investors understood coupon risk properly and knew it was not properly priced in, they did not think it would be an issue in the short-term," said Christy Hajiloizou, a credit analyst at Barclays.

"But the EBA regulatory opinion and the introduction of Pillar 2 as a requirement means that it's now at the forefront of investors' minds."

BAMBOOZLED

The area of confusion is how SREP requirements interact with the various pillars, what needs to be filled first and how this impacts a bank's ability to pay coupons.

Many, including the EBA in its December opinion paper, are calling for the ECB to clarify its position.

Some believe the ECB will only enforce payment restrictions if a bank does not meet its CET1 requirement of 4.5% of risk weighted assets.

Others believe intervention would come earlier if a bank did not meet its total capital requirements, which includes a further 1.5% of RWAs as AT1 and 2% as Tier 2.

If the latter view prevails, banks, which thought they had until 2019 to meet new capital requirements, will have to do it a lot quicker.

Under the more lenient CET1 requirement, BBVA for example has a 234bp cushion to protect investors from missed coupons. But that falls to 84bp under the stricter interpretation.

VICIOUS CIRCLE

Banks short on capital therefore face an uphill struggle as investors have seen their security blanket to potential coupon deferral reduced.

"Banks face a bit of a Catch 22 situation," added JP Morgan's Henriques. "To improve their solvency they need to issue more AT1, but investors are concerned about their compliance with the SREP ratio."

Market participants are hopeful the ECB will clarify its position, which could bring much needed stability to the market.

"There is no way an asset class can grow and prosper if regulators raise a new point every year that changes the goalposts," one syndicate banker said. "If this keeps happening, investors are going to ask themselves: what else is coming next? Should I be involved in this product?" (Reporting by Helene Durand, Editing by Sudip Roy, Julian Baker)

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