* Gulf banks seen needing $35 bln of capital by 2019
* Capital-boosting bonds emerging as important tool
* But some GCC regulators haven't clarified treatment
* Ultra-tight pricing seems excessive to some
* Hybrid instruments like CoCo bonds also possible
By Archana Narayanan
DUBAI, Feb 2 (Reuters) - Fast-growing Gulf Arab banks plan to bolster their reserves by issuing capital-boosting bonds, but uncertainty over regulation and ultra-tight pricing increase the risks for issuers and investors.
Basel III standards, now being phased in around the world, will require banks to hold more capital. While Gulf banks have very high capital adequacy ratios, their rapid expansion, and the fact they operate in emerging markets with lower sovereign ratings than the core developed economies, mean they will be hungry for more capital in coming years.
The banking sector of the six-nation Gulf Cooperation Council (GCC) is expected to need an additional $35 billion of capital by 2019, according to a study by consultants Strategy&.
Retained earnings and equity issuance will provide some but not all of that money. So banks are turning to other instruments, especially perpetual bonds with equity-like characteristics that boost Tier 1, or core, capital. Contingent capital securities known as "CoCos", convertible into shares in certain circumstances, may also be used.
Kuwait's Burgan Bank and Abu Dhabi's Al Hilal Bank issued Tier 1 bonds designed to be Basel III-compliant last year. Dubai Islamic Bank (DIB), the United Arab Emirates' largest Islamic bank, sold $1 billion of Tier 1 Islamic bonds last month at 6.75 percent.
Qatar Islamic Bank, Qatar's Doha Bank and Oman's Bank Dhofar have all announced plans to issue Tier 1 bonds since the start of this year.
Capital-boosting bonds are good options for banks in the region as they provide efficiency, flexibility and diversification, said Christoph Paul, head of Middle Eastern and North African capital markets at Morgan Stanley.
But the trend to issue such bonds has been slower in the Gulf than in many other parts of the world, for a good reason: details of how national regulators will treat the instruments remain unclear in some countries.
Saudi Arabia, a member of the committee which drafted Basel III, as well as Kuwait and Bahrain, have clarified what conditions the bonds must meet for their regulators to count them towards Tier 1 capital totals.
The United Arab Emirates, Qatar and Oman have not yet finalised their guidelines, however. This creates considerable uncertainty for the issuing banks - in theory, they could issue bonds only to discover months or years later that their national regulators do not recognise the instruments as capital-boosting.
"We are in that limbo where everybody is trying to figure out what is required or not to issue capital instruments," said a senior banker at a UAE lender, declining to be named because he was not authorised to speak to media.
A key issue is loss absorption: unlike the previous Basel II regulatory regime, Basel III rules call for all capital instruments to absorb losses fully when a bank becomes non-viable, but leave it to national regulators to decide exactly how and when investors would shoulder the losses.
GCC governments have in the past been very supportive of their banking systems - most of the big banks have large state shareholdings - so in some cases, banks seem to be assuming that their regulators would never take the inconvenient step of disallowing their Tier 1 bonds.
But making such assumptions is not comfortable for some institutional investors, who tend to prefer legal and regulatory certainty.
One risk is that an issuer, finding its outstanding bond was not Basel III-compliant, might decide to try to revise the terms - a strategy which India's IDBI Bank adopted last year, angering investors.
In these circumstances, the tight pricings being achieved by GCC issuers of Tier 1 bonds are remarkable, and not necessarily healthy.
In developed markets, the pricing difference between Tier 1 bonds under Basel III and Basel II has been about 250 to 300 basis points, bankers said. DIB, however, achieved a tiny difference.
A regional asset manager noted that $1 billion of Tier 1 sukuk from DIB, callable in 2019, were issued under Basel II rules in 2013 at 6.25 percent. He calculated that represented a spread of only about 25 bps to the bank's latest sukuk, taking into account the fact that DIB's latest issue is not callable.
Such a small spread may mean investors are not fully appreciating the much higher risk of loss embedded in the new Basel III structures. The willingness of some Gulf investors to shoulder this risk threatens to price international investors out of the market.
"In reality, these new-style notes should pay a much higher premium since they don't seek a rating and stand way behind existing subordinated bonds because of the loss absorption trigger," said one senior Dubai banker.
"Consequently, they would be wiped out before the old-style bonds in the event of bankruptcy, however unlikely this is." (Editing by David French and Andrew Torchia)