ANALYSIS-Brave new world beckons for bank hybrid capital

Published: 22 Oct 2009 17:10:08 PST

* Bankers sculpt new hybrid capital landscape

* Regulators provide window for "old-style" hybrid bonds

* Investors lap up product they once shunned

LONDON, Oct 22 - A rush of new issues is expected to alter the face of the market for hybrid bank capital, with regulators poised to approve rules that could include structures that provide loss-absorbing contingent core capital.

Contingent capital would give banks the right to raise money from an investor under certain conditions -- such as a fall in its Tier 1 capital ratio below a specified level.

The concept, or use, of contingent capital is not new but it looks set to become a key component of measures to boost the balance sheets of struggling banks and help them withstand future crises.

"Because the regulatory environment is so central to capital management actions, the entire world is working on new products and what will fit regulatory requirements and be saleable," said Chris Lees, head of European financial institutions group, debt capital markets, Citi.

Already, some issuers such as Sweden's SEB and Societe Generale are taking the first steps into the new regulatory landscape by including provisions in the language of their bond documentation that makes it easier for hybrid securities to absorb losses.

Not all issuers have gone down this route. Hectic issuance of old-style hybrids has take place over the past six months, sustained by a revival of investor appetite for the asset class and a fair degree of regulatory forbearance.

"There is a concern that life will become more difficult for issuers and structurers of hybrid Tier 1, so there is a strong incentive for people to issue where they can if they plan to raise hybrid," said Patrick Buxton, director, capital management strategy group at Citi.

Since May, European bank hybrid bond issuance has reached 12.4 billion euros, according to data from Societe Generale.

This is a remarkable turnaround for a market which shut completely from October 2008 until April this year because of the credit crisis.

Values on these securities plummeted early this year, but have largely recovered. A BNP Paribas hybrid Tier 1 bond, for example, was trading at 28 cents on the euro back in March, but is now at 93 cents, according to Societe Generale.

Given the volatile performance of these instruments, it is remarkable that investors have proved so willing to buy, and that regulators have allowed banks to sell them.

NORTHERN SHOCK

"Northern Rock opened everyone's eyes to the risk in hybrid capital," said Lees, referring to the UK bank that was nationalised right at the start of the credit crunch in 2007.

Holders of certain forms of Northern Rock hybrids were nationalised along with shareholders.

"At that stage, there were a number of investors who said they would never touch a hybrid again, now it's clear that many accounts are asking 'What's next?'" Lees said.

Hybrid bonds have certain equity-like features. For instance things such as permanence: frequently these securities have very long maturies or are even perpetual but with "call" dates where the borrower is expected, or likely to pay back.

Investors who buy them include institutional and retail investors in Europe, United States and Asia.

"They are not the best instruments to hold for many corporate bond investors, as principal can be put at risk without an event of default," said Roger Doig, credit analyst at Schroders.

"But we can manage the risk if we select those that have characteristics that are favourable to us as bondholders and there can be a more attractive risk/reward profile than bank senior debt," he said.

The 12 billion euros of old-style hybrid bank capital instruments that have been sold in the past six months show that investors will likely be receptive to the new forms of hybrids currently under construction.

Over the past decade or so, an estimated 900 billion euros of bank hybrid debt has been issued in Europe, Middle East and Africa, according to UBS.

Regulators always had suspicions about the merits of hybrid capital and thus, limited the amount of this form of capital could contribute to banks' Tier 1 ratios.

A raft of proposed policy announcements have since come out that address issues around the form, quality and quantity of bank capital. These also include proposals for counter-cyclical capital buffers and a leverage ratio for banks.