Even before the final account of losses has been tallied or the regulatory dust has settled, the new structure of bank balance sheets appears to be emerging.
Banks are increasingly strengthening core capital bases – the pool of equity and retained profits – at the expense of more innovative junior bonds and so-called hybrid capital instruments, which had become so popular over the past decade.
France’s Crédit Agricole on Wednesday became the latest big European bank to exploit the distressed market values of junior bonds with an offer to pay about 72 pence in the pound to redeem up to £750m of such bonds.
Its move follows last week’s offers from Lloyds Banking Group and Royal Bank of Scotland to buy back or exchange junior debt with respective face values of up to £7.5bn and £15bn.
Earlier UBS reaped a profit of SFr305m (£184m) by spending SFr537m on bonds with a face value of SFr842m. The key to such deals is that such a gain can be added directly to a bank’s core capital base as retained profits.
In UBS’s case, this added just 0.1 percentage points to its core tier one capital ratio – the measure that investors and regulators increasingly have focused on to judge a bank’s financial strength.
But the Swiss bank’s trade was opportunistic and aimed mainly at putting a floor under the market for the bonds while helping out those investors who were desperate to sell at almost any price.
Many investors are happy with these buyback or exchange offers. They have turned the market from one where there were no buyers – and prices kept falling – to one where there are hardly any sellers, as investors expect banks to step forward with buy-back offers.
Richard Thomson at Henderson Global Investors in London says the exchanges and tender offers have been extremely positive for the market. “There will definitely be more offers in the future and many securities have been trading at higher values as investors anticipate deals,” he says.
Peter Jurdjevic, at Citigroup, which is helping manage Agricole’s offer, says most banks are interested in taking steps to boost core capital: “It is difficult to predict who will make offers or when but we expect to see a number of other banks come forward over the next month.”
Investors and analysts are examining which banks have the lowest levels of core capital – known as core tier one, or tangible common equity – as a proportion of total capital. This includes other so-called hybrid capital instruments, such as tier two subordinated bonds, which occupy a grey area between equity and debt.
Banks with the lowest core capital – whose tier two bonds are trading at the biggest discounts to face value – are expected to be most likely to make tender or exchange offers soon. In the UK, Barclays and Standard Chartered are among the favourites.
Banks whose bonds are at the lowest prices generally have to offer higher premiums to win over investors, because they are being asked to give up more of any potential recovery. But the size of the premium offered can be a clue to how keen a bank is to boost its capital base.
However, even with Lloyds and RBS’s huge offers – both came at near double market prices – the two banks can still add to their tier one ratios a maximum of just 1.03 and 2.03 percentage points respectively before tax, according to analysts at BNP Paribas.
While the moves are generally popular with investors, not all those who own junior bank bonds are likely to accept. In the UK, insurers are huge investors in such debt and there are concerns that crystalising losses on such bonds through selling them back at a discount would be too painful for some to contemplate.
“Much has been written about insurers being better positioned than banks, yet most have more than their capital buffer invested in the subordinate debt securities of banks,” says Andy Hughes of JPMorgan.
So far, there has been much less activity in the US, with only one small regional lender, Webster Bank, buying back a tiny $22m (£15.3m) of such bonds. Mr Jurdjevic says this is because many are more focused on repaying Tarp funds to the US government.
However, US banks are expected to follow suit in due course as many in financial markets and financial regulation believe that so-called hybrid capital securities outside core tier one have had their day.
They became very popular in the past decade because they helped banks to increase leverage and boost returns to equity holders – and while some see that they still have a role, their importance is expected to be much less in the future.
“Banks do need tier two bonds to absorb regulatory deductions from their capital base, but the level of tier two capital that banks require is likely to be far lower going forward due to the focus on core tier one rather than total capital,” says Mr Thomson.
There are others who think that once the dust on the crisis has really settled, bankers will once again come up with new instruments and new ways to boost leverage – and with it, risk and return.