Have economic support measures curtailed risks associated with Additional Tier 1 capital?
This document is intended for professiona investors only within the meaning of MIFID II.
By Jérémie Boudinet, Credit Fund Manager, La Française AM
In the wake or face of Covid-19, are banks in a financially sound position to cope with deteriorating balance sheet metrics and what are the implications for Additional Tier 1 Contingent Convertibles (CoCos) bondholders?
Following the 2007-2008 financial crisis, banks spent over a decade building up their capital buffers until at year-end 2019, it was estimated that globally, banks held approximately US$5 trillion of capital in excess of Pillar 1 regulatory requirements (Source: Bank of International Settlements, May 2020). Now regulators and authorities are relaxing capital buffer requirements, allowing banks to operate temporarily below the level of several required liquidity and capital buffers (Pillar 2 Guidance, capital conservation buffer, liquidity coverage ratio…). The European Central Bank even asked banks to stop paying dividends or buying back shares until at least the end of 2020, preferring to redirect capital to lending and to support their balance sheets. But there is growing concern about the implications of such a set of measures on AT1 Cocos.
Is coupon nonpayment a major concern?
One could argue that the primary risk looming in the AT1 market is the nonpayment of coupons. We on the other hand would disagree. We believe that there is very little chance that authorities will put pressure on banks to cancel coupons and this is clearly supported by a number of factors including several statements from the European Central Bank’s Prudential Supervisory Board. Andrea Enria, EU Bank Supervisor said, “The ECB doesn’t plan to suspend coupon payments on subordinated bank bonds, even after guiding lenders to suspend dividends to preserve capital.” Additionally, the potential savings associated with suspending coupon payments on AT1 is insignificant compared to the suspension of dividends, whereas the implications of such an action on investor confidence and a bank’s access to financing would be disastrous. This view has been confirmed by the European Parliament in November 2020, which stated in a report about capital buffers that “The coupons on the instruments qualifying as AT1 capital should not be restricted."
The Q2 and Q3 2020 earnings seasons were also quite reassuring, as almost all European banks have proven that they were able to bolster comfortable and higher solvency ratios than at the end of 2019, thanks to the dividend suspension, prudential easing and national measures on loan guarantees to support the economy.
With the benefit of hindsight, we view the European banking sector as being partially “administered” by regulators. Regulators limit dividend distribution and can control banks’ access to unlimited and cheap central bank liquidity in order to cope with the current very-low rate environment. Regulators are also pushing for more consolidation, with significant M&A moves, such as the mergers between Bankia and CaixaBank and UBI Banca with Intesa Sanpaolo. A few years ago, banks were supposed to avoid being too-big-to-fail. Now, the opposite is true, which in our view is positive for the stability of the banking system and, thus, for the continuation of AT1 coupon payments.
Subordinated debt & Contingent Convertibles are suitable for professional investors as defined below. Execution only services can only be provided to professional investors. Retail investors are excluded from the positive target market.
Professional Investors have the following characteristics:
- Good knowledge of relevant financial products and transactions
- Financial industry experience
Subordinated debt & Contingent Convertibles are not suitable for retail investors unless they have professional investment advice AND the investment is for diversification purposes only or have signed a discretionary portfolio mandate.
THIS DOCUMENT IS INTENDED FOR PROFESSIONAL INVESTORS ONLY WITHIN THE MEANING OF MIFID II. It is provided for informational and educational purposes only and is not intended to serve as a forecast, research product or investment advice and should not be construed as such. It may not constitute investment advice or an offer, invitation or recommendation to invest in particular investments or to adopt any investment strategy. Past performance is not indicative of future performance. The opinions expressed by La Française Group are based on current market conditions and are subject to change without notice. These opinions may differ from those of other investment professionals. Published by La Française AM Finance Services, head office located at 128 boulevard Raspail, 75006 Paris, France, a company regulated by the Autorité de Contrôle Prudentiel et de Résolution (www.acpr.banque-france.fr) as an investment services provider, no. 18673 X, a subsidiary of La Française. La Française Asset Management was approved by the AMF (www.amf-france.org) under no. GP97076 on 1 July 1997.