Political Technicals of Bank Capital Regulation

The political strife of the 2008 global financial crisis may have passed peak tension; in fact, media reports suggest that the UK in particular has moved on from the mistakes of those at the top of international finance. The debate, however, as to how to react to the crisis from a political standpoint, stretches further than fines, constraints and protests. Post-crisis regulation has entered into a struggle at the very core of the financial world, in the capital structures of the banks themselves, in an attempt to redefine what a bank is and what it does, and bolster the financial integrity of the institutions.

Why Banks?

First off, banks have been specifically targeted post-crisis era due to systemic importance to global market liquidity; over, say, corporations, whose operations can adapt, or be redefined, in the face of financial strife, and who are only regulated in so far as they can influence the market (e.g. through anti-trust laws). Regulation could, therefore, be described, not as a means of changing the capitalist system, but reinforcing it and making it stronger. Some rhetoric spilling from banking circles points to overregulation as a chokehold; this, however, stems from nostalgia for an era of liberalisation, and misses the point that the regulatory strengthening of banking capital structures is only a good thing in the long run for financial institutions.

Second, banking activities by nature have a high level of leverage: i.e. they employ a little of their own capital alongside a lot of others’ capital, to maximise profits. Corporate leverage can also be high, but, importantly, it is regulated by the market through the costs of raising debt. Third, bank balance sheets, again by nature of activities, tend to be highly liquid, unlike corporate balance sheets, which are more static and viscous. Banks, then, by virtue of role, leverage and liquidity, are thought to require far more intricate and carefully-structured regulation to ensure that the global economy doesn’t see another Lehman-style bankruptcy.

Banking Capital Structures

In order to ensure that business activities can prosper, a bank attempts to match the assets on its balance sheet (e.g., mortgages, loans, investments) with liabilities. These liabilities are effectively the bank’s corporate means of financing its activities, and can be raised in two ways: through debt or through equity. Debt is raised by selling bonds: i.e. the bank takes capital from investors for a fixed amount of time and offers fixed coupon payments in return. Equity is raised by selling shares: i.e. the bank takes capital from investors for a perpetual amount of time, and offers floating returns based on profitability. The two types of financing suit different types of investors looking for different rates of return and different risk levels.

The reason debt and equity have varying levels of risk is because they are legally bound in different ways, and therefore are placed differently within the capital structure. Generally, issuers of debt are bound to pay coupons (usually annually or biannually), and can be legally approached if they do not (see the Greek crisis that has unfolded this summer), whereas issuers of equity, whilst needing to pay dividends to attract investors, are not bound to do so, and so investors take the risk that they may not receive any return, nor may they have their original investment returned to them.

The initial issuance of equity is a significant move for a corporation, as it makes the company public given that any investor (generally) can buy in and, in certain circumstances, influence business operations. Debt, however, does not relinquish the same corporate power. Banks, though, in the modern era, as with many corporations, issue both debt and equity so as to benefit from the pros and cons of both forms of financing. It is at this stage that the conflict between the two comes into the fray, though. In reality, banking capital structures don’t really exist: if a bank did absolutely no business, and laws did not account for lack of coupon payments, the structures wouldn’t matter. However, when revenue needs to be distributed to creditors or shareholders, or when losses need to be absorbed, the hierarchy of corporate finance becomes critical.

Revenues, after operating and other costs, are sent through the top down the capital structure; i.e. the creditors who hold the bank’s debt are paid first, followed by the equity holders, who are paid out of the remaining profits. Losses are distributed in exactly the opposite manner; they eat up the equity first, before neglecting the service of the debt above it. The basic structure is displayed opposite. With banks that take deposits, there exists a third layer of financing above debt, which requires servicing before the corporate financing below.
Whilst this is the outline of the capital structure, banks are so big that within both of these main sections, there exist various other levels that render the foundations of banking activities rather complex. In equity, shares can be, for instance, of preference or ordinary standard, and within debt there exist various differences in covenants that place different types of debt at different places in the capital structure. This is because there is so much debt that, in the case of insolvency, there needs to be in place a hierarchy of what forms of debt get written down in what order. In the case of exponential losses, equity acts as a buffer, to be eaten up before the debt can be affected (equity can be treated as a buffer because of the inherent risks investors take when purchasing equity). Once equity is all gone, however, debt must begin to be written down, i.e. the security of the debt loses value. The covenants of the type of debt determine which debt gets written down first. There is, hence, a distinction between senior and subordinated debt, by which subordinated debt gets wiped out before senior debt. This is displayed opposite.

New Paradigms of Regulation

While there existed guidelines on the worthy ratios between the different types of debt and equity relative to the assets the bank held on the other side of the balance sheet, regulators have become increasingly preoccupied with these ratios, and they are now seen as important indicators of the security of a bank’s finances. Specifically, the Basel III guidelines, building on the initial two conference regulations, have emerged as important legislation on the ratios of bank leverage. European banks are now required to hold certain amounts of capital – equity and/or debt – relative to the assets, measured and ranked by risk (i.e. if one banks holds predominately mortgages but another holds predominately government bonds, the former will have a higher number of ‘risk-weighted assets’).

Aside from required levels of capital, though, the post-crisis dynamic encouraged the development of new forms of debt altogether. In parallel to the rhetoric of increased liquidity, a clash has developed between banks and regulators as to how these levels should be achieved. On the one hand, regulators want banks to hold as much equity as possible; equity is very easy to swallow during times of financial distress, and only requires servicing in times of prosperity. Ideally, in a vacuum, a regulator would want a bank to be entirely financed by equity, so that equity investors in a bank’s capital structure held the entirety of the risk of the bank’s bankruptcy. On the other hand, however, banks find equity expensive to raise, precisely because it is riskier. Banks, thus, desire to finance their operations through debt, because debt can be funded through fixed rate returns, and inevitably has a discount because it can be securitised on the bank’s assets. The downside to funding banking operations exclusively through debt, though, is that the operations are naturally risky given the leverage used by banks, and therefore, what may seem to be secure debt instruments are in fact far riskier.

AT1 Debt

It appeared, then, that a compromise was going to have to be hit, as this dichotomy in financing interests and the rise of increased capital ratio rhetoric came together, and it materialised. Within subordinated debt, a new form of debt was created, known as Mezzanine, or AT1 (Additional Tier), with distinct characteristics differentiating it from other forms of debt in the capital structure. AT1 debt sits immediately above equity in the structure, as one of two types of subordinated debt – along with LT2 (Lower Tier) – beneath senior, and effectively, acts as another capital buffer to protect depositors and senior bondholders in the case of bankruptcy. They are interesting instruments, not least because they are perpetual bonds – i.e. they have no maturity date – but also because they only sit in the structure as debt – paying coupons – as long as the bank is prosperous, and then convert to equity if capital ratios beneath subordinated debt become too low. In essence, AT1 bonds allow banks to have their debt in the good times, and the regulators to have their equity in the bad times.

Given that a bank’s capital structure is so large, different types of debt and equity trade in tandem but almost as different entities. The intuitive idea with bank debt might be that, if the issuer takes on more debt in any part of the structure, then the ability of the bank to maintain the rest of its debt would be inherently compromised. However, because the different forms of capital have varying covenants, the holders of the various forms of debt react dissimilarly. For example, the holders of senior bank debt will only benefit from issuance of subordinated debt or equity, because, simply, in the case of large losses, the lower parts of the structure will be eaten up first. It makes sense to picture the capital structure like a steam liner – if profits are food, and losses are water, the upper decks get fed first and the lower decks get flooded first. Therefore, the more lower decks there are beneath the senior debt, the safer the senior debt is.
The figure opposite details the capital structure of UBS AG and UBS Bank (the holding and operating companies) (figures are in €millions, correct to 08/2015).

 

Conclusion

AT1 therefore, sits at the centre of the debate on how banks should capitalise themselves to avoid being systemically risky. They form a compromise between the bank’s desire for as much secured debt as possible, and the regulators need for equitable security. The scope and severity of the capital regulations is increasing with venom over the next few years to 2018; whether regulators will continue to probe the banks into capitalising further beyond the instigation of Basel III is to be observed with interest.