Most European investors consider there to be several challenges to investing in Basel III-compliant capital instruments, according to a Fitch Ratings' quarterly investor survey conducted in October. The key issues arise from regulatory uncertainty.
The two main issues identified by survey participants were the influence on non-performance of regulatory and model risk, and uncertainty about loss-absorption trigger points, including the definition of "point of non-viability" (PONV). Of less concern, but still meaningful, were the issues of mandate restrictions, inadequate pricing of risks and secondary market liquidity.
A bank could be restricted from making coupon payments on additional tier one (AT1) securities if changes in capital buffers, requirements or risk weights imposed by European regulators cause a breach of its combined capital buffer requirements. These regulatory and model risks amplify uncertainties for investors.
Fitch believes the most easily activated form of loss-absorption is the non-payment of interest on AT1 securities, making it the key rating driver for such instruments. Unless a bank were to suffer a very substantial and sudden loss, coupon omission would be likely well before an equity conversion or write-down trigger is hit, based on the levels of these triggers in the handful of European bank AT1 deals launched so far.
Regulatory and model risk is of lower concern in Asia-Pacific at present because the banks have relatively comfortable capital ratios, which are less affected by Basel III changes due to their simpler structures, meaning that there has been less focus on additional capital buffers. But Asia-Pacific investors were more concerned about the PONV; and in our investor survey for the region published last month, foresaw more challenges with market liquidity and pricing than European investors. Pricing and liquidity in Asia is being distorted by the involvement of private bankers and the influence of private or retail investors attracted to these securities in the low-interest environment.
Investor uncertainty about PONV has arisen because regulators have not always defined what events would trigger it, and there may be a fair amount of judgement in the decision for Tier 2 instruments. There may also be more than one authority involved if a bank has substantial operations in multiple markets, which could complicate the process.
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