DealBook: European Banks Shuffle Bonds to Bolster Capital

Chris Ratcliffe/Bloomberg NewsBNP Paribas of France is one of the European banks raising capital by rejiggering bond holdings.

LONDON — European regulators are pressing banks to shore up their balance sheets and bolster their capital cushions as the sovereign debt crisis continues to wreak havoc on the Continent.

But some financial firms, including Barclays of Britain, Commerzbank of Germany and BNP Paribas of France, are rejiggering their bond holdings in a complex maneuver that allows them to improve their capital levels without raising additional funds. It’s a costly accounting strategy that may drain cash, leaving firms more vulnerable to the economic turmoil.

“Banks have to conjure up extra capital from thin air,” said Bridget Gandy, co-head of European banks at Fitch Ratings in London. “New debt is expensive if they have to refinance using the capital markets.”

Faced with a tight deadline to raise new capital, many big European banks are reorganizing existing debt to increase their buffers. The strategy, known as liability management, involves buying back or exchanging hybrid securities — investments that pay dividends like bonds, but can be converted into equity — at a discount.

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• Graphic: Conjuring Up Capital

Under accounting rules, financial firms can then book the difference between the original face value of the securities and the current discounted price as a profit.

The banks can do so because they have already collected the full amount of the debt from investors and have to repay only the smaller amount.

A bank, for example, can buy back $10 billion of hybrid securities from investors at 70 cents on the dollar, or $7 billion. By doing so, the firm cuts the amount of debt on its balance sheet and books an extra $3 billion for its buffer of highest-quality capital, minus any taxes.

“This will be a key means by which European banks will generate significant core capital,” said Huw Richards, managing director of debt capital markets at JPMorgan Chase in London.

While the deals have passed regulatory muster, analysts worry that using cash, or liquidity, to buy complex debt instruments may leave banks at risk if the market volatility continues. For many financial firms, it remains prohibitively expensive to sell bonds in the current environment. So banks are relying on cash reserves to meet short-term financing needs, making it especially important for firms to remain liquid.

“Banks are having to use cash to exchange hybrid securities for equity,” said Lisa Hintz, a European bank risk analyst at Moody’s Analytics. “But they’re trading cash for equity, and liquidity is at a premium right now.”

Europe’s banks are scurrying to comply with new capital rules. In response to the crisis, the European Banking Authority announced plans in October to force firms to put aside extra funds to cover potential future losses. By June 2012, the region’s financial institutions will need to increase their core Tier 1 capital ratio — the strictest measure of a bank’s ability to resist financial shocks — to 9 percent of assets, up from the currently mandated level of 2 percent.

On paper, some of Europe’s biggest banks already meet the minimum requirements. But in this rapidly deteriorating environment, their capital could quickly evaporate.

Policy makers are also clamping down on the types of securities that can be used toward banks’ reserves in the future. In particular, authorities are assessing what hybrid investments will count as capital.

The Continent’s banks are struggling to meet the new rules. Regulators estimate European financial firms must raise a minimum of $142 billion by next summer. Greek banks alone have to come up with $40 billion.

With investors reluctant to pump more money into the Continent’s troubled financial sector, banks have turned aggressively to asset sales to increase their capital base. On Wednesday, Grupo Santander of Spain said it would sell its Colombian units to CorpBanca of Chile for $1.23 billion.

In total, European financial players are expected to sell or write down more than $1.8 trillion of loan assets over the next decade, according to the consulting firm PricewaterhouseCoopers. That compares with just $97 billion from 2003 to 2010.

The fire sale, however, has not been enough. Local politicians have raised objections to selling banking assets to foreign firms. And potential buyers, including leading private equity firms in the United States, are largely sitting on the sidelines in the hopes that asset values will continue to drop.

“Deals are taking longer to complete,” said Christopher Clark, a corporate finance partner at the accounting firm BDO in London. “Firms are taking more time to check their due diligence.”

To supplement the sales, banks are finding ways to restructure their debt in a bid to increase their capital levels. On Monday, Barclays said it was offering to buy back as much as $3.9 billion of securities at a discount of up to 30 percent. The bank said the deal would help meet regulatory limits on using hybrid securities toward the bank’s core Tier 1 capital, as well as bolstering its funding reserves.

Last week, the Lloyds Banking Group announced plans to exchange $7.7 billion of similar debt for new bonds. The firm, which is 41 percent owned by British taxpayers after a $27 billion bailout in 2008, asked investors for up to a 30 percent discount on the securities. Lloyds said the deal was in response to market volatility and would help improve the quality of its capital base.

The French banks BNP Paribas and Société Générale also have announced similar deals worth billions of dollars. The financial firms said they remain well capitalized, and the offer would allow investors to offload hard-to-sell assets at a price higher than current market values.

“This is totally new territory for banks,” said Peter Hahn, a banking professor at Cass Business School in London and a former managing director at Citigroup. “Firms are taking money from wherever they can find it as they restructure their capital base.”

The current owners of some hybrid securities are often eager to trade the investments for cash. The deals allow investors to dump underperforming securities, which in some cases are trading 50 percent below their face value.

But some institutional investors like pension funds and insurance companies, which typically hold bonds for long periods of time, say they are being shortchanged because of the large markdowns that banks are demanding.

In November, Santander announced plans to exchange $9 billion of so-called subordinated debt at a nearly 10 percent discount. It said the aim was to retire securities that no longer counted toward the new regulatory capital requirements. The deal also would allow bondholders to exchange their existing investments for debt that offers a higher interest rate.

Investors balked at the terms. So far, Santander has said only 24 percent of bondholders have agreed to the deal, and some questioned whether the bank was offering a good deal.

“Investors need an incentive to accept these offers,” said Georg Grodzki, head of credit research at British pension and insurance provider Legal General.

“A low take-up usually means investors believe bond issuers want to retain the benefits for themselves.”

Article source: http://dealbook.nytimes.com/2011/12/07/european-banks-shuffle-bonds-to-bolster-capital/?partner=rss&emc=rss