Credit Research

Credit Note 3 September 2010

Basel III – Impact for bondholders

Bond issuance to become extinct?
If implemented as planned, the Basel III proposals would have many implications for
issuing banks and bondholders alike. In addition to higher funding costs, financial
institutions would face the challenge of finding a new investor base – not only for newly-
issued subordinated Tier 1 or Tier 2 bonds but potentially also for part of the senior debt.
The Basel Committee’s latest proposal to write-off or convert (subordinated) debt if a
bank needs state support could make the issuance of sub debt almost prohibitively
expensive for weak names, and could also adversely affect the funding costs of the
good names. Regulators are currently trying to resolve the so-called bondholder moral
hazard, where bondholders rely on the systemically important banks being bailed out by
their governments to avoid making losses while taxpayers suffer. While the regulators’
rationale is clear, they might be well on the way to taking it a bit too far. However, the
Basel Committee has asked market participants to submit their comments by 1 October
2010. Initially, the Committee intended to publish the calibrated set of rules by the end of
2010 to become effective at the beginning of 2013. However, as a result of the impact
studies conducted by the banks in H1 2010, we expect further watering down of the
current proposals and potentially an extension to the original timeframe.

The severity of the financial crisis has triggered efforts to reform and stabilise the financial
system across the globe. The US enacted the Dodd-Frank Wall Street Reform and
Consumer Protection Act in July 2010, but reforms are currently still being discussed in
Europe. The fragmentation of the European market, reform proposals, their implementation
at the EU level as well as national legal initiatives such as the bank restructuring law in
Germany1 mean they are being drafted simultaneously.
In Europe, among the most important reform ambitions is the Basel Committee’s proposal
on strengthening the resilience of the banking sector, or the international framework for
liquidity risk measurement, standards and monitoring. Of course, the Basel Committee’s
reform proposal is in fact designed for a global reach, but given the US’ reservations about
the Basel regulatory measures, we believe they might be implemented in Europe first.
The reform packages focus on:
• Improving the structural quality and quantity of regulatory capital
• Improving the capture and coverage of counterparty risk
• Introducing a leverage ratio
• Reducing pro-cyclicality and building countercyclical capital buffers
• Outlining ideas on how to deal with systemic risk and the phenomenon of
interconnectedness
• Introducing a global standard for measuring and limiting liquidity risk
The timing of Basel III: The initial consultative document was released in December 2009.
While comment collection and impact assessments have already been concluded, a fully
calibrated set of standards still needs to be developed. The timeframe is until end of 2010,
and the aim is to implement the new standards by the end of 2012. However, the Basel
Committee proved its willingness to slacken the reins in July this year when it relaxed the
timing of full implementation of the net stable funding ratio and the pillar 1 migration of the
leverage ratio to 2017. Amendments and additions to the original document were also
made on the composition of core capital, counterparty credit risk and the leverage ratio in Analyst Banks
July. In August 2010, the Basel Committee released further suggestions on how to shape Claudia Vortmüller
the terms and conditions of Tier 1 and Tier 2 capital instruments, i.e. subordinated bank +49 69 136 22325
claudia.vortmueller@commerzbank.com
debt, in order for it to be eligible going forward.
cbcm.commerzbank.com
1
Bloomberg: CBIR
The German parliament has just passed draft restructuring legislation which aims at dissolving
distressed banks in an efficient manner. This includes burdening subordinated debt holders in the
case of bank restructuring.

For important disclosure information please see pages 5 and 6


Grandfathering of
outstanding subordinated
debt recommended
The initial proposal on the
composition, for Tier 1
and…
… Tier 2 capital
2 3 September 2010
Conserving and improving the quality of capital: In our view, the composition and quality of
equity capital is among the most urgent topics that need to be resolved. It is largely
acknowledged that equity capital best absorbs losses on a going-concern basis but what
happens when a bank has reached the point of non-viability? In August 2010, the Basel
Committee released an additional proposal to ensure the loss absorbency of regulatory capital at
the point of a bank’s non-viability. The idea is to enhance the entry criteria of regulatory capital to
ensure that all regulatory capital instruments issued by banks are capable of absorbing losses in
the event a bank is unable to support itself in the private capital markets. So far, in many
instances during the financial crisis, capital instruments issued by bailed-out banks have not
taken any losses at all.
Without doubt, the Basel III rules will have a significant impact on the composition of banks’
equity capital bases. To avoid disruption of the existing secondary market, the Basel Committee
has recommended that members consider the possibility of allowing the grandfathering of
instruments which have already been issued by banks prior to the publication of the consultative
document in December 2009. FitchRatings is of the opinion that the implementation of this Basel
III proposal would include the grandfathering of recognition of currently outstanding subordinated
debt, UT2 and Tier 1 instruments, at least for a certain time. In addition, the rating agency takes
the view that the proposal will not impact the contractual terms of current instruments. Therefore,
the rating agency is not taking any rating action as a direct result of the proposals.
In the initial proposal, the Basel Committee made the following suggestions: In line with the
existing regulation, Tier 1 capital remains subordinated to depositors, general creditors and the
bank’s subordinated debt. The capital should be available on a perpetual basis, callable only
after a minimum of five years and only if replaced by capital of at least the same quality and with
the respective bank’s capital position not being threatened. The instrument should not feature
incentives to redeem. This already points to the Committee’s intention to phase out hybrid Tier 1
capital, which used to incentivise calls through step-up coupons. Banks should have full
discretion to cancel payments at all times. If classified as liabilities, the instruments must offer
principal loss absorption through either conversion to common shares or a write-down
mechanism which allocates losses at a pre-specified trigger point. Features that hinder
recapitalisation are not allowed.
Tier 2 capital continues to be subordinated to depositors and general creditors of the bank. Sub-
categories, i.e. the distinction between upper and lower tier 2 will disappear. The minimum
regulatory maturity should be at least five years. In the last five years to maturity, recognition of
regulatory capital decreases on a straight-line basis per year (not implemented in Germany so
far). Tier 2 will be callable only after a minimum of five years and only if replaced by capital of at
least the same quality and if the bank’s capital position is not being threatened. The investor
must have no rights to accelerate the repayment of future scheduled payments (coupon or
principal), except in the case of bankruptcy and liquidation.
TABLE 1: Composition of core tier 1 capital
Capital Items
Common equity
Reserves
Preferred stock surplus
Minority interest
Unrealised gains / losses
on debt, loans and equity
Goodwill and other
intangibles
Deferred tax assets (DTA)
Significant investments in
common shares
Source: Basel Committee
Initial proposal December 2009
Part of core Tier 1 capital
Part of core Tier 1 capital
To be deducted. Surplus will only be permitted to be
included in common equity if the corresponding
shares are permitted in common equity.
To be deducted. Will not be eligible for inclusion in
core Tier 1, even if the instrument is the common
equity of a regulated subsidiary.
To be deducted. No adjustment should be applied to
remove the common equity component Tier 1
unrealised gains or losses recognised on the balance
sheet.
Potentially all goodwill and intangibles may be
deducted, net of any deferred tax liability.
DTAs which rely on future profitability of the bank to
be realised should be deducted from common equity.
Investments in own common shares to be deducted.
Amendment July 2010
No further amendments
No further amendments
No further amendments
Minority interest of a subsidiary with bank status
excluding excess capital attributable to the minority
shareholders will be eligible.
Unrealised losses continue to be deducted.
A level playing field is created through the option to use
IFRS in determining the level of intangible assets if
national GAAP results in a wider range of assets (e.g.
certain software assets) being classified as intangible.
DTAs resulting from a net loss carry forwards continue to
be deducted. DTAs that arise from timing differences may
receive limited recognition in the core Tier 1 capital,
capped however at 10% of the bank's common equity
component.
Investments in unconsolidated financial institutions may
receive limited recognition, capped at 10% of the bank's
common equity component.

Overall, the proposed tightening of the definition of capital and the increase in minimum capital
requirements are quite demanding, and full implementation will take several years. According to
the Association of German Banks, the current proposals are expected to generate total
additional capital requirements of €98bn in Germany (see Table 2 below). This is equivalent to
more than seven times the average annual increase in capital among German institutions over
the past 10 years. Against the backdrop of lower risk-return profiles, banks will face significant
challenges in raising the capital needed.
TABLE 2: Basel III proposal increase in core Tier 1 capital requirements for German banks
Area of regulation addressed by the Basel Committee Additional capital needed (€bn)
To fulfil the higher capital requirements 44
To implement the higher risk weights for exposures to financial institutions 4
To fulfil the higher capital requirements on the trading book 36
To fulfil the minimum Tier 1 capital ratio of 10% 14
Total 98
Source: Association of German Banks

According to the Institute of International Finance, banks would need to raise $0.7 trillion of
common equity and issue $5.4 trillion of long-term debt net globally between 2010 and 2015.

Definition of non-viability
and ‘gone concern’
In the follow-up proposal released in August 2010, the Basel Committee intends to ensure that
all regulatory capital instruments (Tier 1 and Tier 2 securities, including dated subordinated debt
classified as Lower Tier 2) issued by banks can absorb losses if a bank is deemed to be non-
viable. Non-viability is triggered by the earlier of: (1) the decision to make a public sector
injection of capital or equivalent support; or (2) the decision that a write-off is necessary. Capital
instruments should be able to absorb losses in the case of a permanent write off, conversion into
common shares, or a write-off partially offset by the issue of shares. Note the new definition of
‘gone concern’: In respect of regulatory capital instruments, the proposal is to treat a bank as a
gone concern if it would, in the opinion of the regulator, have failed if it had not been bailed out
by the government.

3 September 2010 do not delete 3

Substantial imbalance
between bondholders and
shareholders
Disappearance of LT2
Write-off and conversion in
the context of restructuring
4 3 September 2010
Market participants are saying that the Basel Committee is ignoring the fact that bondholders
can suffer substantial losses on their holdings as the price of the bonds falls, either through
mark-to-market write-downs or by accepting distressed exchange or buyback offers. However,
under the new proposal, bondholders would continue to have limited upside while their downside
would exceed that of shareholders. And while shareholders still have shares where the price
could recover over time, bondholders would be left with nothing, at least in the case of a full
write-off. The Basel Committee acknowledges the fact that a write-off resembles a transfer of
wealth from the instrument holder to the common shareholders. And we agree with market
participants that, in the light of the current proposals and their adoption, an investment in bank
shares would look increasingly attractive versus buying hybrids, even dated subordinated debt.
If the Basel Committee extends the loss absorption to all Tier 2 instruments, the classic Lower
Tier 2 should disappear, in line with our view as given in January 2010. However, depending on
the grandfathering features of existing Lower Tier 2 and how long it will count as capital, the
outstanding Lower Tier 2 of banks perceived as being of good credit quality could tighten in
substantially due to the future rarity of the asset class. The same should hold for the weaker
names that avoid the fate of being restructured. In such a case we would not rule out that even
Lower Tier 2 bonds could be adversely affected.
Features like write-off, conversion to common shares or effectively a combination of the two
could probably only be implemented on a large scale and in a sound manner by including the
features in the new issue documentation. Therefore, the latest proposal should only apply to
newly-issued bonds. In our view, the write-down or conversion mechanism could only be applied
to outstanding Tier 1 and Tier 2 bonds of a distressed bank that is being restructured under, for
example, the legislation adopted in Germany, which becomes effective 31 December 2010.
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