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As Basel III Deadlines Approach, Banks in the Middle East Seek Alternative Forms of Fundraising

As Basel III Deadlines Approach, Banks in the Middle East Seek Alternative Forms of Fundraising

The market for Additional Tier 1 and Tier 2 bonds issued out of the Middle East has blossomed since Abu Dhabi Islamic Bank broke ground on the first Basel III-compliant public Tier 1 capital issuance in 2012.

With many of the region’s economies finalising Basel III implementation in the run-up to the March 2019 deadline, and a number of legacy non-compliant issues that need to be potentially refinanced, we speak with Aziz Ata, Head of FIG and Public Sector, Global Banking, MENAT and Nik Dhanani, Managing Director, Financing Solutions, Global Banking and Markets about the emerging 2018 pipeline and the main factors influencing borrowers to come to market.

Persistently lower oil prices have impacted bank liquidity in the Middle East over the past few years. To what extent has this affected bank capitalisation and capital adequacy ratios in the region? How healthy are the region’s Financial Institutions?

Aziz Ata (AA): It will be not precise to paint the entire region with the same broad brush, but we can split out the GCC – which contains similarly structured economies – from the rest of the Middle East.

In the GCC, bank capital levels have been relatively healthy over the past few years. This is primarily being driven by a few interrelated elements. Financial institutions tend to have very strong internal capital generation and they see very healthy growth. The second driving force is the growing issuance of alternative forms of capital, particularly, Additional Tier 1; a number of banks in the region have issued Additional Tier 1 instruments in a bid to boost their overall capital. Finally, new banking regulations have driven additional demand for regulatory capital. This was driven by the phased introduction of Basel III rules on one hand, as well as new rules being implemented by Central Banks, which in turn have increased capital buffers steadily since the Financial Crisis ten years ago. Tier 1 capital ratios in the region have usually surpassed the global average. Together, these factors contribute to a fairly healthy banking sector.

Outside of the GCC, would you say the picture is much more nuanced? Banks in Turkey, for instance, have quite healthy balance sheets and are regular borrowers in the international US dollar-denominated loan markets as well as the debt capital markets.

Nik Dhanani (ND): Turkish lenders have been quite advanced in terms of their Tier 2 issuance programmes. Many of them have been longstanding issuers in the 144A format, so have regularly tapped into US capital market investors, as well as Asian and European markets. There have been a number of Basel III compliant Tier 2 transactions that feature new loss-absorption mechanisms. We have yet to see Additional Tier 1 issuance from the region, although the authorities are working on detailed criteria for these instruments. I suspect we may see the inaugural Tier 1 transaction from the Turkish banking sector next year, which would be an important milestone for the region. Given the current interest rate environment, we have seen borrowers from outside the region issue these instruments at very cost-competitive levels, which have enhanced return on equity to shareholders – in part because the post-tax cost of Additional Tier 1 capital is in many cases significantly lower than the costs associated with comparable returns on equity.

The Middle East and Turkey still have a raft of mega projects planned for the next five to eight years. To what extent do you see this driving banks’ capital requirements – and to an extent, Tier 2 issuance – over the medium to long-term?

AA: As we move towards the full implementation of Basel III, demand for Tier 2 has stabilised somewhat. But what we have seen is that with oil prices having declined and staying at moderate levels, growth has remained benign, which has weighed on lending. This means there is excess balance-sheet liquidity to deploy, but the demand for credit needs to be there; banks are in a good position to absorb that for the time being, and as their asset book starts to mature they will inevitably need to redeploy that capital.

ND: The way in which we would imagine Tier 2 capital needs dovetailing with some of these factors is the extent to which risk weighted assets grow. As balance sheets grow, we would expect most institutions to keep around 2% of risk weighted assets on their balance sheet in the form of Tier 2 capital. Part of this also depends on the way in which Basel III rules are rolled out in some jurisdictions. It may be possible to find scenarios where financial institutions aren’t necessarily using that 2% threshold of the amount issued, depending on the overall plan for equity capital ratio, but it seems unlikely; outside the GCC, we see most banks holding more than 2% of risk weighted assets in Tier 2 capital, primarily because it is one of the most efficient ways of holding capital given the bank capital regime’s construction. We are still awaiting the formal rollout of the Basel III regime in some GCC countries.

Recent bank failures in Europe and Russia have raised some difficult questions about the effectiveness of AT1 bonds, particularly around embedded bail-in features and the willingness of states to bail out lenders, has this influenced discussions about the appeal of these instruments with investors looking at Middle East and Turkish FIs?

AA: Not really. When we have these discussions with clients, the decision to issue or not tends to centre on price and demand rather than structural features around these instruments. In the GCC and in Turkey, government ownership of corporates and financial institutions is prevalent, so from a management standpoint, the discussion tends to steer towards the cost of Additional Tier 1 instruments compared with the cost of common equity. The wider that delta is, the more we’ll see AT1 supply grow; the narrower it gets, the more likely it is that shareholders will be approached as a source of capital.

From an investor standpoint, demand for these instruments has been quite strong. I suspect that as we move into 2018, the evolving political environment in the Middle East will be top of mind for many investors and likely influence demand going forward.

ND: We also see demand – and the underlying structure of these instruments – as a function of the banking sector rules themselves, which continues to evolve throughout the GCC and the wider Middle East. We have been working closely with regulators from the GCC and elsewhere, providing helpful input where we can – including on the features to be expected in the Basell III world we are in. Some elements of the Basel III rules can already be found in instruments currently out in the market – the point of non-viability and loss absorption features, for instance – and as more specific criteria are published, there could be some influence on issuance. I don’t see these having a dramatic effect on overall demand for the asset class; Tier 1 instruments represent a very interesting way for external stakeholders to gain exposure to FIs while securing slightly higher yield than they would otherwise get on comparable senior debt instruments or Tier 2 issuances.

 

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