China’s forthcoming implementation of Total Loss Absorbing Capacity (TLAC) rules is shaping up to be one of the biggest developments the international bond markets will witness this decade and for the central government, potentially one of its greatest ‘going global’ tests.
At issue is how the country’s big four banks will be able to raise all the capital they need, given that China’s domestic bond market remains too shallow to absorb it all. The quartet has also not cultivated a deep international investor base to compensate.
The net result may be wider pricing and an issuance shock, unless the government ups the regulatory incentives.
There are varying estimates about how much the four banks will require, but one thing they all have in common is a very large figure. In a research report published on February 11, JP Morgan puts it at Rmb4.4 trillion ($652 billion) before the end of 2022.
That is almost 15 times the Rmb269 billion the four raised from capital instruments during 2018, according to Nomura figures.
It is also nearly 10 times the $68 billion net TLAC issuance, which HSBC believes European banks will raise in senior unsecured debt this year, and just over eight times the $80 billion that Japanese banks have raised since 2016.
JP Morgan senior credit analyst, Matthew Hughart, also calculates that were the big four to raise all the money internationally, they would equal two thirds of current outstanding Asian dollar credit.
The four Chinese banks need more TLAC debt than other globally systemically important banks (G-SIBs) partly because they are so large, but also because of the way they are currently funded.
Within Asia, only Japan and China have G-SIBs. One thing their banks also have in common is a business model based on deposits rather than wholesale funding. That means the two have all the more capital to source in order to meet the 33% debt component of the overall TLAC requirement, which all G-SIBs have to adhere to.
Global rules governing G-SIBs currently give the Chinese banks until 2025 to meet their first capital hurdle: 16% of Risk Weighted Assets (RWA) in TLAC instruments. This compares to the 13.5% ratio Japan has to hit this year and the 16% ratios required for European and US banks.
By 2028, Japan needs to be up to 14.5%, while China will need to have hit 18% alongside the European and Western banks.
ACCELERATED IMPLEMENTATION
However, the People’s Bank of China (PBOC) said TLAC implementation would likely get accelerated since credit bonds were close to a maximum 55% level to GDP at the end of 2017. Analysts believe that threshold has now been breached, giving the banks three years to get TLAC to 16% of RWA under global Financial Stability Board (FSB) rules.
Debt capital markets bankers believe acceleration will be a positive step. Sean McNelis, HSBC’s co-head of Asia Pacific debt capital markets, speaks for the majority when he says: “We believe that while the TLAC requirement is very large, it is manageable, particularly if the banks can start raising it sooner rather than later.
“We’ve been encouraging the regulator to give the market as much clarity about the rules as soon as possible so the banks have plenty of time to issue ahead of the formal implementation date,” he added.
Back in November, the PBOC said the government was leaning towards the French approach, which will create a new asset class called senior non-preferred debt. Bankers believe this is still on the cards and McNelis says it will work well for Chinese banks.
Senior non-preferred debt, also known as Tier 3 debt, sits just above senior unsecured debt within a bank’s capital structure. The main difference is that it has to contain loss absorption features in the event that a bank runs into difficulties.
TLAC debt was instituted by the FSB to prevent a repeat of the Global Financial Crisis, when a number of Western banks had to be bailed out by their respective countries’ taxpayers. As a result, capital ratios are rising well above the Basel III 8% minimum to provide banks with much stronger buffers.
But there is a key difference between Asia and Europe, which relates to the role that governments are likely to play in the event of credit stress.
In Europe there is a far greater likelihood that investors will have to bear losses given the long-standing public anger generated by the GFC. By contrast, the Japanese government has re-inforced its support for the sector by making its own format far more issuer-friendly.
Potential losses have been pre-funded through the country’s Deposit Insurance Corp. As a result, its three G-SIBs (MUFG, Mizuho and Sumitomo Mitsui) have been able to use this to reduce their TLAC funding requirements by 2.5 percentage points this year, rising to 3.5 percentage points by 2022.
Some market participants wonder whether Chinese banks will also follow Japan’s lead and issue the majority of their TLAC debt offshore. When the big four had to raise Basel III capital back in 2014, about three quarters was raised onshore.
However, many specialists believe they will not be able to repeat this feat despite the domestic bond market’s rapid growth since then. Overall, JP Morgan calculates that ICBC has the biggest funding requirement (Rmb1.34 trillion), followed by ABC (Rmb1.243 trillion), Bank of China (Rmb993 billion) and CCB (Rmb823 billion).
The biggest hurdle is an institutional investor base, which is still not deep enough even though the government recently allowed insurance companies to start holding perpetual bonds and Tier 2 debt, which is TLAC eligible.
Then there is the fact that while commercial banks are not allowed to hold each others' subordinated debt without taking a capital hit, they have effectively been doing so through wealth management products under the shadow banking sector, which the government has been trying to clamp down on.
Foreign investors are also unlikely to pick up the slack in the onshore market as the predicted big inflows are heading directly into the government bond market.
Nevertheless, Stephen Chang, Pimco’s portfolio manager for Asia, believes that the banks will be able to raise over half of their TLAC requirement onshore, but he says that he expects foreign participation to initially grow quite slowly, given that even CGBs are not in the indices yet.
JP Morgan believes that a “large negative shock” can be avoided and argues that “regulatory support in the domestic bond market will be biggest swing factor” over how much is raised there and at what price. The bank flags how the regulator has always actively supported the market and will find it “unpalatable” if there is a “material negative impact on pricing and re-financing for Chinese issuers” either onshore or offshore.
JAPAN CULTIVATES INTERNATIONAL INVESTORS
But there can be little doubt that the amount of paper flowing into the international bond markets will be very large. And this is where China’s fundraising is likely to differ markedly from Japan’s.
Japan’s big three banks turned to the offshore markets for their TLAC needs because they are already flush with Yen deposits onshore and have a natural dollar funding need thanks to their large international operations.
Chinese banks have also been growing their international branch networks, but they are still far smaller.
More importantly, Chinese banks have not put anywhere near as much work into developing an international bond market following, as other Asian issuers have. Instead, they have historically favoured placing paper with Chinese accounts over international ones.
Indeed, one of the biggest criticisms that international banks constantly level at all Chinese borrowers is their tendency to treat bond issues like syndicated loans; asking syndicate managers how much paper they would like to hold rather than distribute to international investors.
One of the positive outcomes from TLAC may be a change of approach if Chinese banks’ experience shows other domestic borrowers why it is important to engage with investors and diversify their funding base.
This is what the Japanese banks have always done. They additionally benefit from a very long track record tapping international bond markets.
Augusto King, head of Asian debt capital markets at MUFG, told FinanceAsia, “When it came to TLAC, our CFO’s office did a huge amount of work with investors explaining Japan’s rules and how the issuance would affect the bank’s capital ratios. MUFG’s also aims to diversify its investor base and avoid cannibalisation by placing non-Yen debt with non-Yen investors."
The Chinese banks, on the other hand, are now grappling with a weighty issuance pipeline and limited investor education. It could well equal wider pricing and pressure across their entire credit curve.
HSBC’s McNelis believes local currency bond issuance will allow the supply to come in a more orderly manner. “We’ve seen European banks in particular access local currency markets to meet TLAC and we’d expect the Chinese banks to do the same alongside their local RMB and G3 markets,” he said.
Another solution would be to allow Chinese banks to issue capital in local currencies through their branch networks. In certain jurisdictions like Australia, this would also give them a tax advantage.
This would again differ from Japan where debt is issued from the holding company level (like the UK and Swiss model) making it structurally subordinate to operating company debt (French model).
King says that MUFG normally leaves its dollar-denominated TLAC debt offshore, whereas bankers believe that the Chinese banks will repatriate theirs, potentially boosting the big four’s foreign currency reserves.
So what does this mean for where the debt might trade? Historically, Chinese bank capital paper has traded at tight levels relative to European comparables, partly because of a strong home market bid and partly because of high private banking interest.
However, China’s economic slowdown and the government’s de-leveraging campaign reversed this trend during 2018, prompting renewed interest from international investors who saw value open back up.
The question is whether it will last once the issuance flood begins in earnest.
In Europe, greater issuance has resulted in a wider differential between banks’ senior unsecured paper and their senior non-preferred. Late last year, this prompted HSBC to turn from underweight to overweight on the latter.
It believes that, “the spread on these securities should be at least halfway if not closer to Tier 2 than non-TLAC senior unsecured.”
That is certainly the case right now.
For example, BNP Paribas has a 2.375% February 2025 lower tier 2 euro-denominated deal yielding 1.835%. That represents 77bp over a one-year shorter 1.125% October 2023 senior non-preferred issue, which is yielding 1.064%.
The French bank also has senior secured paper with a January 2023 maturity yielding 0.324%.
JP Morgan concludes that Chinese TLAC “looks attractive at multiples two times preferred senior.”
At the 2021 part of the maturity spectrum, ICBC’s dollar-denominated curve spans 3.515% for senior unsecured debt (issued via ICBC Sydney) to 5.139% for a perpetual deal callable in 2021 (issued by ICBC Asia).
