FMA warning on bank capital notes welcome, but much more can be done to give the Kiwi retail investor a fair go

By Gareth Vaughan 

It's something most of us have seen. No sooner does someone dump the remains of a fish dinner in their rubbish bin than a cat or dog comes along smelling a treat on offer.

The pet probably knows it shouldn't but just can't resist going after the tasty morsel. The snack may, however, come with a sting in the tail in the form of getting a bone stuck in its throat if it's a cat, or a boot up the backside from its owner if it's a dog.

From a retail investor perspective some bank security issues remind me a little of this scenario. Offering interest rates above 6%, or even 7% in the current low interest rate environment, such investment opportunities from big, household name banks are an enticing proposition for yield hungry ma and pa investors.

But if something goes wrong naive retail investors could face a nasty surprise with their interest payment tap turned off or reduced to a trickle, or they could even see their debt securities converted into shares.

Thus I am glad to see the Financial Markets Authority (FMA) has issued a guide on bank capital notes.

From the banks' perspective there are clear benefits from the issuance of these capital notes, perpetual subordinated notes and hybrid securities. The two key ones are getting suitable regulatory capital classification from the Reserve Bank for either tier 1 or tier 2 capital under Basel III capital adequacy rules. And secondly, from an income tax perspective, obtaining deductibility for the coupons that are paid on them.

Thus the banks get strong regulatory capital recognition from the Reserve Bank under Basel III, and obtain deductibility for the interest.

British hard line

But back to the ma and pa investors. Does the FMA guide go far enough?

This type of bank security issue isn't unique to New Zealand. In Britain the Financial Conduct Authority (FCA) has taken a stronger line.

Last August the FCA put in place temporary rules restricting the retail distribution of what are known as contingent convertible securities, or CoCos, over there. These rules came into force on October 1 last year and are due to expire on October 1 this year. The FCA is now consulting on making the restrictions permanent. 

"CoCos are risky, highly complex financial instruments. The FCA believes they are unlikely to be appropriate for ordinary retail investors, so has stepped in to restrict their retail distribution to investors who are sophisticated or high net worth. Distribution to professional and institutional investors remains unrestricted," the FCA said.

Closer to home the Australian Securities and Investments Commission (ASIC), has a page on its website warning investors about what are known as bank hybrid securities in Australia. It's headlined "big risk without a big return" and says "you take all the risk."

"Banks and insurers issue hybrids to raise money that can count as regulatory capital under the prudential standards that apply to banks and insurers," ASIC says.

"All new hybrids issued by banks and insurers are designed to be loss absorbing, which means you, not the bank, are at risk of suffering a loss. This protects the bank's depositors, at the expense of hybrid investors," adds ASIC.

In comparison the wording in the FMA guide is of similar strength to ASIC's.

Among other things the FMA points out common features of bank capital notes include; The bank may stop interest payments, or reduce the amount of interest they pay to investors, even if they’re still in business. The bank can convert the notes into shares in the bank, or its parent company, and the value of those shares at the time they are converted may be a lot less than the amount paid for the capital notes.

Additionally the notes may be cancelled so investors lose some or all of their investment, even if the bank is still in business. And, the FMA says, decisions on buy-backs are usually the bank’s call to make.

'Don't base investment decisions on advertised high interest rates'

In a press release announcing the issuing of its guide, the FMA’s director of primary markets and investor resources, Simone Robbers, says; “These types of products are not like a bank term deposit. We want to ensure consumers are not just basing their investment decisions on an advertised high interest rate and the fact that a household name is offering them."

She also says; "Bank capital notes are deliberately designed with features that give banks flexibility over payments. Although it can be difficult to predict when a bank might use these features, consumers should be aware that they can be used when it’s in the bank’s interests to do so." 

"Consumers should also be aware that although bank capital notes are usually listed on the NZX, this doesn’t necessarily mean they will be able to sell their notes quickly, or at all," Robbers says.

Last year I asked the FMA whether they may do as the Brits were doing and block the distribution of these securities to New Zealand retail investors. At that time Robbers said; "It is not our intention to restrict retail investor access to these products as long as we are seeing responsible selling practices from providers and well informed investors."

An FMA spokesman confirmed yesterday this comment still stands.

The FMA points out that, aside from capital notes, its guide also relates to similar products such as perpetual subordinated notes and hybrid securities. Remember that the holders of these securities are near the back of the repayment queue if the proverbial hits the fan at the bank issuer.

Last year ASB borrowed $400 million and Kiwibank $100 million through the types of securities covered in the FMA guide.

ASB's 10-year subordinated, unsecured debt securities are paying investors annual interest of 6.65% for the first five years. And Kiwibank's 10-year unsecured subordinated capital notes, issued by sister company Kiwi Capital Funding Limited (KCFL), are paying 6.61% for the first five years.

In March this year ANZ NZ confirmed it was borrowing $500 million through an issue of mandatory convertible, non-cumulative, perpetual, subordinated, and unsecured notes that are scheduled to pay investors 7.20% per annum up until May 25, 2020.

And Kiwibank is seeking up to $150 million through an issue of perpetual capital notes, again via KCFL, that will pay punters an interest rate north of 7%. (Click here to see where the perpetual capital notes will rank in comparison to other Kiwibank securities).

Low credit ratings

A good measure of the risk these securities carry is their credit ratings. The new Kiwibank offer has a BB- speculative, or "junk," rating from Standard & Poor's (S&P). Last year's Kiwibank issue has a BB+ rating, also speculative or "junk." The ASB issue has a BBB+ S&P credit rating, and the ANZ one a BBB- rating, which is S&P's lowest investment grade rating.

In contrast ASB and ANZ themselves have AA- ratings from S&P, and Kiwibank an A+ rating. See credit ratings explained here.

The FMA notes high take up from retail investors for these securities and predicts more offers from the banks in the months ahead. This does indeed seem likely. ANZ NZ, ASB and BNZ have a combined NZ$3.05 billion worth of total outstanding Basel II securities that won't qualify as regulatory capital by 2018. Thus the banks will want to replace this with Basel III compliant capital, although it's unlikely all of it will be through the likes of capital notes issues.

RBNZ washes its hands of retail investors

As the banks' prudential regulator and overseer of their capital requirements, couldn't the Reserve Bank tweak the rules to make these debt securities that are marketed by the broking firms at retail investors, and bought by retail investors, less complex and more ma and pa friendly? Perhaps. But when I asked last year the Reserve Bank passed the buck to the FMA.

"As the Reserve Bank’s remit is to focus on promoting the maintenance of a sound and efficient financial system, its emphasis is on the financial strength of banks and the system at large. The FMA are responsible for promoting the confident and informed participation of market participants in financial markets," a Reserve Bank spokeswoman told interest.co.nz.

So what about the banks themselves? They could issue plain vanilla bonds instead, although these wouldn't carry such high interest rates and thus would hold less appeal for the yield chasing ma and pa. So what about an idea floated here at interest.co.nz by EY partner Brad Wheeler back in 2012?

Wheeler wrote that New Zealanders should be "demanding the opportunity" to buy shares directly in the Kiwi operations of our Australian owned banks without also having to invest in their parent banks.

"Given the Australian government’s reluctance to move on trans-Tasman tax reform, thus failing to allow New Zealand investors in Australian companies credit for tax paid in Australia, it’s not sufficient to tell these investors they should be satisfied with shareholdings in the Australian banking parents, as some commentators have done,' Wheeler wrote.

"Because New Zealanders can’t use Australian franking credits, it is not tax-efficient for them to invest in Australian-owned banks, even those which are dual-listed in Australia and New Zealand," he added.

"Put simply, it means Kiwi Mum and Dad investors have had to pay tax on the profits made by the bank in New Zealand when those profits have already had New Zealand tax of 28% paid on them. In tax-speak, that’s double taxation – one of the fundamental tenets our tax system seeks to prevent," wrote Wheeler.

A fair suck of the sav

Wheeler said he was revisiting this issue because of the introduction of Basel III.

"The answer may be as simple as raising the new capital required by the Basel III rules, or replacing existing non-compliant or inefficient capital by partially floating New Zealand banking shares," continued Wheeler.

He noted the Australian parents might have an assortment of issues with this, including regulatory, control, accounting and legal considerations. But, Wheeler suggested, the economics generated by the Basel III changes may make it "impossible to continue denying New Zealand investors their slice of the tax credit cake." And a slice of the chunky dividends produced by the Australian owned New Zealand banks.

"We probably don’t need the complex structures we’ve seen in the past. A getting-back-to-basics formula could be the answer to Australian and New Zealand banking capital requirements through an Australian sell-down in their New Zealand banking subsidiaries to meet their capital buffers, and a New Zealand capital-raising to fill the New Zealand regulatory capital coffers," Wheeler wrote.

That sounds suspiciously like common sense. And a fair suck of the sav.

However, for Kiwibank the partial sharemarket float option is politically unpalatable, even for the current government. Thus the suggestion by Michael Cullen, chairman of Kiwibank's parent NZ Post, makes sense. Cullen suggested the NZ Superannuation Fund could take a stake in Kiwibank.

Such a move might even enable further expansion by Kiwibank remembering it's not even active in the rural banking market yet. And for the Super Fund this might prove a better bet than lending money to a Portuguese bank.

*Concerned your KiwiSaver fund could be stocked up on CoCos? Have a read of this article by Victoria University's Martien Lubberink and send it to your fund manager.

This article was first published in our email for paying subscribers early last Friday morning. See here for more details and how to subscribe.

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4 Comments

"And secondly, from an income tax perspective, obtaining deductibility for the coupons that are paid on them."

So if we see moves to prevent claiming of interest as an expense for property owners, we should see this advantage disappear as the bank business is getting the same financial treatment as property investment businesses - remove interest deductiblity from one do so for all.

Not quite designed to fail, more like the crumple zone on a car, designed to take the first impact during a crash. I'd be interested to know how many people who own these, actually understand the risks.
All part of the dash for trash.

Retail investors and their central bank backed advisors cannot help themselves.

The first Irish lender to sell Europe’s riskiest type of bank bond is also the nation’s weakest.

Permanent TSB Group Holdings Plc, which failed European financial stress tests last year, is selling 125 million euros ($136 million) of so-called additional Tier 1, or AT1, bonds this week. The undated securities convert into shares should capital drop below a certain threshold and carry coupons that issuers can just decide not to pay.

The sale will nonetheless “will go down extraordinary well,” said Liam Dunne, a fixed-income trader at Merrion Capital in Dublin. “The world has changed. There is huge demand for Irish assets at the moment.”

Coming less than the six years after Irish banks started to impose losses on junior bondholders as the financial system flirted with collapse, the sale demonstrates the renewed appetite for debt across the euro region.

The market for the riskiest bank debt has swollen to about $80 billion in Europe since Banco Bilbao Vizcaya Argentaria SA sold the first AT1 note two years ago.
“There is a massive hunt for yield at the moment,” said John Cronin, an analyst with Investec Plc in Dublin. “This instrument will play into that.”
Read more

When the housing market corrects and houses become worth less than property investors mortgages, then watch the banks try to screw bond holders and depositors.
Banks are now lending to virtually anyone with a job and fall within the RB guidelines, similar to what happened in Ireland and the States.
Give it about another year or so and the property market will take its toll on the whole NZ economy.