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By Steve Slater and Aimee Donnellan
LONDON, Sept 6 (Reuters/IFR) - European banks are steppingup plans to raise money via bonds that can top up their capital,following a green light from regulators, potentially opening upa market worth up to 240 billion euros ($317 billion).
The bonds, known as hybrids, have equity-like features butare cheaper than equity and could help banks meet tough new rules to prevent a repeat of the 2007-2009 financial crisis whentaxpayers bore the brunt of bank bailouts.
Regulators in Britain, France, Spain and Italy have agreed banks can count hybrid bonds as Tier one capital - a key measureof financial health. They can also be used to help lift banks'leverage ratio, where regulators are setting strict rules to caprisk.
France's Societe Generale sold a so-calledAdditional Tier one (AT1) hybrid bond last week and bankers saidas many as 10 more deals could follow in the coming months,ending a drought in the hybrid Tier 1 market.
Bankers were just as optimistic a couple of years ago aboutprospects for bonds known as "CoCos" or contingent convertiblesthat also had potential to meet regulators' capital demandsbecause they convert to equity in times of stress.
But CoCos did not take off in the way many bankers hadpredicted, as mixed messages from regulators and changes incapital demands deterred all but a few banks from selling them.
Bankers estimate that lenders have sold only about 25billion euros of CoCos since the financial crisis, about a tenthof the forecast size of the market for top-up hybrids.
AT1 hybrids may have more success now regulators arebacking them and given signs of investor appetite. The bonds canbe structured as CoCos or have so-called write-down/write-up orwipe-out features once trigger levels are breached. This meansinvestors potentially could lose some or all of their money.
Societe Generale's bond had a "temporary write-down" featurewhere the bonds would temporarily be wiped out if the bank'score capital ratio fell below 5.125 percent.
"Societe Generale's temporary write-down trade offered aperfect template for other banks to follow," Gerald Podobnik,head of capital solutions at Deutsche Bank, said.
"There are good signs out of Spain, France, Italy and the UKin terms of the tax treatment of these instruments, which willput the impetus on other countries to provide clarity as soon aspossible."
Interest payments on bonds can be tax deductible, adding totheir attractions as a lower-cost option than equity.
Most banks are likely to have to tempt investors with 6-8percent in annual interest on the bonds, an attractive option ina world of near zero interest rates. But this is still cheaperthan issuing equity, which typically costs around 10-12 percent.
"We'll definitely look at it ... there's a price foreverything. If we are compensated fairly for where we are in thecapital structure, and it's the right bank, we'll do it," saidMatt Eagan, co-manager of the $22 billion Loomis Sayles BondFund.
But banks in Europe's weak economies may have to pay nearer10 percent or more, making it less cost-effective.
NECESSARY BUFFER
Regulators have said banks can hold AT1 bonds equivalent to1.5 percent of risk-weighted assets (RWAs). RWAs are assets,such as loans, adjusted for the likelihood of non-payment.
That would equate to 240 billion euros of these hybrids,based on European banks holding 16 trillion euros of RWAs,according to Deutsche Bank analysts.
"We would expect this to be issued over around five years,between 2014 and 2019, implying an annual run-rate reaching 45billion euros of AT1 per annum," the analysts estimated.
But investors are also wary about the riskiness of thebonds, so the 240 billion euro forecast may be optimistic.
The most European banks have ever sold in hybrid Tier 1bonds was $34 billion in 2007 and the only other year it topped$30 billion was in 2006, according to Thomson Reuters data.
Barclays and Deutsche Bank have saidthey will issue those bonds and bankers say the likes of DanskeBank and at least five others are ready to pull thetrigger. Emil Petrov, head of capital solutions at Nomura, saida number of European banks are in preparation mode.
Danske said it was considering its options for issuing AT1bonds, which it said could occur before it repays state hybridcapital in April 2014.
Banks that have issued another class of hybrids known asTier 2 in the last two years, including Barclays and CreditSuisse, have had strong demand, from European and U.S.institutional investors and Asian and private banking customers.
For its AT1 bonds, Societe Generale had more than threetimes the demand it needed for its $1.25 billion offer andSpain's BBVA had its order book covered six times for an$1.5 billion issue in April.
"The combination of the greater regulatory clarity and focuson the leverage ratio has got interest going and more peoplelooking at it," one senior banker said.
