The implementation of Basel II next year will introduce new Tier I capital rules which could see banks shift away from preference shares and into more cost-efficient hybrid capital financing for their Tier I capital needs.
Kate Rushton, corporate analyst at Absa Capital, one of South Africa’s leading investments banks, says that this could mean a drought of new bank preference share issuance in 2008.
Non-redeemable, non-cumulative preference shares currently form an integral part of banks’ capital structure and are generally issued to maintain a cost effective Tier I capital base.
“Preference share prices have come under considerable pressure since Q2 2006 as a combination of higher local interest rates and aggressive supply has impacted the market.”
Rushton says that according to the current banking regulation, non-cumulative, non-redeemable perpetual preference shares can constitute up to 20% of the Tier I capital.
“However, for the big four banks, preference shares as a percentage of Tier I is only an average 12.7%, although ideally, this percentage should be kept at 20% to achieve the optimal cost of capital.
“The reasons behind this, seemingly irrational behaviour by the issuers lie in the limited size of the mostly retail, investor market, compounded by the negative investor sentiment surrounding this asset.
“This is caused by the uncertainty regarding tax treatment of dividends as well as capital losses experienced, due to a glut of issuance in the context of rising interest rates.”
Rushton notes however that the landscape may well change within the next twelve months.
“Changes in banking regulations emanating from Basel II may allow hybrid capital issues to form part of Tier I capital from 2008.
“According to the new rules, the total amount of preference shares and hybrid debt instruments would not be able to exceed 25% of Tier I with hybrid capital capped to 15% of Tier I.”
Draft 4 of the proposed changes to the Banks Act in accordance with Basel II, states that hybrid Tier I instruments are likely to be characterised as non-cumulative, perpetual instruments, callable after year 5 (with coupon step up after year 10) and senior only to ordinary shares.
In addition, issuers will most likely be allowed to deduct tax on coupon payments.
Rushton points that this will impact the preference share market in two ways.
“First, the investor base will change. Preference share investors are largely limited to high net worth individuals and specialist funds. Hybrid capital investors will extend to the institutional market, domestic and international.
“Second, hybrid capital issues will most likely prove to be more cost efficient for the issuer.
“According to our calculations, the after-tax cost of a preference share at approximately 9.79% would be competing against an indicative after tax cost of 6.82% for hybrid capital.
“These factors could lead to a preference share drought in 2008 as banks turn to hybrids as an alternate form of funding.”
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About Absa Capital
Absa Capital, a division of Absa Bank Limited (Absa) and affiliated to Barclays Capital, is a leading South African investment bank with global reach, offering clients financing, risk management and advisory solutions in a wide range of currencies and structures across the globe.