Hybrid capital instruments ?

Question

What are they, as mentioned to be a part of Tier - 2 supplementary capital in the Basel - 2 ?

Answer 1

Developments in

BANK HYBRID CAPITAL -

the regulatory perspective

by Thomas A. Humphreys and Oliver Ireland, Morrison & Foerster LLP

Bank hybrid capital, i.e., instruments that are capital for regulatory

purposes but debt for tax purposes, has been around in any

number of guises since the United States adopted bank capital

rules in the early 1980s.1 The adoption of the Basel Accord

(‘Basel I’)2 paved the way for more sophisticated hybrid capital

instruments. Today’s markets are seeing a new interest in bank

hybrid capital instruments as the regulator draws even clearer lines

between Tier 1 capital and other instruments.

BACKGROUND

Basel I sets out rules for measuring capital adequacy

for banks. It divides capital into two categories:

(i) core capital (‘Tier 1’) and supplementary capital

(‘Tier 2’). Tier 1 capital includes common stock,

non-cumulative perpetual preferred stock, disclosed

reserves and minority interests in the equity accounts

of consolidated subsidiaries. Tier 2 capital includes

undisclosed reserves, asset revalutation reserves, general

provisions/loan loss reserves, hybrid (debt/equity) capital

instruments (e.g., mandatory convertible debt, cumulative

perpetual preferred stock), term subordinated debt and

intermediate term preferred stock.

Basel I then compares regulatory capital to assets by

looking at two ratios (i) Tier 1 capital to total consolidated

assets, and (ii) total capital to total risk-weighted assets. A

bank is required to maintain a minimum ratio of (i) 4% Tier 1

capital to total consolidated assets, and (ii) 8% total capital to

total risk-weighted assets.

In the US, the bank regulatory agencies, (the Federal

Reserve Board (‘FRB’ or ‘Federal Reserve’), the Federal

Deposit Insurance Corporation, the Office of the Comptroller

of the Currency and the Office of Thrift Supervision)

adopted the principles of Basel I in 1989. In particular, even

though Basel I was designed to apply to internationally

active banks, the US bank regulators extended it to all

commercial banks in the US and to bank holding

companies (‘BHCs’), including financial holding companies.

DEVELOPMENT OF BANK HYBRID SECURITIES

The earliest hybrids were US mandatory exchangeables

designed to qualify as primary capital under the pre-Basel I

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capital adequacy rules. These rules included in primary

capital, among other items, common stock, perpetual

preferred stock, and mandatory convertible instruments. In

1985, the US Internal Revenue Service (‘IRS’) blessed one

such instrument: a 10-year deeply subordinated debt

instrument payable in the bank holding company’s

preferred stock.3 At maturity the holder had the right to

receive common or perpetual preferred stock with a value

equal to the instrument’s face amount. If the holder

elected, the issuer would sell the preferred on the holder’s

behalf (and at the BHC’s expense) with the holder having

the right to recover any shortfall against the BHC.

Presumably the instrument’s short term and the

contractual right to receive the instrument’s face amount

convinced the IRS that the instrument was debt for federal

income tax purposes. This ruling marks the only published

ruling by the IRS addressing a bank hybrid security in the

last 20 years.

Outside the US, bank hybrid securities have been

relatively easier to create for one key reason: a number

of jurisdictions permit interest deductions on perpetual

debt instruments. For example, Belgium and France each

permit interest deductions for interest paid on perpetual

debt instruments. The US, on the other hand, does not

permit interest deductions on perpetual debt.

In the mid-1990s, US investment bankers began

exploring alternative avenues to create hybrid securities in

light of this tax obstacle. In 1996, Chase Manhattan Bank

sponsored the first real estate investment trust (‘REIT’)

designed to create Tier 1 capital for a bank. Chase formed a

REIT by contributing cash and assets in exchange for

common stock. The REIT sold non-cumulative perpetual

preferred stock to the public. The REIT used the proceeds

from the offering to buy additional mortgages from Chase.

Income on the mortgages was collected by the REIT and

distributed by the REIT to the preferred shareholders. Under

the special US tax rules applicable to REITs, the REIT could

deduct the dividends paid on the preferred (and the

common). The net effect was to “carve out” the income

stream on the mortgages from the corporate level tax.

The next key development was the Federal Reserve

Board’s decision in 1996 to treat ‘trust preferred’

securities as Tier 1 capital, subject to a limit equal to

25% of a bank holding company’s Tier 1 capital. A

trust preferred represents beneficial ownership interest

in a trust, normally a Delaware statutory trust. The trust

invests the proceeds of the trust preferred offering in a

subordinated, long-dated (e.g., 49-year) debt issued by

the bank holding company. Interest on the debt

instrument can be deferred, usually for up to five years,

without default. The benefit of a trust preferred from a

federal income tax standpoint is that interest on the loan

is deductible. The trust is a flow-through entity for

federal income tax purposes and its income does not

attract a separate tax. The net effect for the issuer is a

tax deduction for distributions on the trust preferred.

The FRB guidance treated such instruments as Tier 1

so long as (i) they were subordinated to all subordinated debt,

(ii) they had a minimum five-year option to defer

interest, and (iii) they had the longest feasible maturity.

The guidance permitted redemption only with the FRB’s

permission. It appears that the most important feature to

the FRB was the five-year interest deferral, the thought

being that a financial institution would either be

bankrupt or have recovered in five years.

After the FRB’s 1996 announcement a number of large

bank holding companies issued a substantial amount of

trust preferred securities. More recently, small issuers

have pooled their trust preferreds in large offerings

organised by investment banks. The idea is to bring the

trust preferred concept to a small bank that otherwise

would be shut out of the trust preferred market.

On the tax side, during the 1990s the Clinton

Administration proposed limiting such securities either

by imposing a maximum maturity date (40 years) or by

restricting interest deductions for instruments that were

not shown on the balance sheet as debt. The IRS, on

the other hand, issued a non-binding ‘technical advice

memorandum’ that held that a trust preferred-like

security was debt for federal income tax purposes.

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That remains the only IRS guidance on such instruments.

Today, the attractiveness of trust preferreds has been

reduced for the largest bank holding companies. In

2005, the Federal Reserve tightened up the treatment

of trust preferreds for internationally active bank

holding companies that are subject to Basel I. In the

case of internationally active bank holding companies,

trust preferreds were limited to 15% of Tier 1 capital.

A combined limit of 25% applies to trust preferreds

and certain mandatory convertible securities which

were described by the Federal Reserve as “securities that

consist of the joint issuance by a bank holding company

to investors of trust preferred securities and a forward

purchase contract, which the investors fully collateralise

with the securities, that obligates the investors to

purchase a fixed amount of the bank holding

company’s common stock, generally in three years.”

Since the 2005 announcement, investment bankers in

the US have been working to create securities that are

treated as Tier 1 capital, create interest deductions for the

issuer, and are outside of the 15% basket and instead

subject to the 25% limit applicable to ‘mandatory

convertible’ securities. The first offering of this type was

accomplished by Wachovia Corporation, a BHC, in

January 2006.

In the Wachovia structure, Wachovia issued an

investment unit (‘Wachovia Income Trust Securities’

or ‘WITS’) consisting of (i) a 37-year subordinated debt

instrument, and (ii) a five-year forward contract on

perpetual preferred stock. Both the WITS and perpetual

preferred carried a 5.8% coupon until March 15, 2011.

The offering is structured so that after five years the

subordinated note is remarketed. Proceeds from the

remarketing are used to exercise the forward contract. If

the note is not remarketed then the note is used to settle

the holder’s obligations under the forward contract.

The Federal Reserve Board on January 23, 2006 issued

a letter to Wachovia that considered this structure. The

letter concluded that the security would count outside of

the 15% basket as Tier 1 capital. The Federal Reserve took

this position despite the fact that at least some market

participants viewed the structure as having a ‘step-up’ in

rate after five years. Thus, the FRB has historically not

permitted Tier 1 instruments to contain stepped-up

interest rates coupled with a call option. The thinking

apparently is that the step-up will induce the issuer to

exercise the call, creating a de facto maturity date for

what the FRB requires be a perpetual instrument. In the

WITS transaction when the perpetual preferred stock is

issued, the issuer will be paying a non-deductible coupon

as compared to a deductible coupon on the subordinated

note. The issue is whether the issuer will be induced to

call the perpetual preferred because its after-tax cost of

keeping the security outstanding has i