On August 23, the Bank of Thailand (BoT) amended its bank capital guidelines, giving domestic banks greater flexibility in being able to meet year end capital adequacy ratios of 8.5%. A new category of capital, upper tier 2 debt, was allowed for the first time, in order to enable the sector to boost weakened capital bases. Previously, although tier 2 debt could theoretically equal tier 1 debt, only lower tier 2 debt was allowed. Since this could not exceed more than 50% of tier 1 debt, the 100% figure was fairly meaningless.
However, while BoT officials have confidently stated that up to Bt160 billion ($3.9 billion) might be raised as a result of the amendment, bank capital experts believe that the figure is more likely to total about $1 billion to $1.5 billion, the majority derived from exchanges and refinancing activity. Despite having fought to get the rules changed in the first place, most experts remain sceptical that much international issuance will result, and certainly not on the scale witnessed so far this year from Korea. To date, only Bangkok Bank has been identified as a likely new issuance candidate via Morgan Stanley Dean Witter.
But all agree that high levels of non-performing loans (NPLs), slippage of restructured loans back to NPL status, and the possibility of more aggressive loan write-offs in future will necessitate further capital raising even though all the major banks have already met their year end provisioning and capital targets. As Standard & Poor's recently put it, "If Thai banks were to liquidate problem assets and crystallize losses of 60% to 70%, S&P estimates that about $25 billion to $32 billion would be required to recapitalize the sector to a level commensurate with its fragile and relatively high-risk operating environment."
While NPLs in the Thai banking system officially stand at around the 35.6% mark, the real level remains much higher because banks have been far too optimistic about implied recovery rates from NPLs. Against an implied recovery rate of 64% in existing loan loss provisions, for example, DBS Thai Danu Bank only managed to achieve 27% at the end of July when it auctioned off Bt30.6 billion of loans at a market clearing rate.
DBS Thai Danu took an aggressive approach to loan write-offs and experts conclude that other banks will now have to follow suit. In particular, bankers believe that Bangkok Bank, Thailand's largest lender, will have to bite the bullet soon. "As Thailand's flagship bank, it should be leading the way and can only do this by raising new capital and moving the whole sector forwards again," comments one banker.
Deutsche Bank, in a recent research report, stated: "The bank's continued refusal to raise capital in the hopes of seeking a higher price should result in limited capacity to extend new lending, to invest in risk management systems and information technology and to achieve quality debt restructuring going forward ... We believe the efforts of the bank to proceed with its capital raising plan is key for the bank to be viewed as a stronger credit among Thai banks."
Back in March, a plan was approved to issue up to 2 billion new shares, which would more than double the bank's outstanding share capital. Unfortunately, having traded at Bt67.5 at the beginning of the year, the bank's shares are currently being traded around the Bt25.75 mark. The resultant reduction in tier 1 equity puts paid to new tier 2 debt ahead of a new share issue, but banks say that the simultaneous launch of a tier 1 and upper tier 2 deal will allow the bank to boost its capital and do so in a way that would spare some of the dilutive effects of pure equity issuance.
Considerations for upper tier 2 debt
For other banks contemplating upper tier 2 debt, experts say there are four key points to consider. "Firstly, a bank has to examine how much capacity it actually has to raise tier 2 debt," says one. "Secondly, it then needs to consider whether the domestic bond market has developed sufficiently to absorb this kind of structure. Thirdly, whether the international markets can deliver an acceptable price and fourthly whether it is cost-efficient to exchange lower tier 2 debt which no longer qualifies as capital into upper tier 2 debt which does."
Traders say that outstanding Thai sub debt, issued in the mid 1990s before the Asian crisis, has consistently traded up to 100bp tighter than Korea largely on the back of investor expectations of buy-backs and exchanges from Thailand's $1.6 billion pool of outstanding subordinated dollar debt. "Anticipation of buy-backs and exchanges has led investors to believe that they will receive a free lunch," says one banker. "Were a Thai bank to issue a new primary deal, however, it is almost certain that the whole sector would get re-priced at a premium to Korea."
Secondary market spreads currently show that those deals with impending call options are trading around the mid 300bp level over Libor, while those with longer bullet maturities are trading in the low to mid 500bp range over Treasuries. Bank of Ayudhya, which ironically may now be considering some form of upper tier 2 deal, set the tightening bias in motion when it called a $150m subordinated FRN due 2005 at par in March. Since the whole sector is trading below par, however, bankers say exchanges or buy-backs make more sense from a cost perspective.
Banks with impending call options include: Krung Thai Bank whose $200 million FRN due 2006 with a step-up call in August 2001 is trading at the 360bp level; Bank of Ayudhya whose $100 million FRN due 2006 with a step-up call in April 2001 is trading at 330bp, and Thai Military Bank whose $100 million FRN due 2005 with a step-up call in May 2000 and every six months thereafter is trading around the 200bp level.
By contrast, Bangkok Bank which has a $266.9 million 8.75% note due 2007 is trading at 516bp/492bp over Treasuries and Siam Commercial Bank which has a $150 million 7.5% note due 2006 is trading at 467bp/440bp.
Banks might consider an exchange of these lower tier 2 debt issues for upper tier 2 debt because the former no longer qualify as capital and many are about to begin amortizing. As one banker explains, "Huge losses in the Thai banking system and the massive write-downs of tier 1 capital that resulted, meant that much tier 2 debt went over the 50% limit and no longer qualified as regulatory capital.
"Now," the banker adds, "we have a situation where lower tier 2 can still only comprise 50% of tier 1, but upper tier 2 can amount to 100% of tier 1. Banks can, therefore, convert some of the existing tier 2 debt which doesn't quality into upper tier 2 debt which does."
Rationale for exchanges and buy-backs
The rationale for an exchange stems from run-offs in banks' dollar loan books which lessens their dollar funding needs, combined with the undoubted cost advantages of re-financing in the domestic market. What might hinder an exchange, on the other hand, is the fact that none of the existing issues are really large or liquid enough to be exchanged and that the debt effectively now constitutes cheap senior dollar debt for those banks that need it.
In terms of issuing new upper tier 2 debt, bankers say there are two major constraints. Firstly, in contrast to Korea, the domestic market can probably absorb much of the issuance and secondly it is doubtful how much capacity banks actually have to issue more debt.
"Because general provisions and asset revaluation reserves come under the auspices of upper tier 2 debt, the actual issuance capacity of most banks is quite small," says one specialist. "Most banks will probably only be able to take on a further Bt10 billion, although there are a few exceptions. But we certainly won't be seeing anything like the $3.9 billion amount being bandied around by the Bank of Thailand."
Where the domestic market is concerned the most crucial consideration is maturity, since debt with less than five years to redemption begins to amortize for regulatory capital purposes. And in this respect the local market has already shown its ability to absorb subordinated debt over seven years in the form of subordinated debentures cum preferred shares (SLIPS) and capital augmented preferred securities (CAPS).
Bankers also highlight that questions remain over the ability of the market to deliver the guidelines set out by the Bank of Thailand. At issue is the fact that the dividends and profits test is being used as banks option to defer interest payments, rather than the far less onerous capital adequacy test adopted by Korea.
Since upper and lower tier 2 debt rank pari passu in a bank's capital structure, the interest deferral language which places upper tier 2 debt closer to equity is the clearest major difference between the two. In Korea, banks have the option to defer interest payments should capital ratios dip below 8%. In Thailand, banks have the option to defer should they fail to make a profit and cease to pay a dividend.
Since dividends and profits have been in scarce supply since the onset of the Asian crisis, some bankers believe that investors are likely to demand a high pricing premium to buffer against any possibility of interest deferral.
Will Thailand pay a premium over Korea?
Recent Korean issues present unappetizing precedents from the international markets. Korea Exchange Bank which launched $200 million in upper tier 2 debt this June, for example, paid a coupon of 13.75% for a 10 non-call five transaction via Credit Suisse First Boston. With a subordinated debt rating of B-/B1, this equated to a launch spread of 765bp over Treasuries to the five year call, stepping up to 1,147.5bp thereafter. The offering is currently being traded at a bid/offer spread of 672bp/654bp.
Whether Thailand would need to pay a premium over Korea divides specialists. Analysts have consistently stated a preference for Korean sub debt over Thai sub debt on the basis that the Korean banking system is in far better shape. For new Thai issues, this could imply coupons touching the 14% level.
Others, however, believe that the continuing scarcity value of Thai paper will ensure that the currency secondary spread differentials remain intact. "We continue to believe that Thai bank subordinated debt will continue to trade tight relative to Korean paper for technical reasons," says JP Morgan in a recent report. "On the assumption that the net increase in supply is modest, then this factor will still hold."
