Taiwan: the promised land for Asian DCM?

The Island Republic may finally be preparing to take up residence in the international debt markets, with a number of bank capital transactions under consideration.
Taiwan has long been the bedrock of regional issuance in the international equity markets, but the vibrancy of its domestic debt markets has proved a continual constraint to international debt issuance in any size or regularity. However, mass upheaval in the domestic banking sector, now starting to undergo rapid government-enforced consolidation, may be the catalyst that encourages domestic issuers to look to overseas funding for almost the first time. Alongside a significant uptick in M&A activity and the establishment of Asset Management Companies (AMC), all banks are paying much closer attention to their Capital Adequacy Ratios (CAR) and Return on Equity (ROE).

Sector specialists say that just under a dozen banks are considering issuing bank capital transactions, with one to two offerings expected within the next six months. Many also believe that, whereas the relaxation of tier 2 capital requirements in Thailand last August proved to be a false dawn for international issuance, conditions propelling Taiwanese issuers are very different. So too, few doubt that the reception from international investors would be anything other than extremely strong, given the potential dream team of high rating and high yield.

Potential issuers fall into two categories. One prospective group of largely government-affiliated banks is being driven to improve capital ratios because of rapidly increasing NPLs and associated provisioning. This group includes three partially state-owned banks: Chang Hwa Commercial Bank, Hua Nan Commercial Bank and First Commercial Bank.

The second group largely comprising private sector commercial banks, has high, but inefficient capital ratios by global standards, leading many to start thinking about re-dressing the balance. The impending legislative approval of the Financial Holding Company Act, which should prompt intense merger activity between Taiwan’s 50 plus banks, 300 odd credit co-operatives and an influx of foreign banks, is also encouraging stronger domestic banks to build up war chests for acquisitions. Into this group falls: Chinatrust Commercial Bank and to a lesser extent Bank SinoPac, Taishin International Bank and Fubon Commercial Bank.

Should a Taiwanese bank venture into the international sub debt markets, however, it will not mark investors' first exposure to the sector. Indeed, the last 'international' deal from the country comprised a $300 million tier 2 issue by state-owned Chiao Tung Bank back in April 1998. Led by Merrill Lynch and Chiao Tung, a 10-year step up deal was priced at 65bp over Libor for years one to five and 300bp thereafter.

Yet, the deal was international in little more than name only. Carrying what was considered highly aggressive pricing at the very height of the Asian crisis, placement was directed almost exclusively to offshore Taiwanese banks and handled mainly by Chiao Tung itself. Prior to this, international issuance had been extremely sparse, with just two issues from Bank of Taiwan and Hua Nan Commercial Bank back in 1996 and 1997.

A $200 million (floating rate note) FRN for the then-rated AA-/Aa3 Bank of Taiwan in November 1996 was significant chiefly for putting Taiwan on the map. Led by Goldman Sachs, the five-year deal also had an exceptionally tight launch spread of 6.25bp over six month Libor on an issue price of 99.733. The following August, Hua Nan then followed with an Asian FRN via BayerLB and Tokyo Mitsubishi International. Pricing came at 18bp over Libor on a five-year final maturity and three-year call.

The example of Chinatrust

Since then, the only active issuer has been Chinatrust, which set up a $750 million medium-term notes (MTNs) program arranged by Merrill Lynch in late 1998 and has to date issued about $200 million in a series of small private placements.

The Baa1/BBB rated bank is considered the most innovative in its approach to fundraising and became the first domestic bank to issue a hybrid tier 1 deal last year. The preference share offering, while not tax deductible for the bank, proved to be an enormous hit with investors and appears to have given it confidence to proceed with either a domestic or international tier 2 deal. Should it opt for a domestic transaction, it will be following in the footsteps of Taiwan Co-operative Bank, the only local bank that has ever raised domestic sub debt funding.

Treasury official Gloria Hsu says that Chinatrust has been studying the subject for some time. "We want to improve our capital mix and also build the overall ratio up to about 12%,” she comments, “but we haven't yet finally decided which way to go. The flexibility of our MTN program means that we can issue in the international markets and we might do this later in the year.

"However," she adds, "it’s definitely cheaper for us to issue in the domestic bond market. We have a very strong domestic rating of AA+ and yields are much lower."

Hsu says that the bank is contemplating an NT$10 billion ($306 million), 10-year issue and believes that Chinatrust could achieve an all-in cost around the 6% level. This would encompass a domestic treasury yield of around 5% and a credit spread of a further 1%. By contrast, she says that should the bank tap the international dollar markets, it will be faced with an all-in cost around the 7.5% level, equating to more than 200bp over Treasuries for a 10 non-call five offering.

Benefits of tier 2 issuance

For stronger banks like Chinatrust, bankers say there are a number of reasons why an international deal still makes sense despite the superficial cost benefits of the local bond markets. Chiefly these revolve around re-investment cost of capital and the potential cannibalization of a bank's senior deposit base.

Where the former is concerned, specialists believe that Taiwan's huge liquidity surplus will make it difficult for a bank to find suitable investment vehicles for proceeds that do not incur a negative cost of carry. "It may seem cheaper to issue domestically, but it all depends on what the bank decides to do with those funds," one banker notes. "If a bank raises US dollar funding, it has a lot more re-investment options."

Similarly in Europe and the US, banks have tended to avoid raising subordinated debt in their home markets to avoid cannibalizing their senior deposit base. "A bank's senior investor base is always going to comprise the largest segment of its balance sheet and will be the most comfortable with its credit," a second banker explains.

"But if there is a choice between funding at Libor flat on a senior deal or 10bp over Libor on a subordinated deal, then this group will naturally choose the latter and most attractive option. The issuing bank could then find that this feeds through to a detrimental increase in its senior funding levels."

Growing dichotomy of sector’s financial ratios

Whether a bank opts to go domestic or international, the net effect should be a more efficient CAR and by default higher ROE. Earlier this week, Taiwan’s central bank reported that the average ROE for the country's 53 local banks dropped from 5.87% to 4.9% during 2000. Return on Assets (ROA) similarly fell to 0.39%.

At the bottom end of the scale, 10 banks turned in negative ROE, with Medium Business Bank of Kaohsiung the biggest offender on minus 58.98%, followed by Cathay United Bank on minus 28.67%. For most of these banks, poor asset quality and the intensely competitive nature of Taiwan's over-banked market has seen margins cut to shreds.

At the other end of the scale, the country's strongest lenders managed to turn in highly respectable levels, with Central Trust of Taiwan leading the pack on an ROE of 20.42%, followed by Chinatrust on 14.81%, United World Chinese Commercial Bank 13.65%, Chiao Tung Bank 12.92%, China Development Industrial Bank 12.22% and Fubon Commercial Bank 11.20%.

Where CAR is concerned, analysts say the sector average stands at the 9% to 10% level, although again some banks such as Bank of Taiwan command much high levels around the 16% to 17% mark.

Too much tier 1

At a time when many banks' stock prices are hovering close to NT$10 par value, sector specialists believe that a more efficient capital mix could help spur new upward momentum. As one ratings analysts puts it: "The main problem in Taiwan is that 90% of bank capital is tier 1. Most banks are not managing their capital effectively or leveraging themselves sufficiently. They need to increase tier 2 and tier 3 not keep issuing new equity."

Consequently, some observers argue that banks such as Bank SinoPac and Taishin International Bank should revert existing depository receipt (DR) mandates into subordinated debt mandates. The former mandated Merrill Lynch last year for a roughly $150 million new share issue, while the latter mandated Salomon Smith Barney for a $100 million new share deal.

"It's been very difficult for domestic banks to raise domestic equity," a second analyst explains. "The stock market's poor performance is making it difficult to boost capital with a rights offering." 

50 years of crony lending push state-owned bank towards crisis

For state-owned banks plagued by rising NPLs and deteriorating capital ratios, bankers also argue that there are virtues to an international deal over and above improvement of financial ratios. "In this instance, banks should regard an international deal as a stepping stone," says one. "At some point, the government will be selling down equity in these banks, and to get the best possible price, it helps to have already built up an international following. At a time when it's difficult to issue straight equity, a sub debt deal provides a good opportunity to strategically position oneself. For the largest banks which are also starting to think beyond Taiwan's borders for future business, it makes sense to start developing some kind of international profile."

According to government figures, Taiwan's seven largest banks saw NPLs rise to about 5.5% of total credit in January, a 4.7% deterioration on the previous month. Chang Hwa Commercial Bank came out worse by NT$ amount, with six-month past due loans amounting to NT$58.14 billion, a ratio of 6.98%.

Shortly behind was Hua Nan on NT$50.80 billion (6.25%), followed by First Commercial Bank on NT$54.89 billion (6.37%), Taiwan Business Bank NT$49.93 billion (7.15%), Taiwan Co-operative Bank NT$70.4 billion (5.78%), Land Bank of Taiwan NT$61.41 billion (5.27%), and Bank of Taiwan NT$40.56 billion (2.90%).

In total, the government has said that the sector wrote off NT$156.3 billion during 2000, while setting aside NT$156.7 billion in provisions. However, industry specialists and the rating agencies have concluded that the true NPL figure is at least double the official NT$0.73 trillion ($24.7 billion) figure, particularly since many of the smaller credit co-operatives are said to be running NPL levels closer to the 16% mark. To stem rising domestic panic about the true state of the banking sector, the government also announced this month that it will no longer report NPL figures on a monthly, but a quarterly basis.

As the ratings analyst explains: "Most domestic banks are under-provisioned, but even if you take this into account, few of the top lenders slip below the BIS 8% minimum. The main problem we foresee is that many banks have only put up about 25% of reserves against their official NPL ratio, when they should be providing a 50% plus cushion."

Many analysts hope that the enactment of new legislation promoting industry consolidation will also lead to stricter reporting requirements - particularly making banks report on a three-month past due basis and factor restructured loans into the equation.

The combined impact of over-banking, government ownership, and half a century of crony lending, fuelled by legislative inaction and bureaucratic inefficiency, is pushing the banking sector into crisis at a time when declining property and stock prices are eroding the collateral underpinning most loans. Yet while the country faces similar problems to Korea and Thailand, most observers agree that it is on much smaller and more manageable scale.

Investors likely to show strong support for international issuance

Specialists argue that international bond investors will be comforted by the halo of government ownership, to the extent that a subordinated deal from a state-owned bank is likely to receive a better reception than one from one a nimbler private sector player that has kept NPLs below 1%. This is also reinforced by the ratings scale currently employed by the agencies, which sees, for example, state-owned Bank of Taiwan on an A1/A+ rating versus Chinatrust’s Baa1/BBB rating and Bank SinoPac’s BBB- rating. Taiwan itself currently has an Aa3/AA+ sovereign ceiling.

"There’s also an attractive momentum play to consider,” says one. “As merger activity begins to gather steam during the second half of the year, this could significantly push secondary spreads tighter.”

For international investors, Taiwanese credit has always been highly prized because it employs the winning combination of security and rarity value. Throw in the additional yield offered by subordinated over straight debt and any prospective deal should meet the same enthusiastic reception recorded for deals this year by Bank of East Asia and DBS.

Hong Kong’s Bank of East Asia, which raised $550 million in January, is considered to provide the nearest comparable for Taiwan. The Baa1/BBB+ rated bank raised 10 non call five tier 2 funding at 281.5bp over Treasuries in late January and has since seen secondary levels tighten to the mid 240bp mark.

Who will win the mandates?

The deal’s bookrunner JP Morgan has also been Asia's most active and innovative lead manager of bank capital transactions at either ends of the credit spectrum and is expected to be similarly prominent in Taiwan. So too, Salomon Smith Barney is said to be well placed, because of its product experience in Korea and its deep roots in Taiwan’s domestic bond market (Citibank) and the banking sector (Citibank and through its links to the Fubon group). Merrill Lynch and Goldman Sachs have also previously led international deals from the country and both have a strong, local corporate finance presence. 
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