Hong Leong Bank Bhd’s (HLBB) offer for EON Capital Bhd at 1.4 times book value will go down in the country’s history as one of the lowest offer prices made for a domestic banking group. Given that the proposed takeover offer is the first local banking acquisition deal in the aftermath of the global financial crisis, the offer price is said to have taken into account the implications of impending changes in the capital requirements of banks.

HLBB’s offer, industry observers say, could set the tone for future banking deals in terms of valuation because banks will have to adhere to higher and more stringent capital requirements set by the Basel Committee, going forward.

The valuation offered was at the low end of previous banking transactions that were mostly done above two times book value. However, some bankers argue that the offer price was fair, given that asset prices had come off their peak during the global financial crisis.

“We can no longer use pre-Lehman Brothers prices as the benchmark for today’s banking transactions because changes in the banking landscape have caused bank valuations to come off as well,” a banker says.

The global banking crisis may be over but the dust has not quite settled for the banking industry. At the World Economic Forum in Davos recently, regulators deliberated on imposing more rules on financial institutions but top banks are fighting what they fear will be over-regulation of the industry.
As bankers and regulators struggle to attain conformity in banking reform, what is imminent for banks is the requirement to beef up the quality of their capital.

In December 2009, the Basel Committee — an international banking regulator — released a consultative paper that proposes a redefinition of the Tier-1 capital of banks. The gist of the proposal is that Tier-1 capital must consist predominantly of common stock and retained earnings — in other words, shareholders’ funds. Currently, a certain amount of hybrid capital instruments is allowed to be Tier-1 capital.

Bankers say bank valuations will be affected by higher Tier-1 capital requirements as higher equity suppresses the return-on-equity (ROE) of banks.

“When the new regulations kick in, banks will have to raise capital and possibly make cash calls to shareholders. EONCap’s shareholders may not have much choice but to fork out extra money to comply with the new capital requirements if they do not take up HLBB’s offer now,” a banker opines.

While the Basel Committee has not given the new benchmark for minimum capital requirements for banks, expectations are running high that the Tier-1 capital ratio could be raised to between 6% and 8% from 4% now. Under the new proposals, minority interests and intangible assets such as goodwill will no longer be included in Tier-1 capital but unrealised gains and losses are to be included.

The Basel Committee has also proposed that banks be subject to a capital charge for mark-to-market losses associated with deterioration in credit worthiness. Counterparty credit risk will be incorporated for the purpose of calculating risk-weighted assets.

This proposed new ruling is expected to take effect in 2012.

AMMB Holdings Bhd deputy group managing director and CFO Ashok Ramamurthy tells The Edge that while the proposals for capital requirements are still in draft form, three clear points are emerging.

“Firstly, the regulatory minimum Tier-1 ratio requirement will be higher and slanted towards ordinary or core equity. It is speculated that ordinary equity composition imposed on banks could potentially increase to between 75% and 85% of Tier-1 compared with 50% before. Secondly, in addition to higher Tier-1 and more ordinary equity, banks will be required to maintain capital conservation or counter-cyclical ordinary capital buffers. Regulatory authorities will be able to impose higher or lower buffers depending on the economic cycle and place restrictions on the quantum of dividend payments based on the perceived adequacy of the quantum of buffers,” he says.

“Also, the definition for Tier-2 will be simplified. Innovative and non-innovative capital under Tier-1 currently is likely to be folded under Tier-2,” he adds.

Another banker says the new proposals are a reflection of regulatory concern over the capital base of banks after the downfall of Lehman Brothers, which was caused by overleveraging and weak capital structure.

When the US subprime mortgage crisis rocked the banking system, many Western banks turned out to have thin buffers to cushion the huge write-offs of their financial assets. This is because banks were allowed to classify “engineered” financial instruments — innovative capital that was essentially debt — as Tier-1 capital.

When these toxic assets were written off, they ate into the capital base of banks, forcing some of them to the brink of collapse. Trillions of dollars had to be pumped into the banking systems, particularly in the US and euro zone. The rest, as they say, is history.

Much of the debate on how banks should be run is still ongoing but the pertinent point that banking regulators are making is that banks must not be allowed to stand on a weak capital base.
Where do local banks stand?

In a research report dated Jan 18, Credit Suisse says on average, Malaysian banks have a Tier-1 capital ratio of 13% and risk-weighted capital ratio of 14.6%. However, excluding hybrid instruments as required under the new proposals, the Tier-1 equity ratios for Malayan Banking Bhd (Maybank), Public Bank Bhd (PBB), CIMB Group Holdings Bhd and AMMB will fall below the 8% benchmark.

“We estimate the equity Tier-1 ratios for these banks at: PBB (5.6%), Maybank (5.8%), CIMB Group (6.7%) and AMMB (7.2%). Taking into account retained earnings for FY2010 to FY2012, Maybank (6.9%), PBB (5.8%) and CIMB (7.4%) would still fall short of the 8% mark,” the report says.

The proposed reforms will have zero impact on HLBB (given that the bank has no innovative or non-innovative hybrid capital). Credit Suisse notes that CIMB, Maybank and HLBB will suffer from comparatively larger deductions for investments in subsidiaries and associates.

“CIMB Thai forms a large part of CIMB’s subsidiary deductions while Chengdu Bank accounts for the bulk of HL Bank’s deductions. Maybank also suffers from comparatively larger deductions due to its investments in the insurance business and its associate stake in Pakistan’s MCB Bank,” it says.

Still, industry observers believe Malaysian banks will not be that affected by the new capital ruling.
“Malaysian banks have been running much higher core Tier-1. The changes will not be a shock to the local banking system. Some banks will see some constraints but the majority of banks will not be impacted much by the new ruling,” says an industry observer.

BNP Paribas says as the full adoption is only expected in 2012, it is likely to be transitional to reduce potential disruption of the banking system. Nevertheless, local banks are taking no chances. According to Bank Negara Malaysia, it is in consultation with local banks on the new capital ruling but there has yet to be a formal written guideline on this.

PBB, being most affected by the new proposals, has already guided analysts that it will lower its dividend payout to about 50% to 55% from about 80% in future financial years as well as possibly make a cash call of RM4 billion, depending on the new benchmark.

Capital-raising modes set to change
On Jan 29, Fitch Ratings said it had downgraded 592 hybrid capital instruments issued by banks and non-bank financial instruments worldwide. Some of the affected banks include HSBC plc, Barclays, Deutsche Bank and DBS Bank, to name but a few.

The reason for the downgrade is the significant change in the way banks classify their capital. Under the new banking framework that is under consultation, innovative hybrid capital instruments will be phased out and not allowed to be classified as Tier-1 capital.

AMMB’s Ashok believes fewer banks will think about issuing innovative instruments today when it comes to raising capital until there is further clarity on these issues.

”Banks will need to figure out ways to improve ordinary equity ratios or find alternative instruments that are similar to ordinary equity, for example, convertible preference shares or contingent capital which will be like a debt instrument but convert to equity under specific circumstances,” he says.
RHB Investment Bank Bhd CEO Chay Wai Leong says local banks have not started raising capital to adhere to the new ruling yet, but plans are underway.

In view of the new capital requirements, analysts believe banks will either have to raise new capital or lower their dividend payout ratio.

Credit Suisse notes that Maybank would need to either raise RM3 billion in equity or 6% of its market capitalisation or reduce its dividend payout ratio to 20% from the forecast 50% for FY2010-FY2012. “Our calculations suggest that CIMB would need either a cash call of RM1.3 billion (or 2.6% of market capitalisation) or limit its dividend payout to 56% (versus our forecast of 65% average payout for 2010-12).

“However, given that the shortfall is fairly small, we believe CIMB can fulfil its capital requirements through dual listing in certain Asean markets as planned and the sale of its ‘bad’ bank.”

The implications for bank valuations
BNP Paribas says apart from the lesser flexibility to undertake financial engineering to boost ROE, rising capital buffers will also cause ROE to fall. “As capital buffers are being built up, ROE will fall and this may, over time, have an impact on bank valuations.”

A local banker points out that with the pressure on ROEs, banks will no longer be able to command the kind of premium they are used to should they be up for sale. “Likewise, banks keen to acquire other banks will refrain from ‘overpaying’ to not spoil the market,” she says.

According to some Hong Kong analysts, Chinese commercial banks have to dispel rumours that they are willing to pay more than two times book value for overseas bank acquisitions. “Chinese regulators are monitoring the bidding prices set by the banks,” a banker says.

This is because a bank’s valuation is also dependent on the potential economic growth of the country it is operating in, another banker says. “As global economies are still recovering from the crisis, lower projected GDP growth will continue to put a damper on bank valuations. Hence, we believe the days when Bumiputra-Commerce (Holdings Bhd) paid two times book value for Southern Bank Bhd are gone and local banks are likely to command less than two times book value,” he adds.

Additionally, with the new capital requirements, the option of funding bank acquisitions via the issuance of hybrid capital instruments has gone out the window.

“With fewer funding options, banks may be even more cautious with acquisitions and may refrain from placing bids for several banking stakes,” a banker says. In the case of HLBB, it is said that the bank was also interested in bidding for Thailand’s Siam City Bank (SCB).

But when the EONCap deal came through, HLBB made a business decision to not participate in bidding for SCB in view of the new capital requirements.

RHB’s Chay says while the new ruling has not been firmed up yet, fewer funding sources will naturally lead to more challenges in funding acquisitions. “However, we believe banks looking for acquisitions will not take the limited funding options too seriously until the new ruling is implemented,” he says. He believes that the new capital ruling will in fact set the stage for banking consolidation.

“As capital requirements increase, some banks will find that they may not have the right proportion of returns compared with their high capital commitment. Naturally, banks that have difficulty in raising such high capital can be takeover targets for bigger banks,” he explains.

Nevertheless, Ashok says Malaysian banks are reasonably well placed, with average ordinary equity ratios of around 8%, ROE of around 15% and dividend payout ratios of about 35% of their annual profits. “The proposed changes to capital and liquidity will require some refinement of our business practices and asset pricing, in particular liquidity premiums, to continue to provide reasonable shareholder returns. The majority of Malaysian banks will not be materially impacted, although some banks could face constraints on dividend payouts and lower ROE during the period of realignment. The question is, how long will that be?”

Nevertheless, some bankers opine that the new ruling requires a lot of fine-tuning.

According to CIMB Group Holdings Bhd deputy CEO and treasury and investments head Datuk Lee K Kwan, making banks adhere to such high capital commitments and creating disincentives for banks to raise hybrid capital could be detrimental to consumer banking activities.

“Hybrid capital instruments are a valuable financing tool for banks as they offer consumer banks lower costs of doing business. But with the new requirements, the cost of funds will shoot up, given that equity from shareholders has to be justified with high ROE. Thus, the new capital requirements can effectively disrupt the lending activities of banks worldwide,” he says.

Lee adds that the rise in lending costs could be worse for Western banks because they would have to raise more Tier-1 capital than their Asian counterparts. AMMB’s Ashok says further clarity is needed on the capital that banks had raised previously.

“For example, with a 10-year innovative and non-innovative instrument that has already been issued, will banks be allowed to recognise them as Tier-1 for the remaining duration or for an interim period only? Would the quantum be based on issued amount or will it have to be amortised?” he asks.

Lee believes it will be challenging for banking regulators worldwide to reach a consensus. “The new requirements could turn out to be quite different from what is being consulted at the present time,” he says.

The new capital framework and regulations to strengthen the global financial architecture is an ongoing process, but what is clear is that banks will have little choice but to up their game because the landscape, going forward, will become more challenging and only the nimble of feet will survive.

This article appeared in Corporate page of The Edge Malaysia, Issue 792, Feb 8 – 14, 2010