The Capital Strategy of Preferred Shares By Commercial Banks: Combining Shares and Creditor’s Rights and Reaching Regulatory Requirements

Firstly creating profits increment by low cost, then sharing profits increment by two types of shareholders, this is probably the capital strategy what the listed banks is looking for in issuing preferred shares

Source: Securities Times   Reporter: Zhang Xin    Published on: June 24, 2014

Imagine that, in your birthday party, with limited budget, do you want to eat a small cake that you can barely afford alone or share a big sweet cake with some best friends? Yes! What preferred shares does is to make a bigger cake, and as return, you should also let preferred shares to enjoy a small slice of them (don’t worry, even what left is still bigger than what you can afford alone). Indeed, as two hands for balancing corporate governance, the role of common shares and preferred shares shall be supplementary rather than competitive.

“For listed banks, preferred shares are much more than just capital supplement. What’s more important is encouraging various investors and improving corporate governance by meeting demands of certain investors and achieving balance via system design,” as said Mr. Tang Bin, Board Secretary of IB. His opinion of preferred shares is not limited to capital sufficiency rate.

Firstly creating profits increment by low cost, then sharing profits increment by two types of shareholders, this is probably the capital strategy what the listed banks is looking for in issuing preferred shares.

Inheritance and innovation

The return of preferred shares

Industrial Bank surely has a say for preferred shares based on intensive consideration and practices.

Back to 1988, when established as a joint-stock commercial bank, IB issued common shares and preferred shares. However, preferred shares favored by some investors nowadays did not attract enough investors at that time, and only less than 4 million shares were issued. In 1996, IB redeemed outstanding preferred shares according to Company Law and related regulations of People’s Bank of China.

“As there was no company law when issuing, the equity design was made by taking reference of foreign banks. There were RMB common shares, preferred shares and foreign capital and foreign currency shares,” said Tang Bin, “But under then financial environment and monetary policies, even joint-stock was not well known, not to mention preferred shares. As a result, the actual size issued was only one eighth of planned size.””

Although the preferred shares issued were small in size, these international factors are the first experiments of corporate governance by IB and the beginning of active capital management system of IB at present.

Without doubt, the reopened preferred shares are improved in terms of contract design and interests balancing than the rules of 1988. But the system spirit of preferred shares creation has been inherited.

Preferred shares become trump card

Common shares bear bigger rights and responsibilities

There are some controversies about the advantages and disadvantages of issuing preferred shares. Common shares holders fear that their interest will be impaired, while potential investors of preferred shares worry about banks cancelling dividends or compulsory converting to common shares. In fact, their worry is unnecessary.

In terms of system design, the preferred shares holders’ priority in distribution of earnings does not mean common shares holders have to surrender part of their profits. The priority is a compensation for waiving voting power of preferred shares. Besides, the common shares’ interests are also guaranteed by regulatory rules. Taking the structure of wealth management product that more familiar to the public as an example. Preferred shares and common shares are like priority level and inferior level in trust and fund products, whereas preferred shares holders can receive fixed dividend and bear relatively low risk, and common shares holders can receive higher dividend and bear higher risk.

From Basel Accord I to Basel Accord III, what is the spirit of such accords? The answer is “shareholder responsibility”. Basel Accord keeps to emphasize that banks' shareholders need to continue their contribution responsibility to banks and improve the capital sufficiency level of banks. The more “stock” features of capital tools issued by banks, the higher of capital property and its ability to absorb losses, and the higher risk that buyers need to assume. Accordingly, different capital property level also determines the difference of interest rate pricing. The capital tools with higher capital property will require higher returns. Given that dividend will be cancelled and not accumulated as well as compulsory converting terms when agreed trigger event occurs, i.e. preferred shares holders will have to assume higher risks than investors of second level capital tools, the former has rights to demand a higher earnings than the latter.

Senior managers at SPDB once calculated cost-income ratio. And the result is that “earning 5 billion yuan by spending 1.8 bilion yuan to borrow 30 billion yuan”. In its assumption, the dividends rate was estimated at 6% and the net ROE of banks was estimated at nearly 17%. What common shares holders worry most about the above calculation is the real dividend rate resulted from market-oriented enquiry, and whether the net ROE of banks can remain at current level.

Tang Bin told the reporter that, “Every bank has a bottom line for dividend rate, and will give up issuing preferred shares if the rate exceeds their bottom line. And if such situation occurs during the existence of preferred shares, banks will choose to redeem preferred shares.” As to the net ROE of banks, among four banks that published preferred shares program, both of IB and SPDB are around 22% in 2013, ABC exceeded 20% and BOC reached 18%. So far, the net ROE of relevant banks boasts a very high safety margin than the dividend rate estimated by market.

Besides, although it looks that banks have rights to “cancel dividend and convert to common shares compulsorily”, but it was incorporated as necessary terms in issuing program to comply with relevant provisions of Basel Accord III, not the target that banks seeks to achieve.

The preferred shares holders have at least three cards in their hands as guarantee for stable earnings.

Firstly, banks are in credit business and will not cancel dividend for preferred shares easily without extreme situation;

Secondly, different from other sectors, banks are good at identify risks and has sound operation as a guarantee for timely payment of dividend for preferred shares in the long run;

Thirdly, constraints from corporate governance. Both bank constitutions and issuing program requires that, 1) before fully payment of agreed dividend to preferred shares holders, it will not distribute dividend to common shares holders. If dividend of preferred shares of any given accounting year is cancelled in whole or partly, then the dividend of common shares of this accounting must not be distributed; 2) preferred shares holders may recover their voting power and control if dividends of preferred shares are not paid as agreed for three accounting years accumulatively or two accounting years successively. That is to say that cancellation of dividend of preferred shares will cause both types of shareholders to loss dividend. The common shares holders therefore will participate in banks operation more actively, enjoy their rights and assume their responsibility to safeguard their interests, which will prevent banks from cancelling dividend.

Compulsory converting as a guarantee

instead of a goal

After careful analysis we can find that market dilatation caused by compulsory converting is the problem worries investors most. In fact, compulsory converting is just a small probability event in theory.

There are two situations that will trigger compulsory converting: 1) “the core tier one capital sufficiency rate fall to 5.125% and below” 2) “the trigger event of second level capital tool occurs (CBRC believes that the company will cease to survive without converting or written-off; relevant departments believes that the company will cease to survive without capital injection or support of same effect by public sector)”.

Tang Bin indicated that, “for the first situation, regulatory bodies have set several ‘safety door’ for the capital sufficiency rate to prevent it from reducing to 5.125%. ””

Specifically, based on Basel Accord III and relevant regulations of CBRC, when core tier one capital sufficiency rate lower to less than 8%, the bank will be restricted in new business or required to supplement capital; when core tier one capital sufficiency rate lower to less than 7%, the bank’s dividend of that year will be restricted, and will be required to use whole or part of current profits to supplement capital by regulatory bodies according to core tier one capital sufficiency rate. Between 7% and 4.5%, there are four levels with 0.625% gap between each. Each level has different requirement for the proportion of capital retained. When the core tier one capital falls to 5.125% and below, regulatory bodies will require the bank to use all of its profits in the current year to supplement capital.

“For the second situation, under severe system risk, state capital injection will be inevitable, which means banks are under custody by the state temporarily. In that case, dilatation pressure will not be the primary concern for common shares holders.”

In fact, common shares holders with the rights and responsibilities in managing bank will surely operate legally with the bank and avoid the above extreme situation. As indicated by Tang Bin, “With the small probability of compulsory converting, the goal of converting price is 1) to systematically ensure such investment is equity type and 2) to calculate the shares that should be considered as to recover the voting power of preferred shares when trigger event occurs.”