Source: China Business News Reporter: Xia Xinyu Published on: June 24, 2014
Abstract: Will the creation of preferred shares hamper the earnings of ordinary shares? How to determine when there are both opinions about the beneficial and harmful effect of preferred shares?
Recently, Shanghai Pudong Development Bank, Agriculture Bank of China, Bank of China and Industrial Bank have successively published plan for releasing preferred shares. This new investment instrument based on capital tool of banks brings expectations and doubts to the market.
For institutional investors, which one is better in terms of risk and earnings expectations? Preferred shares, ordinary shares or subordinated debts? CSRC said preferred shares must not convert to ordinary shares and dividends that can't be granted shall be accumulated to next year, while the CBRC said preferred shares of banks is possible to convert to ordinary shares and dividends can’t be accumulated. Which one is the true story?
Will the creation of preferred shares hamper the earnings of ordinary shares? How to determine when there are both opinions about the beneficial and harmful effect of preferred shares?
With the above questions, CBN interviewed Tang Bin, director and board sectary of IB.
How to understand the preferred shares as being both shares and debts?
Among various types of tools that investing in banks, “the higher of capital property, the higher of ability to absorb losses and to assume risks, and of course higher the ROE,” said Tang Bin. Then how shall we rank the capital property of preferred shares?
Tang Bin said, if full capital property is 1 and non capital property is 0, then the ranking for investment in banks from 0 to 1 shall be: deposits, financial debts, subordinated capital debts, preferred shares and ordinary shares. There is also perpetual debt that intermediate between subordinated capital debt and preferred shares.
From the perspective of liquidity, deposits can be made and withdrew at any time; financial debt and subordinated debt must be matured before banks to pay principle and interest; and ordinary shares and preferred shares are “perpetual” unless redeemed by banks.
From the perspective of repayment order, Tang Bin indicated that, assuming a bank goes wrong, the deposits protection is equivalent to compulsory cashing, and then financial debt, subordinated debt, preferred shares and ordinary shares in order. A requisite condition for preferred shares of banks requires “compulsory converting to ordinary shares when the tier one capital adequacy ratio falls to 5.125% or below or the trigger events of second level capital tools occurs”.
From the perspective of yield rate, Tang Bin said that, the yield rate of one year deposits in banks is 3.25%; and as shown in the results of release of written off subordinated debt this round, the interest rate at debt issued by 5 stock holding banks recently is 6.15% to 6.8%. With a high capital property, the yield rate of preferred shares is higher than that of written off subordinated debt generally. As for ordinary shares investment, it entitles to ROE of banks in theory, and those non-cash dividend forms the capital reserve and increases net asset value per share, and all of which belongs to shareholders theoretically.
“When creating banking capital tools, banks have to follow the principles that balancing the rights among different financial instrument holders and helping them to receive earnings according to respective risk exposure,” said Tang Bin.
The pricing mechanism of preferred shares
Do preferred shares worth to invest or not? Tang Bin said, “the pricing of preferred shares are mainly considering reference principle, adjacent principle and risk premium principle.” Based on the order of capital property of different investment products, the dividend of preferred shares obviously shall be expensive than that of subordinated capital debt.
“Taking the preferred shares adjacent to perpetual debt abroad, the pricing is the interest rate of perpetual debt plus a risk premium of about 50 BP. As there is no perpetual debt for reference domestically, preferred shares may add proper premium based on subordinated capital debt with written off terms,” Tang Bin analyzed that, “besides, the pricing of preferred shares is also impacted by the supply-demand situation of capital at releasing and recognition to issuer by investors.””
The interest rate of perpetual debt issued by China CITIC Bank International in April this year is 7.25%, and that of subordinated capital debt issued by several stock-holding banks recently is 6.1% to 6.8% respectively. However, as the preferred shares are still in pilot, it is hard to say how many BP should be added based on the referenced interest rate of these debts.What exactly is the condition of converting to ordinary shares?
Except for inferior to other debt based investment products in terms of payment order, what makes investors wondering most is that preferred shares of banks is possible to convert to ordinary shares and dividends can’t be accumulated. Both of these characteristics make the preferred shares more like shares than debts.
Tang Bin called these two points “additional capital terms.” He said it is actually an idea under Basel Accords, which reflects the capital property of capital tool and intends to protect depositors and taxpayers. In another words, preferred shares of banks have higher ability to absorb risk than that of general companies. Therefore, the preferred shares holders may discuss how to match the risk pricing and get to know the probability of trigger events.
First of all, the trigger condition of converting is the core tier one capital of the bank fall to 5.125% and below. What is the basis of such data? Tang Bin believes that compulsory converting to ordinary shares is a core condition for preferred shares of banks to absorb losses. As a quantitative trigger indicator, 5.125% comes from Basel Accords Ⅲ. When core tier one capital fall to 7% (i.e. 4.5% of core tier one capital plus 2.5% reserve capital), the profits distribution of banks will be limited. Between 7% to 4.5%, there is four regulatory levels with 0.625% gap between each two. Every level lowered, the minimum rate of capital retained will increase accordingly. 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 for replacement capital, therefore 5.125% was adopted by international banking industry and Chinese regulatory bodies as a trigger point for capital tools to absorb losses.
And just because of the regulations different from non banking preferred shares, Tang Bin said, CSRC requires all the preferred shares of banks shall be offered non-publicly to less than 200 qualified investors, so as to protect medium and small investors and remind risks to investors.
The probability of triggering 5.125%
There is risk to invest in preferred shares, but what is the probability for core tier one capital sufficiency to drop to 5.125%?
In respect of capital sufficiency, “8% is ‘reaching the standard’ internationally but only ‘pass' in China. According to the new capital accord, 10.5% is ‘reaching the standard’.” If the capital sufficiency of a bank lowers than 10.5%, the new business and subsidiaries will be limited; if lowers than 8%, the existing business and subsidiaries will be limited,” said Tang Bin.
According to 2013 annual report of listed banks, the core tier one capital sufficiency of all 13 banks exceeds 8%, 7 of them exceeds 9% and 2 of them even exceeds 10.5%; except for Ping An Bank and Huaxia Bank, the capital sufficiency of other banks all reach 10.5% and above. “As many banks issued capital debt since this year, the general capital sufficiency is better than that at the end of last year.” said Tang Bin.
8% is the pass line for capital sufficiency. What will happen if it lowers than 8%? As introduced by Tang Bin, firstly, regulatory bodies will require the bank to supplement capital by all means; secondly, if timely capital supplement is impossible, regulatory bodies will require the bank to sell assets which might involve interest-bearing assets and impair the profits of the bank; lastly, if the capital sufficiency rate is still below the standard, then the bank will have to sell relevant business units or subsidiaries or branches.
“The trigger event of compulsory converting is more like a small probability event in theory.” Although it is very unlikely for banks to distribute no dividend and converting to ordinary shares compulsorily due to the sector attribute and diligent regulation, it is still necessary to protect the rights for preferred share holders in different aspects.
In the constraint of corporate governance, Tang Bin said, banks may provide system guarantee of dividends for preferred share holders by establishing mechanism to recover voting power and dividend braking; distribute no dividends before fully paid agreed dividends to preferred shares holders; 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.
Does the ordinary shares impaired by preferred shares?
The calculation of capital sufficiency rate of banks includes core tier one, other tier one and tier two capital. As introduced by Tang Bin, according with the minimum capital requirement of The Capital Management Method of Commercial Banks (Trial), when calculating the 8% capital, the minimum level for core tier one capital is 5% (higher than 4.5% specified in Basel Accords), and the capital stock of ordinary shares could be calculated into this part of capital; and the minimum level for tier one capital sufficiency is 6%. In respect of financing efficiency, the most effective release room for other tier one capital is 1%, and preferred shares could be calculated into this part of capital. When core capital is increased, then other tier one capital can also be increased proportionally.
As the financing cost of preferred shares is lower than that of ordinary shares, qualified banks will consider to improve financing efficiency by combine ordinary shares and preferred shares. Taking IB as an example, it is estimated that the risky assets of the bank may reach 3 trillion yuan in 2015, therefore it plans to offer 30 billion yuan preferred shares as 1% of risky assets.Will the preferred dividends to preferred shares holders impair those of ordinary shares holders? Tang Bin said that, firstly, by supplement bank’s capital with preferred shares and subordinated debt with written off terms, the pressure of continued contribution for ordinary shares holders is actually reduced (the core content of Basel Accord is “shareholders responsibilities” which believes ordinary shares holders have a responsibility for continued contribution); secondly, the preferred shares holders are only superior to ordinary shares holders in terms of agreed dividends.
As the theory of “generating earnings with borrowed assets” as mentioned in The Smart Preferred Shares Plan of SPDB reported by our newspaper on May 27 shows, borrowed capital with preferred shares may be used with leverage effect to risky assets. Based on the current ROE of banks, financing of 30 billion yuan may increase profits by 5 billion yuan, and preferred shares holders can only take 2.1 billion yuan of them with an assumed interest rate of 7%, all of the rest will be the extra earnings for ordinary shares holders.
Tang Bin indicated that, “we should stress the equality of rights for shareholders of the same type of shares and the balance of rights for shareholders of different types of shares.” And such “balance” has been well designed under proportioned risk-profit and other systems mentioned above of preferred shares.