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CIO Thematic Research | 4Q19

Europe ’ AT1s

Source: AFP Photo

Source:Source: AFP Pexels Photo CIO INSIGHTS 4Q19 | 93

Theme II: Europe Banks’ AT1s

Philip Wickham Europe Banks’ AT1s Fixed Income The Additional tier-1 (AT1) space has been the top performer within the European banks’ capital structures in 2019 to date, yielding close to a 10% absolute return. We anticipate demand to remain high and retain a general favourable investment stance toward these equity hybrid securities. Moreover, while the valuation of the European banks’ AT1 notes has narrowed relative to Asia Pacific and North America peers, the former still has the widest credit spreads globally. We prefer the higher-rated European issuers and selected lower-rated European issuers for more risk-tolerant investors.

AT1 securities are a relatively new asset class. This set of assets was introduced by Europe’s banking regulator in 2013 with the goal of improving banks’ capital bases and limiting the reliance on public funds during a banking crisis (unlike in the last decade). There are several key characteristics of these equity hybrid instruments:

• AT1 notes constitute hybrid capital that absorbs losses when a ’s regulatory capital ratio (CET1 ratio) falls below a certain trigger level. • The trigger level varies across Europe and globally, but is usually between 5.125- 7.000% (with regulators recently preferring a higher trigger). • Loss-absorption mechanisms vary, but are usually either a conversion into equity or a write-down of the AT1 instrument. • The coupon payment and the exercise of the call are entirely at the discretion of management. The coupon is also non-cumulative and is automatically suspended if a bank’s equity base breaches a maximum distributable amount (MDA) threshold, which is a function of the CET1 regulatory requirement. • AT1 securities are an additional layer of capital ranking just ahead of common equity and up to 1.5% of RWA (risk-weighted assets) can be included to meet Tier 1 regulatory requirements. • However, a fair argument is that AT1 securities rank below common equity in a bank’s capital stack given the loss-absorption mechanism occurs before common equity is impaired. CIO INSIGHTS 4Q19 | 94

Supply risk is modest as most European banks have reached their threshold for AT1 securities, but several European banks have not maximised their allowed 1.5% tranche for AT1 notes. We anticipate potential net new issuance from these financial entities. Issuances from other European banks are expected to be for replacement of maturing instruments and the natural growth in expanding capital structures.

Figure 1: Largest 50 global banks by asset size 4,500 Asia-Pacific Americas Europe, Middle East, and Africa 4,000 3,500 3,000 2,500

USD billion 2,000 1,500 1,000 500 0 RBS, UK HSBC, UK Lloyds, UK CCB, ABC, China BOC, China ICBC, China CMB, China , UK SPDB, China BBVA, Spain MUFJ, SMFG, Japan TDB, Canada RBC, Canada Citigroup, US AN, CBA, Australia JP Morgan, US Mizuho, Japan UniCredit, Italy BOCOM, China , US CS, Switzerland , Finland Santander, Spain Minsheng, China Everbright, China Japan Post, , Australia D Bank, Germany China CITIC, Norinchukin, Japan BNP Paribas, France Goldman Sachs, US Deutsche, Germany , US , Canada , US Intesa Sanpaolo, Italy Postal Savings, China Groupe BPCE, France Credit Mutuel, France Industrial Bank, China Credit Agricole, France , Netherlands UBS Group, Switzerland Standard Chartered, UK ING Groep, Netherlands Societe Generale, France

Source: Bloomberg, DBS

Figure 2: Largest 50 global banks by market capitalisation 400,000 Asia-Pacific Americas Europe, Middle East, and Africa 350,000 300,000 250,000 200,000

USD million 150,000 100,000 50,000 0 HSBC, UK Lloyds, UK ICICI, QNB, Qatar Switzerland CCB, China ABC, China

Netherlands

ICBC, China CMB, China SPDB, China

SMFG, Japan TDB, Canada RBC, Canada Citigroup, US MUFG, Japan JPMorgan, US BMO, Canada AN, Australia NAB, Australia CBA, Australia Mizuho, Japan BCA, DBS, BOCOM, China Wells Fargo, US US Bancorp, Capital One, US BNY Mellon, US Sberbank, Russia HDFC Bank, India PNC Financial, US NCB, Saudi Arabia Westpac, Australia BNP Paribas, France Goldman Sachs, US Morgan Stanley, US Scotiabank, Canada Charles Schwab, US Itau Unibanco, Brazil Bank of America, US First Abu Dhabi, UAE Postal Savings, China , China Al Rajhi, Saudi Arabia Industrial Bank, China Banco Bradesco, Brazil Bank Rakyat, Indonesia Hang Seng, , Spain UBS Group, ING Groep,

Source: Bloomberg, DBS CIO INSIGHTS 4Q19 | 95

Consolidation remains overdue in Europe. While European banks are well represented among the world’s largest banks by asset size, they are minnows when measured by equity market capitalisation within the global industry (Figures 1 and 2). We believe this is due to the overbanked financial systems in Europe that would benefit from consolidation, specifically cross-border across the continent. A restoration of profitability and growth should improve the credit profiles and valuations of the region’s banks. Some recent large mergers that were considered or rumoured included AG and AG, ABN AMRO Bank NV with either Nordea Bank Abp or UniCredit SpA, and Commerzbank with either UniCredit or ING Groep NV. In addition, Deutsche Bank and UBS Group AG explored an alliance between their global operations.

Domestic rather than true cross-border mergers to date. A banking union – a single pan-European market – remains elusive and partially lies behind the weaker credit profiles of the European banks relative to their global peers. This will further weaken with new barriers after the UK’s exit from the EU in October this year. We highlight that banks expanding across national borders are unable to move funds freely. Even across the Eurozone, countries operate individual deposit insurance programmes.

European banks have high exposure to sovereign debt. This exposure is at 170% of Tier 1 capital against around 50% for American banks. Moreover, around 60% of a European bank’s sovereign debt holdings is of the country where the bank is headquartered. As such, a sovereign debt crisis would also lead to a banking crisis, which was and remains a significant concern for several European nations. The uncertainty about the politics and budget for next year remains a current risk for Italian banks, which we anticipate will result in continued price volatility until resolved.

Impact of low interest rate environment in the Eurozone. Several banks have warned of the negative impact of this environment on profitability:

i) UniCredit cut its revenue forecast to EUR18.7b from EUR19.0b for 2019; ii) Commerzbank stated its profit target for the year is looking “significantly more ambitious”; and iii) ABM AMRO said low rates would injure its net interest income.

The low interest rate environment weighs on banks’ profitability as lending costs are lowered, some having to pay to store funds at central banks, all without a similar reduction in rates paid to depositors. Swiss banks charge negative interest rates on corporate, institutional, and wealth client deposits (but not on retail accounts). Nevertheless, the experience in the country indicates negative rates can be imposed without a large exodus of deposits.

There is market speculation that the ECB would implement a tiering system that would expose bank deposits only over a certain threshold to charges. Moreover, one European bank CEO stated that the negative rates environment may be counterproductive as consumers are uncertain on the future in this situation and end up saving more rather than less. However, we highlight that a low interest rate environment is generally supportive for asset quality, at least in the short run. CIO INSIGHTS 4Q19 | 96

Retreat from global investment banking. European banks have experienced continued declines in market share for global investment banking services – in both sales and trading and origination and advisory. The largest in 1H19 was Barclays Plc (followed by Deutsche Bank, Group AG, and UBS), but revenues were only one-third to one-half of the five largest American banks. The eclipse of European banks is partially self-inflicted as their business restructuring has resulted in large-scale reductions or full exits of various investment banking segments over the last few years. We do not anticipate a ramp-up of investment banking activities from European banks over the medium term, or at least until cost-income ratios are materially improved.

Reduce exposure to short-dated British banks’ paper due to no-deal Brexit risk. For investors concerned about a messy no-deal Brexit potentially derailing expected calls of AT1 notes from British banks, we recommend switching into either: i) Longer-dated sub-debt notes of the British banks (to remove the possible extension risk); or ii) AT1 notes from banks outside of the UK (to remove both extension risk and reduce any financial impact of Brexit).

The worst impacted British banks are Santander UK Plc, Lloyds Plc, Group Plc, trailed by Barclays, then HSBC Plc, and lastly, Standard Chartered Plc.

Exposure to Argentina is light at the European banks. Exposure is highest at Santander and Banco Bilbao Vizcaya Argentaria SA (BBVA). However, we highlight that the size is very manageable in terms of profits (2-4% of the consolidated group) and lending (around 1%). In addition, both Spanish-based banks operate under a “multiple-point- of-entry” approach that results in very limited intra-group funding. We would view any material widening of credit spread in the notes of Santander and BBVA, that result from negative news in Argentina, as a buying opportunity. The situation would likely be similar to political risk from Turkey last year, which caused the credit spreads of BBVA to widen quickly before retracing to prior levels over the following months. However, the political situation in Mexico warrants monitoring given the high exposure of BBVA to the country (around 50% of profits and 15% of lending).

Political risks are heightened but remain manageable outside of a “black swan” event. The continued political protests in Hong Kong have raised worries of a harsh crackdown by Chinese authorities. The credit spreads of both HSBC and Standard Chartered have widened modestly from this speculation (due to their large exposures to the economy of Greater China), but we remain optimistic that a solution can be achieved via dialogue.

In addition, politics dominate the news out of Italy with tensions toward a new government to remain a feature for the coming months. There are many scenarios for the future Italian government, which is expected to face pressure on its fiscal budget for next year and a potential breach of EU state-aid rules (for a proposed bailout of Banca Carige SpA) by EU authorities.

Key downside risks include rising asset impairments from loan books, continued declines in investment banking segments, a sharp economic downturn globally and/or in Europe, additional onerous regulations and rules, increased equity-friendly strategies (such as higher dividend pay-outs), and/or higher provisions and operating costs than expected. CIO INSIGHTS 4Q19 | 113

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Glossary of Terms: Acronym Definition Acronym Definition ASEAN Association of Southeast Asian Nations IEA International Energy Agency AxJ Asia ex-Japan IG investment-grade bbl barrel IMF International Monetary Fund BI IP intellectual property BNM Bank Negara ISM Institute for Supply Management BOE Bank of England IT Information Technology boepd barrels of oil equivalent per day JGB Japanese Government Bond BOJ Bank of Japan KTB Korean Treasury Bonds BOK Bank of Korea LTRO long term refinancing operation BOT Bank of Thailand M&A merger & acquisition bpd barrels per day MAS Monetary Authority of Singapore BSP Bangko Sentral ng Pilipinas mmbbl million barrels CAGR compound annual growth rate mmbpd million barrels per day capex capital expenditure MSG Malaysia Government Securities CAR capital adequacy ratio NAV net asset value CET1 common equity tier 1 NEER nominal effective exchange rate CPI conusmer price index NII net interest income DM Developed Markets NIM net interest margin DPS dividend per share NPL non-performing loan DPM discretionary portfolio mandates O2O online to offline DPU distribution per unit OMO open market operations DXY US Dollar Index OPEC Organization of the Petroleum Exporting Countries EBITDA earnings before interest, tax, depreciation, and OPM operating profit margin amortisation EC European Commission P/B price-to-book ECB European Central Bank P/E price-to-earnings EIA Energy Information Administration P/NAV price-to-net asset value EM Emerging Markets PBOC People's Bank of China EPFR Emerging Portfolio Fund Research PCE personal consumption expenditure EPS earnings per share PM portfolio manager ETF exchange-traded fund PMI purchasing managers' index EU European Union QE quantitative easing FCF free cashflow RBA Reserve Bank of Australia FDI foreign direct investment RBI Reserve FTA free trade agreement REIT real estate investment trust FX foreign exchange RM relationship manager GDP gross domestic product ROA return on asset GFC Global Financial Crisis ROE return on equity HY high yield RPGB Philipine local government bonds GLOSSARY 4Q19 | 116

Acronym Definition Acronym Definition RRR reserve requirement ratio UST US Treasury SAA Strategic Asset Allocation VaR value at risk saar seasonally adjusted annual rate VAT value-added tax SD standard deviation VIX CBOE Volatility Index SGD NEER nominal effective exchange rate WTI West Texas Intermediate SGS Singapore Government Securities YTD year-to-date SOE state-owned enterprise YTW yield to worst SOR swap offer rate WTO World Trade Organization TAA Tactical Asset Allocation ZIRP zero interest rate policy UCITS Undertakings for Collective Investment in Transferable Securities