RBC’s preferred-share experiment could open a $20-billion market

Share

Canadian banks are likely to sell more than $20-billion worth of new shares, now that investors have showed they can stomach a new style of securities.

This week Royal Bank of Canada became the first domestic lender to test investor appetite for a special type of preferred share that converts into common equity during a catastrophic crisis. The deal, originally for $200-million, sold out quickly, and was ultimately up-sized to $500-million, prompting rating agency Moody's Investor Service to estimate that more than $20-billion worth of these shares will eventually hit the market.

The figure is so large because banks are in a bit of a squeeze. In the early days of the financial crisis, Canadian lenders sold billions of dollars worth of ordinary preferred shares to beef up their capital levels. A few years later, the Basel Committee for Banking Supervision, which oversees bank capital guidelines, rewrote its rulebook, declaring these shares would eventually no longer qualify for capital purposes because they couldn't be converted into common equity.

At the same time, the Office of the Superintendent of Financial Institutions, Canada's banking watchdog, ruled that the country's banks had to hold enough capital to amount to 9.5 per cent of their risk-weighted assets. The first 8 per cent had to be comprised of common equity, but the remainder could come from a select list of "capital compliant" securities.

While banks were given the option to sell the new style of preferred shares to fill the 1.5-per-cent gap, there was no guarantee that investors would be willing to scoop them up.

"We've all been waiting for the first bank to go ahead and do something," Moody's credit officer Dave Beattie said in an interview. Now that RBC has set a precedent, and a wildly popular one at that, "I would expect other people to follow the format pretty closely."

RBC priced the deal attractively, offering investors a 4-per-cent annual coupon. This interest rate was especially lucrative considering that the banks have been sitting on their hands, waiting to test the demand for this 'non-viable contingent capital,' so there was pent-up investor demand for new bank product. There is already speculation the next deal could come with a lower coupon, although John Aiken, an analyst at Barclays Capital, stressed that such a rate cut isn't a guarantee. "You have to consider that Royal is one of the best credit risks of the Canadian banks," he said. Future deals "will be very much contingent on the market's outlook for the banks themselves."

Investors don't appear to be focusing on the new conversion privilege. "Right now, everyone is viewing the conversion feature as a very low probability event," Mr. Aiken said.

Moody's estimates that RBC's offering could serve as a watershed moment for Canada's capital markets, akin to Toronto-Dominion Bank's sale in 2000 of innovative Tier 1 capital securities. To beef up its capital levels after its acquisition of Canada Trust, TD was the first bank to sell a special type of securities that paid a juicy yield to investors, but did not cost the bank much in annual payments because of a unique tax structure. Other banks soon caught on, and this type of capital became an industry norm until OSFI changed the rules for what could qualify in capital calculations.