• Deutsche Bank's Co-CEO criticized AT1s after market rout
  • Lenders may have to sell the notes to meet capital regulations

Deutsche Bank AG’s John Cryan says the riskiest bank debt is “very expensive,” misunderstood and hard to justify. For Europe’s weakest lenders, it may be something else -- unavoidable.

Struggling banks have few ways to raise the capital needed to meet regulations coming into force through 2020 because they are already cutting costs, and thin-to-nonexistent profits will provide little help. Stockholders sitting on losses are also unlikely to support right issues. That leaves so-called additional Tier 1 notes, the target of the Deutsche Bank co-chief executive officer’s ire.

“If they find it hard to make profits, or if issuing equity is too expensive, then AT1s may be the only alternative,” said Anders Buvik, a high-yield fund manager at DNB Asset Management in Norway, which oversees 61 billion euros ($70 billion) of assets. Buvik holds Deutsche Bank AT1s.

The bonds are the most expensive form of bank debt to compensate holders for being first in line for any losses. The potential costs for weaker lenders have increased this year because of a selloff, centered on Deutsche Bank, that was driven by investor concerns about capital levels and greater awareness of the notes’ risks.

Market Rout

The slump pushed the yields on additional Tier 1 notes issued by Deutsche Bank, UniCredit SpA and Banco Santander SA to more than 10 percent, according to data compiled by Bloomberg. Industrywide, the bonds have lost 3 percent this year, based on Bank of America Merrill Lynch index data. That comes after two years of market-beating returns.

Deutsche Bank needs as much as $7 billion of additional Tier 1 notes by 2020 on top of the $6 billion it has already sold, according to Bloomberg Intelligence analyst’s estimate. The lender is also trying to bolster capital levels by halting dividends and shrinking operations, which reduces the amount it needs to hold. Still, Cryan this week said that a return to profit is key to cutting Deutsche Bank’s reliance on AT1s. 

“Once we get ourselves into a proper profitable position, and we’re building equity, we shouldn’t really need these instruments,” he said at a conference. “I just think they’re very expensive and I just don’t like them because I don’t think they’re sold very well.”

He said the bank will probably be unprofitable this year, following a 6.8 billion-euro loss in 2015.

Tax Advantage

Lenders may prefer to sell additional Tier 1 notes rather than shares to avoid depressing stock prices. Coupon payments are also tax deductible, which produces cost savings of about 30 percent, according to Joseph Faith, a credit strategist at Citigroup Inc.

“Even if you think they’ll issue at the levels suggested by the market now, the cost of equity is still higher,” he said.

UBS Group AG, one of Europe’s strongest banks, sold $1.5 billion of the securities on Monday, the first sale in the region since the selloff shuttered the market in mid-January. The overall market may more than double to 240 billion euros by 2020, according to JPMorgan Chase & Co.

The European Commission has suggested giving “particular protection” to holders of additional Tier 1 notes, which could reduce the risks and potentially the costs. Banks can be barred from making payments on the notes if capital levels fall too low.

“The regulator has no choice but to make AT1 investing easier for investors because banks need these instruments,” said David Benamou, the chief investment officer of Axiom, which manages about 500 million euros of financial debt.

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