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N O V E M B E R 2 0 0 5

N O V E M B E R 2 0 0 5. H Y B R I D C A P I T A L D I S C U S S I O N. IFR AWARDS 2002. IFR AWARDS 2003. IFR AWARDS 2004. FINANCIAL BOND HOUSE OF THE YEAR. Hybrid Capital: Overview. I B A. 1. Overview of bank capital structure. Components of a bank’s capital (hierarchical).

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N O V E M B E R 2 0 0 5

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  1. NOVEMBER2005 HYBRIDCAPITALDISCUSSION IFR AWARDS 2002 IFR AWARDS 2003 IFR AWARDS 2004 FINANCIAL BOND HOUSE OF THE YEAR

  2. Hybrid Capital: Overview IBA 1

  3. Overview of bank capital structure Components of a bank’s capital (hierarchical) Cost/Risk for investor Tier III Subordinated debt (Dated) Approved by BIS in 1993 Not yet issued in India Low Lower Tier II Subordinated debt (Dated) Approved by BIS in 1988 Already issued in India Max up to 50% of Tier I “Supplementary” capital Upper Tier II Subordinated debt (Dated & Perpetual) Max up to 100% of Tier I (along with Lower Tier II Approved by BIS in 1988 Not yet issued in India Regulatory Capital Hybrid Tier I “innovative” Approved by BIS in 1998 Not yet issued in India Max up to 15% of Tier I Tier I 50% at least of minimum capital ratio of 8% “Core” capital Common Equity & Retained earnings High Recognition of hybrid capital • Hybrid capital combines characteristics of both debt and equity, and has been recognized by BIS as a form of bank capital since 1988 • BIS guidelines recognize hybrid capital instruments as either Tier I (Hybrid Tier I) or Tier II (Upper Tier II) • Hybrid Tier I carries more risk for investors, but provides more capital support • Upper Tier II is less risky for investors, but only provides supplementary capital support 2

  4. Each capital instrument adds more equity features along the spectrum from debt to equity Increasing equity characteristics ¹ Inclusion of an interest rate step-up will relegate an instrument to "innovative" status Key differentiating features for Upper Tier II and Hybrid Tier I 3

  5. What is Hybrid Tier I Main characteristics of Hybrid Tier I Main components of Tier I as per the Basel Accord • Perpetual and senior only to equity • No fixed costs (Coupons are deferrable and non-cumulative) • Loss absorption (Interest and principal can be loss absorbing) • Can be innovative (limited to 15% of total Tier I) or non-innovative • Ordinary shareholders’ equity (net of any own shares held); • Retained earnings, i.e., internally generated capital from accruing profit to reserves; • Perpetual non-cumulative preferred stock (what is known in the market as “Tier I preferred”) and other hybrid capital securities; • Reserves created by appropriations of retained earnings, share premium and other surpluses; • Minority interests created when a bank has a subsidiary that it does not wholly own What is innovative Hybrid Tier I • The new BIS guidelines laid emphasis on the significance of equity and retained earnings as the key components of Tier I capital • To preserve the sanctity of capital structure of banks, BIS stated that total Tier I capital “with any explicit feature—other than pure call option – which might lead to the instrument being redeemed is limited—at issuance—to 15% of the consolidated bank’s Tier I capital” • Hence this draws a clear line of distinction between innovative and non-innovative Hybrid Tier I capital, the latter not being subject to 15% limit • Innovative Hybrid Tier I • A fixed income instrument • Structured as to create economic characteristics of a directly issued Tier I preference share • Retaining sufficient debt-like characteristics as to remain tax-deductible • Economic maturity (due to step-up and call date) 4

  6. What is Upper Tier II Main characteristics of Upper Tier I Key characteristics • Maturity: The UK FSA and some other regulators require that UT II is perpetual, but this is not a requirement in the Own Funds Directive or under BIS • Deferrable coupons: Coupons can be deferred at the option of the issuer but they are cumulative, so the issuer has to pay deferred coupons in the future. This can include interest on interest • Loss-absorbing: Principal and interest must be suspended to allow the issuer to remain solvent. In some early instances of UT II guidelines, the principal and interest could be written down, but this is largely not in use today • Step-up: The use of coupon step-ups has given these otherwise long dated/perpetual bonds a shorter economic maturity date. The amount of step-up on UT II varies across jurisdictions • Ranking: UT II is subordinated to senior debt, but ranks ahead of all forms of Tier I capital. It may or may not be subordinated to LT II depending on jurisdiction • Senior to equity (including preferred), but junior to all forms of senior debt, including deposits • Coupons are cumulative, but deferrable • Loss absorption (Interest and principal can be loss absorbing) • Can include a step-up in most jurisdictions Main components of Tier II as per the Basel Accord • Includes general provisions, up to a maximum of 1.25% of risk-weighted assets, but excluding specific provisions • Revaluation reserves from fixed assets and fixed asset investments • Instruments that combine the characteristics of debt and equity / dated deferrable subordinated debt 5

  7. Regulatory review of hybrid capital BIS guidelines, 1998—Hybrid Tier I Features • To qualify as Tier I, securities must • Be issued and fully paid up • Be permanent • Have non-cumulative interest deferral (linked to dividends) • Be able to absorb losses within the bank on a going concern basis • Be junior to depositors, general creditors, and all indebtedness • Neither be secured nor covered by a guarantee of the issuer or related entity or other arrangement that enhances the seniority of the claim vis-à-vis creditors • Hybrid Tier I with an 'economic' or final maturity is limited to 15% of total Tier I capital • Hybrid Tier I can have a call option after a minimum of five years, although redemption is subject to regulatory approval • A step-up of the greater of 100 basis points or 50% of the original issue spread is permitted after a minimum of ten years BIS guidelines, 1988—Upper Tier II Features • The Cooke Committee put a further distinction on subordinated debt when it divided Tier II into Upper and Lower categories • Upper Tier II may not be reimbursed on the bearer's initiative or without prior agreement of the supervisory authority • The debt agreement must provide for the credit institution to have the option of deferring payment of interest on the debt • The lender's claims on the credit institution must be wholly subordinated to those of all non-subordinated creditors • The documents governing the issue of the securities must provide for debt and unpaid interest to be such as to absorb losses, while leaving the credit institution in a position to continue trading • Only fully paid-up amounts shall be taken into account • Limit: Up to 100% of Tier I capital 6

  8. Hybrid capital provides operating and strategic flexibility for bank management in pursuing performance objectives While common equity is the most common type of Tier I capital, it is also the most expensive form of capital to raise Increasingly banks are facing growing pressure from shareholders to maintain and improve returns As a result, the ability to raise cost-efficient non-dilutive subordinated capital is increasingly recognized as a means of balancing the often divergent interests of banking industry regulators, whose overriding objective is to preserve and strengthen the integrity of a bank’s balance sheet, and shareholders who are demanding high returns on their equity investments For banks, the issuance of hybrid qualifying capital is an attractive means to address the needs of both of these important constituencies Hybrid capital helps improve return on equity as it is non-dilutive and significantly lower cost compared to equity Value of hybrid capital Benefits of hybrid capital • Non-dilutive • Tax-deductible • Senior creditor protection • Cost-effective • Economic maturity 7

  9. The cost of issuing HT I is typically much lower than the cost of equity on a pre-tax basis, and even lower on a post-tax basis, since there is no tax benefit associated with the cost of equity Unlike Tier II, HT I can directly replace common equity to help offset such items as Goodwill. It has therefore been used extensively as an acquisition currency The effect of adding HT I to a capital structure is to further lower the Weighted Average Cost of Regulatory Capital Why do banks issue hybrid capital The most cost-effective capital structure can be created using a barbell approach Note: Illustrative cases based on indicative $ LIBOR levels 8

  10. Key provisions of hybrid capital IBA 9

  11. Hybrid Tier I Upper Tier II Maturity Interest deferral Loss absorption Status Understanding key provisions of hybrid capital:Maturity BIS requirement • “Permanent form of capital” • Silent on this • Most jurisdictions Perpetual. Some dated (Germany, US, Korea) • Perpetual with step-up and Dated What’s prevalent Trade-off—dated v perpetual 10

  12. Hybrid Tier I Upper Tier II Maturity Interest deferral Loss absorption Status Understanding key provisions of hybrid capital:Interest deferral BIS requirement • Optional interest deferral link: Non-payment of common share dividends • Optional interest deferral link: Dividends, or breach of minimum capital ratio What’s prevalent Trade-off—dividends v capital ratios 11

  13. Hybrid Tier I Upper Tier II Maturity Interest deferral Loss absorption Status Understanding key provisions of hybrid capital:Loss absorption BIS requirement • Conversion into directly issued preference shares in the event of breach of CAR • Mandatory non-payment of interest / principal if profitability cannot support What’s prevalent Trade-off—suspension v conversion 12

  14. Hybrid Tier I Upper Tier II Maturity Interest deferral Loss absorption Status Understanding key provisions of hybrid capital:Status BIS requirement • Rank junior to Equity but ahead of depositors, general creditors and all indebtness of the bank • Rank ahead of all Tier I but is sometimes junior to Lower Tier II What’s prevalent Trade-off—pari passu v junior 13

  15. Regulators have placed different requirements on how Hybrid Tier I is implemented in various regions Tier I—regulatory differences in selected jurisdictions 14

  16. The key is to frame Hybrid Tier I guidelines under terms that would offer most value to the banking system Hybrid Tier I 15

  17. Some of the provisions will have significant impact on the pricing of an Upper Tier II subordinated debt issue Investors will often compare the provisions across different jurisdictions to understand the relative value among subordinated debt issues by banks in different locations Upper Tier II hybrid instruments are available to most jurisdictions that follow BIS guidelines—but with significant variation Comparison of Upper Tier II provisions across the world 16

  18. The key is to frame Upper Tier II guidelines under terms that would result in the most efficient structure Upper Tier II 17

  19. Value of hybrid capital for Indian banks IBA 18

  20. The Indian banking sector’s strong growth will require additional capital Strong growth in credit • Indian banks are entering a phase of loan growth, giving rise to a large funding/capital requirement • Loan growth has been strong at 32% oya and is expected to remain strong at 20—25% in near future Shareholder value • Increasing competition will lead managers to place more focus on shareholder value • Hybrid capital plays a role in managing capital to generate a better return on capital Basel II compliance • Adoption of Basel II norms (w.e.f. 2006) increases sensitivity to asset quality • Banks need to meet operational and market risk related capital charges Primary drivers for incremental capital need Balance sheet clean up • Although banks have made considerable progress in bringing down net NPLs, average gross NPLs still remain high at 7%—9% • Banks will need additional capital to improve significantly on asset quality metrics 19

  21. Banks in India would need to raise approx. $9—12bn in capital to meet expanding credit demand and fuel economic growth Key assumptions Key findings • Based on study of 13 banks representing 80% of the sector’s assets • Key drivers based on the latest research analyst estimates of: • Net Income • Dividend pay-out ratio • RWA and Asset growth • Reclassification of Investment Fluctuation Reserve • We estimate that these banks will need approx. INR 552bn in capital to maintain its current CAR levels (as of Mar 05) • Although banks will be able to use subordinated term debt (Lower Tier II) to finance much of their capital requirement, this would not meet the total capital requirement • To avoid further equity dilution and optimize the capital structure in line with international standards, banks will need to make use of new category of low cost non-dilutive capital, including Upper Tier II and Hybrid Tier I which are available internationally to banks • Some banks will also need to raise Core Tier I, but Core Tier I requirements can be minimized by use of non-dilutive subordinated capital Capital requirements for Indian banks 2006—2010 (INR bn) Finance Minister on Indian banks’ capital requirements "Banking capital has to be augmented every year. The additional capital formation has been estimated at Rs 8,000-9,000 crore annually. My own calculations suggest that an additional Rs. 60,000 crore capital might be required by the banks over the next five years" P Chidambaram, Honorable Finance Minister, 24 October 2005 Source: JPMorgan 20

  22. Relevance of Hybrid Capital for Indian Banks—Hybrid Tier I Advantages of Hybrid Tier I • Shareholding restrictions: While Tier I capital provides the most financial flexibility, raising new equity may not be feasible for many Indian Banks due to: • Government of India (GOI) minimum shareholding restrictions of 51% or 55% in state-owned banks (SOEs) • With GOI holding nearing its threshold levels, the quantum of equity capital that can be raised is restricted • Foreign institutional ownership limits in case of both public (20%) and private sector banks (74%) • This restricts the foreign investor participation in future equity offerings which are close to such FII limits • Absence of FII participation may impact the valuations given their strong interest in the sector • Domestic consolidation: Hybrid Tier I is widely used by international banks in conjunction with acquisitions, as it can replace Tier I lost through goodwill, unlike Tier II capital. At the same time, Hybrid Tier I is non-dilutive in nature and allows for re-rating of the stock GOI holding nearing its limit in most State-owned banks FII ownership being exhausted FII limits: SOE: Max. 20% allowed PSB: Max 74% allowed Note: As on 30 Sep 05, except UBI as on 30 Jun 05 *Holding in UBI will come down to 55% post its planned equity offering of US$300mm in 4Q05/1Q06 21

  23. Relevance of Hybrid Capital for Indian Banks—Upper Tier II Advantages of Upper Tier II • Balance sheet expansion remains a primary driver for incremental capital requirements, especially as macroeconomic factors continue to improve and asset quality remains robust • Tier II capital supports strong loan growth without diluting existing shareholders’ equity • As banks in India have already made aggressive use of non-dilutive low cost Lower Tier II capital, additional capacity is not enough to meet the estimated whooping capital need INR419-522bn for the sector • With Investment Fluctuation Reserve’s (IFR) reclassification as Tier I, capacity for term subordinated debt (Lower Tier II) has expanded but this is still not sufficient to meet the estimated capital needs for Indian Banks • Under BIS guidelines, banks are allowed to raise Subordinated Tier II capital up to 100% of Tier I and can issue the remaining balance of 50% in form of Upper Tier II capital Need to explore other alternatives to meet capital shortfall Capital shortfall INR bn Estimated capital need at Target CAR 12.0% (for 13 banks under study) 22

  24. Basel II implication for Indian banks • Basel II attempts to build a regulatory capital framework that more closely reflects the underlying risk profile of banks • As banks would need to create a capital charge for market and operational risk in addition to credit risk, the Risk-weighted assets of the banks will substantially increase under Basel II • Also risk-weightings for different borrowers will change with adoption of Basel II which would be more closely linked to the inherent riskiness of the borrower • Such a move will help strengthen the risk management practices at the Indian banks and will realign regulatory and economic capital needs of the banks • A critical innovation under Basel II is the use of credit ratings to differentiate the credit quality of assets held by banks and provide for capital accordingly REAL ECONOMIC CAPITALISATION MAY NEED TO BE STRENGTHENED IN THE WAKE OF BASEL II “The key concern remains the ability of the weaker PSBs and small private sector banks to raise fresh capital, especially in view of the upcoming Basel II accord to be adopted by FY2007. Consolidating with bigger banks with a stronger capital base would be an alternative for these banks, while RBI has also indicated that foreign banks would be allowed to participate with majority shareholdings in banks being restructured. Moody’s expects that the new Basel II norms are not likely to have a significant impact on the PSBs’ capital needs with regard to their credit risk profile under the standardized approach” Moody’s April 2005 IFR balance to be treated as Tier I capital “This move eases the burden on Tier 1 capital requirements prior to full implementation of Basel 2. Tier 1 ratio improves by 150bps for our coverage universe given that avg IFR was 4.61% at Mar05. However, Tier 2 ratio reduces correspondingly & total CAR remains constant. While banks will still need to raise capital, they can now raise more Tier 2 capital as pressure on Tier 1 has reduced. Hence, banks with low govt. holding will find it easier to raise capital” JPMorgan 14 Oct 2005 Basel II—Capital treatment Economic capital as % assets High risk Low risk Probability of default (%) 23

  25. With increasing domestic competition, Indian banks face greater pressure to focus on return on equity as a measure of performance In addition, increased competition from the foreign banks in near future will further drive domestic banks to be more efficient in managing their operations and capital structure Capital management is an important component in any strategy to optimize shareholder return, with hybrid capital playing an important role in supplying additional capital support Increasing leverage moves banks towards a capital structure designed to optimize ROE With capital requirements expected to increase in the near future, hybrid capital provides non-dilutive support with lower negative impact on EPS than core equity In addition, the cost of hybrid capital (including Hybrid Tier I and Upper Tier II) is lower than that of core equity Raising non-dilutive hybrid capital will enable banks to fund growth and with minimum negative impact on stock ratings Shareholder value will become an increasingly important benchmark for Indian banks Increasing focus on ROE requires focus on capital management ROE coming under pressure Source: Company reports, Mean IBES estimates for 2006 through 2008 Note: Average industry ROE calculated for 13 banks Generating superior ROE will drive the valuation at Indian banks 24

  26. A bank’s capital structure is critical to valuation as it has a direct impact on sustainable ROE ROAE v P/BV of regional banks¹ Indian banks Other banks Equity requirements impact ROE and COE, and P/B ROE - G P/BV = COE - G Where: ROE = return on equity G = growth COE = discount rate Source: JPMorgan research, Company reports and industry data Note: Book value and ROE for FY04; Market data as of 15 Nov 2005 ¹ Graph data is for regional banks in Hong Kong, Malaysia, Singapore, Korea, India and Taiwan 25

  27. Importance of accessing international markets • With lower funding costs, domestic markets may be the first funding option for most Indian banks. However, access to international markets remain important for several reasons • Individual investors represent a significant part of the domestic market, but banks should be cautious about relying on this investor base • Domestic investors may not fully understand the implications of subordination provisions inherent in Lower Tier II structures • Banks create moral hazard by selling to its own depositors, since there is a risk that RBI will intervene to protect depositors from loss • Banks will also be limited in selling to each other, since regulators will place strict limits on the capacity of local banks to own local bank securities • Limits will be imposed to restrict systemic risk, since cross holdings amongst banks will likely magnify the impact of financial distress within the system • Accessing international investors provides a counterweight to over-reliance on domestic investors, promoting overall stability for the system 26

  28. Hybrid Tier I Applications Structural considerations Markets IBA 27

  29. Why Banks issue Hybrid Tier I? • Increasing Tier I capital provides the greatest degree of financial flexibility and highest level of capital support • Supports reductions made in balance sheet clean-up • Additional capital is required to write-off non-performing loans and to increase coverage • Creates capacity to issue additional Tier II • Replaces capital spent on acquisitions • HT I can directly replace goodwill reductions created by an acquisition • HT I provides support for core capital ratio, while allowing time for the stock to be re-rated post-realization of revenue and cost synergies • Hybrid Tier I allows banks to achieve the benefits of raising Tier I while minimizing financing costs and dilution • Maintains expectations of shareholders’ return through its non-dilutive and low cost nature • Optimizes capital structure, bringing it in line with international peers as issuing tax-deductible Hybrid Tier I will reduce WACC and improve valuations 28

  30. Issuers face several decisions in designing an optimal HT I issuance structure Tier I issuance options • Issuers have multiple considerations in designing the structure for a Hybrid Tier I issue, with implications on pricing, tax effects, and target investor base Tier I issuance decision tree Tier I • Summary of key considerations: • Core has no step-up and is therefore perpetual; Innovative has a step-up after year 10 • Headroom: Innovative is capped at 15% of total Tier I and non-innovative is capped at 30% of total Tier I Core Innovative • Indirect issuance: Commonly used for tax efficiency, but subject to stricter regulatory scrutiny • Direct issuance: Features can be potentially be included to provide tax efficiency Direct Direct Indirect • International market deeper while domestic may have limited capacity • Danger of systemic risk • Cost of raising funds off-shore vs. on-shore issuances INR INR $ INR $ 29

  31. Permitted features vary across jurisdictions, with some more favorable for investors Hybrid Tier I Preferred Non-preferred 30

  32. Bank capital evolution in United Kingdom (UK) Hybrid Tier I regulatory requirements Hybrid Tier I—regulator’s views • Guiding principle • Deeply subordinated, undated and non-cumulative • Structure • Preference shares (perpetual non-cumulative) • Call • Only after 5 years Call option at discretion of issuer (5 year intervals between calls) Must have no other provisions which require future redemption • Step-up • Only after 10 years • Interest accrual • Non-cumulative (but may be paid in scrip) • Interest deferral • Yes • Loss absorption • Yes • Ranking • Junior to Tier 2 capital except for dated preference shares with which it is pari passu • Eligibility • Tier I ratio of at least 4% over risk-weighted assets (Initially it was at 6%) • Indirectly issued Tier I doesn’t exceed 15% of Total Tier I • Key components of HT I remain as in BIS guidelines, 1998 • FSA has divided capital into three tiers for regulatory purposes, reflecting the extent to which instruments meet the underlying principles of capital—loss absorbency and permanence • Preference shares have long been used by U.K. banks to reach target Tier I ratios • In January 1998, the Financial Services Authority (FSA) published guidelines which favor a tax-deductible Tier I structure involving the use of a non-operational special purpose vehicle (SPV) as the issuer of the preferred securities • In November 2003, FSA issued a consultative paper (CP155) on proposed changes in bank capital instruments, particularly Tier I capital Structure approved by FSA—innovative HT I issue via an SPV • SPV is integrated in the solo-consolidation of the parent company and consolidated basis (i.e. through creation of Minority interest) • Issue is effectively tax-deductible • The instrument’s main features are as follows: • Loss absorption on an ongoing basis is required; • A call is permitted every 5 years or a 100 bps step up can occur from year 10; • issuers need a minimum Tier I equity ratio of 6%; and total use is limited to 15% of Tier I capital 31

  33. Bank capital evolution in United States (US) Tier I guidelines (US) Hybrid Tier I—regulator’s views • Structure • Indirect trust preferred permitted. Combined with other cumulative preferreds limited to 25% of Tier I capital • Maturity • Trust preferred securities are dated. Minimum 30 years • Call • No puts but can call with Fed permission • Step-up • No • Interest deferral • Yes case by case basis • Loss absorption • No specific regulations • Ranking • Junior to Tier II • Eligibility • Equity to asset ratio greater than 3% • The components of Tier I capital remains as in BIS guidelines, 1998 • Fed allows limited amount of cumulative preferred perpetual securities in Tier I capital (25% of Total Tier I but in practice it is limited to 15% of Tier I) • In US the regulators look at preferred securities and subordinated notes and debentures as an additional cushion above equity to protect depositors and other senior creditors • Capital requirements are an important aspect of capital adequacy, which is one key component of the regulators’ assessment of the safety and soundness of banks and Bank Holding Companies Structure approved by Fed—Innovative HT I issued via an SPV • Trust preferred securities were first approved by Fed in October 1996. (Cumulative preferred securities) • Issued out of special purpose subsidiary that is wholly-owned by the parent bank / company • The proceeds on-lent to the parent in form of a very long-term deeply, subordinated note • To be eligible as Tier I capital, these securities must provide for a minimum five-year consecutive deferral period on distributions to preferred shareholders • In addition, the inter-company loan must be subordinated to all other subordinated debt and have the longest feasible maturity. Typically, this has been 30 years 32

  34. Singapore and Korea are the only two jurisdictions in non-Japan Asia to have issued international Hybrid Tier I Best deal records—JPMorgan led transactions Singapore was the first jurisdiction in non-Japan Asia to issue international Hybrid Tier I, followed by Korea—JPMorgan is the only house to have executed deals for banks in both jurisdictions, and have done so in both an innovative and non-innovative format • JPMorgan issued the first ever Hybrid Tier I transaction for a Korean Bank, with a $200mm perpetual step-up 10 issue for Hana Bank • No other house has issued perpetual Hybrid Tier I in Korea • In Singapore, JPMorgan has executed both innovative and non-innovative Hybrid Tier I for OCBC, both in a perpetual format • No other house has executed both formats for Hybrid Tier I in Singapore 33

  35. Type Innovative capital with non-cumulative dividends 10 year step/call allowed, callable only with MAS approval Subordination Ranks below all classes of subordinated debt Interest deferral Optional deferral if no common dividend paid in past or current fiscal year or if payment would cause breach of CAR requirements Mandatory deferral? Mandatory deferral if no positive distributable profits at last earnings period Loss absorption Mandatory exchange to preferred shares if breach of CAR requirements or other signal of serious deterioration of financial position Limit Upto 15% of total Tier I capital Singapore—Hybrid Tier I regulatory requirements Korea—Hybrid Tier I regulatory requirements Regulatory differences across Asia • Type • Innovative capital with non-cumulative dividends • 10 year step/call allowed, callable only with FSS approval • Subordination • Ranks below all classes of subordinated debt, senior to junior shares • Interest deferral • Optional deferral of dividends if no common dividends paid in past 12 months, mandatory dividend payment otherwise • Mandatory deferral? • Mandatory deferral if designated (or payment of dividend would cause designation as) • a "non-performing financial institution" or • under a management improvement order or • recommendation (CAR<8% qualifies subject to FSC discretion) • Loss absorption • No conversion conditions • Limit • Upto 15% of total Tier I capital Structure of HT 1 deals out of Singapore Structure of HT I deals out of Korea • JPMorgan has executed both innovative and non-innovative HT I offerings by OCBC • In Jan 2003, OCBC issued its first ever non-equity Tier I transaction with $500mm of Perpetual Preferred Shares sold in the domestic market, being the second Perpetual Preferred to be issued by a Singapore bank • Recently JPM acted as a joint manager for OCBC’s first HT I deal amounting S$400mm in perpetual 10-year step-up format • Post successful offering of innovative HT I in local currency OCBC is now preparing for issuing innovative HT I in foreign currency and the issue is being arranged by JPMorgan • JPMorgan issued the first ever HT I transaction for a Korean Bank, with a $200mm perpetual step-up 10 issue for Hana Bank • Only the second out of non-Japan Asia despite the fact that the deal was done in worst month (December) of year • This was also Hana’s debut international issue and is generally unusual for a bank to tap the global capital markets with a HT I issue 34

  36. Due to lack of clarity on what was acceptable as Tier I, the banks’ efforts led creation of a wide range of Tier I structures (tax-efficient), thus being advantageous to certain banks Hence to create a level playing field among the international the banks, BIS in October 1998 issued a clarification on: Type (Structure) of instruments to be included in Tier I, The limits on types of Tier I (15% limit), Step-up guidelines, and Limitations on issuing tax-deductible instruments The new BIS guidelines were framed to ensure equal access to all international banks to cost-effective tax-efficient Tier I capital issued through Special Purpose Vehicle (SPV) in domestic and international markets Overview of Hybrid Tier I Structures Regulatory considerations Tier I structures—strong v weak Most common form Note: 1 being the most safe and 5 being the most risky 35

  37. Except for dated Hybrid Tier I structures, pricing and trading performance between categories is similar Which structure is chosen is ultimately driven more by regulatory considerations: What is required to achieve Tier I status? Is equity accounting treatment required for Tier I status? Does the issuer have capacity to issue “innovative” Tier I? What factors impact the characterization of Tier I as “innovative”? Is it possible to create tax efficiency from a direct issue? The question of which structure to use is ultimately driven more by regulatory and tax considerations Drawing line between innovative and non-innovative Tier I structures • Vanilla Tier Is • Issued via SPV and with step-ups • Direct issues (RCIs / PROs) • Issued directly by the bank, so no SPV, but with step-ups and coupons are effectively cumulative • Equity settlement • They have no step-ups but all have equity settlement features • Tax-efficient, non-innov. HT I • They have no step-ups but effectively tax-deductible (franked with tax-credits) • Non-innovative • No step-up, directly issued, no stock settlement, non-cumulative coupons Pure Innovative Pure non-innovative A C D E B 36

  38. Direct vs. indirect Direct issues Indirect SPV structure • Features of non tax-deductible direct issues • No step-up • Directly issued • No stock settlement • Coupon mechanism is ‘non-cumulative’ • However the success of such structure by and large depends on whether there exists a domestic retail base to sell such securities • This structure achieves both the objectives of HT I issue efficiently • Use of step-up create an economic maturity for the instrument, thus making it attractive to institutional investors • Use of SPV structure to create “cumulative dividend payments on the security, thereby making coupon payments effectively tax-deductible How the SPV structure creates tax deductibility Direct issues Direct issue structure SPV issue structure Bank Bank 1 Potential distribution 3 4 Common security proceeds Inter-co security Preferred proceeds 5 Guarantee Preferred shares Preferred proceeds 1 Separate tax treatment 6 2 SPV Common securities Preferred proceeds Investors Preferred shares 2 Investors 37

  39. In complying with the BIS requirements such as perpetual, non-cumulative with discretionary payments, tax deductibility would be lost in most jurisdictions if directly issued. As a result, most Hybrid Tier I is issued via a Special Purpose Vehicle (“SPV”) and then on-lent to the bank via a deeply subordinated perpetual instrument, which contains deferrable (but cumulative) interest payments Regulators lay down mandatory conversion features of Hybrid Tier I issues, in the event of financial distress. For example, in Singapore, this structure would provide a mandatory exchange of the preference shares for Tier I-qualifying shares issued directly by the Bank to investors. Further The MAS has recently tightened requirements with regards to this new security In a consultation paper published in August 2005, the MAS wrote: “At the minimum, this mandatory exchange shall be triggered and shall take effect immediately….”. In a footnote, MAS further clarified that: “The Authority considers it unacceptable for substitution to be contingent on any event, and for the issuance of shares by the Reporting Bank qualifying as Tier I capital to be subject to any delays, such as receipt of approval from investors. 1 The Bank contributes common equity to establish a fully owned, controlled and consolidated SPV 2 SPV issues preference shares to investors The issue is guaranteed by the parent bank or the holding company on a preferred basis this allows the funds to be rated directly on par with directly issued securities 3 4 Funds from preference shares are lent to parent bank via a deeply subordinated loan The interest payments on the loan are paid out of pre-tax income by the bank and flow through the SPV directly to investors 5 As the SPV is not liable for tax if it distributes all of its income, the dividends on the preference shares are effectively tax deductible 6 Tier I structuresVanilla SPV issues Innovative Hybrid Tier I issue through an SPV How SPV structure works Bank Bank How the structure achieves tax-deductibility: Potential 1 3 distribution 4 Common co Inter - - Preferred Guarantee security 5 security proceeds proceeds 6 Separate tax treatment SPV Common securities Preferred shares 2 Preferredproceeds Investors 38

  40. Tier I structures“Payment in kind” structure • The bank can issue a perpetual preferred instrument by using “Payment in Kind” structure, which effectively would be tax-deductible (due to effectively cumulative coupons) and a dated maturity (due to equity put or conversion option at the end of the year 5) • The key features are highlighted below: • Maturity: Undated, perpetual instrument with issuer call option at par, but no economic incentive attached to the call • Dividend payments: Dividends at the discretion of the board and deferrable if dividends are not declared on common stock • Non-cumulative: Deferred dividends do not accumulate. Deferred payments, however, are typically cumulative as deferred coupons must be settled by the proceeds from the fresh sale of equity shares • Ranking: Senior to common equity in right of dividends and liquidation preference, but junior to all forms of debt, including Tier 2 subordinated debt • As a debt instrument in form, the bank can offer the instrument directly to a large pool of international fixed income investors • In addition, as a debt instrument, the instrument may offer tax deductibility on payments How the structure works? • How is tax-deductibility achieved? • Cash dividend payment or “payment in kind” via the issuance of common equity to a trust. This makes the coupon deferral effectively cumulative in nature • How is 5-year effective economic maturity created? • If the securities are not called at the call date at the end of the year 5, the investor can effectively put bonds back to the bank, which has to sell fresh equity in order to repay the bonds at the par The Bank Perpetual preferred instrument Preferred proceeds Investors 39

  41. Direct issues popularly known as Perpetual Regulatory Tier I securities (PROs) or Reserve Capital Instruments (RCIs) have the following features: Directly issued long-dated or perpetual securities Have a call and step-up without the use of an SPV Coupons are effectively cumulative—deferred coupons must be satisfied via the sale of equity to raise cash. This ensures the reserves of the bank are not depleted. Also at times interest on interest is payable Interest on such securities is paid out of pre-tax income and hence tax-deductible How does this differ from UT II PROs/RCIs rank ahead of equity in liquidation and behind all debt (including UT II). Also spreads on such securities are likely to be more volatile than UT II Such securities (with a step-up coupon) are subject to the 15% limit for Hybrid Tier I Tier I structuresDirect issues (PROs, RCIs…) Achieving tax efficiency through a direct issuance Direct issue structure Bank Tax treatment:. Dividends are deductible pretax due to cumulative nature Cash dividend payment or “payment in kind” via the issuance of common equity to a trust Preferred shares Preferred proceeds Investors 40

  42. Traditional Preferred Structure Bank Cash dividend payment with linked tax credit Preferred shares Preferred proceeds 2 1 Investors Tier I structuresTax-efficient, Non-innovative Tier I Preference Shares How it works • Through the “franking” of preference share dividends with a tax credit section, the cash portion of the coupon can be reduced by approximately 20% of the gross amount • An added advantage is that this is achieved without using any of the 15% allowance for tax deductible innovative Hybrid Tier I • With regulatory approval for this structure existing in Singapore, DBS and OCBC have issued a significant amount of preference shares without diluting existing shareholders equity and through the dividends, utilize existing tax credits. This in effect creates the equivalent of tax deductible Tier I if the bank has unutilized tax credits • JPMorgan has worked with both DBS and OCBC in issuing non-innovative preference shares, and possesses a unique familiarity with the allowable features of this product JPMorgan assisted OCBC’s offering of $500mm tax-efficient non-innovative Hybrid Tier I perpetual securities • JPMorgan executed a similar structure for OCBC, which operates in a similar tax regime, and as such is the only international bank with the familiarity and understanding of the issues involved • Importantly, while OCBC is a major underwriter in Singapore, where 100% of the securities were placed, they saw the clear benefit of hiring JPMorgan to advise and structure the transaction in a manner that ensured regulatory approvals, a smooth execution process in partnership with OCBC, and the necessary investor confidence • In relation to the latter, JPMorgan prepared detailed materials to educate investors so that it was feasible to issue an instrument far superior to an earlier issuance in Singapore by DBS Bank • Beyond the structure adopted, JPMorgan also reviewed structures that had incremental cost benefits that are the subject of on-going work in Singapore • Terms of conditions • OCBC issued its first ever non-equity Tier I transaction with S$500mm of Perpetual Preferred Shares sold in the domestic market • The transaction is a Perpetual issue, with a call option at the end of year-5, year-10 and every dividend date thereafter, and provides OCBC with greater flexibility in managing its capital structure going forward • By using section 44 tax credits, OCBC is able to make the issue effectively tax-deductible Tier I, while retaining non-innovative Tier I status • With the nervousness in the equity markets, average returns in the corporate bond market and low deposit rates, the issue provides an attractive tax-advantaged yield relative to bonds/deposits and good returns for the risk relative to equities • The deal was extremely well received, resulting in an over-subscription 41

  43. The regulator recognizes that capital instruments that are economically equivalent to preference shares could be eligible for non-innovative Tier I treatment. These non-innovative Tier Is are defined as instruments that feature the following No step-up Directly issued No stock settlement Coupon mechanism is ‘non-cumulative’ With BIS guidelines limiting innovative HT I to 15% of consolidated banks’ Total Tier I capital and most banks in UK nearing the 15% limit The UK banks wanted to raise Tier I capital without being counted as Tier I capital and hence FSA issued a Consultation paper in October 2002 giving more clarification as to what counts as innovative and subject to 15% limit and what is non-innovative, thus being out of 15% limit However the success of such structure by and large depends on whether there exists a domestic retail base to sell such securities Tier I structuresNon-innovative Tier I preferred securities How the structure works? The Bank Perpetual preferred instrument Preferred proceeds Investors 42

  44. Hybrid Tier I issuance has increased manifold post BIS guidelines in 1998 • From the beginning European and US Banks have been active issuers of Hybrid Tier I capital • By far, European Banks have been the largest issuer of Hybrid Tier I capital with more than half of Hybrid Tier I issued in Euro Amount of Hybrid Tier I issued internationally ($ mm) Top HTI issuers globally Source: Bondware Note: Issuances in $, Euro, STG, Yen, KRW, S$ Source: Company reports, JPMorgan estimates 43

  45. Due to inclusion of equity-like features, hybrid capital exhibit greater volatility SMFG Upper Tier II UFJ Hybrid Tier I 29 July 03: Market sentiment leads to short-term drop in demand 25 May 05: UFJ deferred coupon payment on its OPCO Tier I securities 26 May 05: Immediate impact on pref share price Source: JPMorgan Source: Bloomberg • Subordination increases volatility in price performance hybrid capital instruments, leading to potential for equity–like volatility • 2003: Temporary mismatch in demand led to dramatic drop in SMFG Upper Tier II pricing before demand re-stabilizes • 2005: Deferral of coupon payment (first ever deferral by Hybrid Tier I issuer) leads to substantial drop in UFJ Hybrid Tier I pref share price 44

  46. HSBC’s perpetual subordinated bond price performance during Asian financial crisis Increased volatility in bond prices during Asian financial crisis Source: Bloomberg 45

  47. The investor base in Hybrid Tier I has become broader and deeper over the past five years Private banks form largest part of investor base contribution approx. 60% of the demand for HTI International investor base for Hybrid Tier I is extremely broad and well-developed Rationale for each investor category Widening investor base for UT II issuances • Private clients • Will often buy Hybrid Tier I as a means to achieve a yield pick-up relative to cash deposits that would otherwise be placed with the bank. Private clients are often not sensitive to the risk provisions of capital instrument and will instead focus on name and yield Investor breakdown by industry • Bank • While restrictions are imposed on banks holding the capital of other banks, some jurisdictions do permit up to a % of the banks capital base to be held in the capital instrument of another bank Investor breakdown by geography • Funds • Fixed income funds have become increasingly attracted to HT I. Typically rate of return orientated, these investors often find significant value in the instrument relative to corporate senior debt • Other • Includes some insurance, asset management, and other clients Source: JPMorgan 46

  48. Upper Tier II Applications Structural considerations Markets IBA 47

  49. Why Banks issue Upper Tier II? • Banks prefer to issue UT II as compared to raising equity or Hybrid Tier I capital when • Capacity to issue Lower Tier II is full as they must decide between raising more Tier I/equity or issuing Upper Tier II • Supports growth without diluting the current shareholders’ equity • At the time of acquiring another bank, to provide support for capital ratios, while allowing time for the stock to be re-rated post-realization of revenue and cost synergies • Additional capital is required to write-off non-performing loans and to increase coverage • Equity markets are unfavorable for new issuance resulting in low valuations Upper Tier II offers value to banks as it is significantly lower cost than tax deductible Tier I or equity 48

  50. While Lower Tier II is uniform, significant variation exists with Upper Tier II across jurisdictions Upper Tier II Efficient Inefficient 49

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