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Bank roll

The banking industry is changing irrevocably and pockets of value are starting to open up for the selective investor

Never mind jokes about the sunshine of Rio de Janeiro, Nick Clegg has come up with an interesting proposal to redistribute shares in RBS and Lloyds, bought as a firesale rescue in the panic of 2008, to the put-upon UK taxpayer. But does he mean to reward us or punish us?

It is hard to know where to start with the modern banking system. Sub-prime and self-certified mortgages for 110 per cent of the value of the property, wholesale products that diluted and obscured liability, over-extension and under-capitalisation – it is a long and undignified list.

And now we learn that the importance of rescuing Greece is that its public debt is stacked up in the vaults of German and French banks.

Why do we like bank debt? An important theme of the Old Mutual fixed-interest desk has been the healing of the UK and West European banking system. It has been a slower process than we would have liked but we are beginning to identify pockets of value. The ones we like at the moment are deeply buried but perhaps all the more interesting for that.

We need to begin by looking at what is changing. All the G20 financial centres are committed to adopting Basel III by the end of this year, with new rules phasing in from 2013 and due for completion by the end of 2019. The regulations require banks to hold more and better quality capital.

The portion of capital made up of equity will need to rise and the non-equity portion will need to take losses in a crisis to protect the rest of the bank, either by converting to equity on a given trigger or by writing off principal.

Bonds included in the non-equity portion will not be allowed to include incentives for the bank to bring redemption forward to the earliest possible date.

So far so good but the opp-ortunity that interests us is not in the new capital instruments the banks will be issuing, it is in buying out the old.

Other features that will no longer be allowed are “pusher language”, equity settlement or alternative coupon satisfaction mechanisms. Pusher language consists of covenants that tie payment of one bond with payment of another. Equity settlement and ACSM allow an institution to conserve cash – possibly under instruction from a regulator – by honouring a coupon payment in some other way, such as a transfer of common stock.

National and regional regulators are expected to enhance the new rules with gold-plating. The Swiss national regulator, for example, has said it will require a minimum 10 per cent ratio for core tier one, compared with the 7 per cent required by the framework.

The Basel committee on banking supervision, which developed the rules, has also decided that the biggest banks will need to provide 1 to 2.5 per cent additional tier-one capital as common equity.

As deadlines approach, banks will be under pressure to ensure their capital structures are compliant and so are under increasing pressure to redeem as early as possible their non-compliant capital.

We are focusing on stocks trading below redemption value and with the greatest number of features ineligible under Basel III, on the expectation that these are the most likely to be redeemed early.

Banks remain a complex sector at the present time and we are highly selective in where we expect to invest.

We are cautious on senior debt, which is likely to become loss-absorbing as it is drawn into the new European bail-in regimes. We are also avoiding banks in the eurozone, as well those in France and Germany that carry significant peripheral debt.

Our focus is on national champions – whose existence is important to the economy – in the UK and Scandinavia and more selectively in France, the Netherlands and Belgium.

Banks have had a difficult time in recent years, some of their problems, perhaps even the majority, were self-inflicted. They will be different institutions in the future, in part by choice and in part by force of regulation. In our view, the process of transition will open pockets of value for the astute, selective investor.

Christine Johnson is manager of the Old Mutual corporate bond fund

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