Banks juggle €100bn to reduce debt A race by Europe's banks to shore up their balance sheets to meet new rules on capital has led to a wave of offers to bondholders involving tens of billions of euros in debt that could end up shrinking the region's capital market. It has been a busy juggling act. In the past six months, lenders including BNP Paribas, Commerzbank, RBS and UniCredit have offered holders of a range of debt instruments from covered bonds to so-called hybrid debt the chance to sell or swap those notes at a premium to market rates. The activity is part of a reorganisation of banks" balance sheets that enables them to convert debt into higher-quality core tier one capital, rather than embark on a round of dilutive capital raisings. Since October, when France's BPCE announced a tender, more than 20 of Europe's biggest banks have targeted about €100bn of subordinated debt in so-called liability management (LM) exercises, estimated by analysts at Barclays to be equivalent to almost 20 per cent of the European bank capital market. The banks are responding in part to the challenges of the eurozone debt crisis but also to regulatory requirements such as the European Banking Authority's stress test, under which lenders must increase their capital ratios to 9 per cent by June. After the 2008-09 financial crisis a number of banks under stress, notably in the UK, embarked on such LM exercises because they were facing heavy losses. But Andy Burton, co-head of liability management for Europe and Asia at Credit Suisse, says any stigma attached to using LM has vanished and it is no longer seen as "the tool of distressed banks." The main reason to manage liabilities in this way is capital generation, but it becomes more attractive when bond prices are low, as they were at the turn of the year. "Banks are being required to raise additional capital by the EBA and so have looked at all the means available to them," says Miguel Angel Hernandez, credit research analyst at Barclays. When bond prices are low liability management becomes a very attractive way to raise capital. One recent exercise by Credit Suisse focused on retiring old debt and replacing it with new debt instruments well in advance of the 2019 deadline for lenders to comply with Basel III banking regulations. However, analysts also say that LM is accelerating the shrinkage in Europe's bank capital market at a time when the sector is already being squeezed by regulation and the impact of the debt crisis. Mr Hernandez says the number of bank capital instruments in Europe has dropped one-fifth to €400bn since January. As bond prices have rallied this year, so the incentive to shore up capital positions via LM has begun to diminish. Even so, more than €40bn of debt has been bought back. In some cases banks are thought to have acquired securities using cheap, three-year money borrowed from the European Central Bank. Mr Burton says many of this year's deals have been "mop-up trades," issues that have taken more time to come to the market or those where banks have come back to their bonds for a second or third time. Analysts still expect banks to use LM, but less often as the pool of available bonds diminishes. Investor appetite for banks" LM exercises has varied. Take-up by bondholders on a recent RBS transaction, for example, was strong but other exercises have not enjoyed high acceptance levels. Bondholders railed against an offer last year by Santander to exchange €6.8bn of its subordinated bonds for new senior notes at what were regarded as punitive terms, with less than 20 per cent agreeing to the exchange. Neil Williamson, head of European credit research at Aberdeen Asset Management, says Santander's "coercive tender upset a lot of people," prompting some to say they would boycott the bank's future transactions. Investors generally don't like getting back less than they lent a bank. That said, liability management offers can be useful if the bonds have been downgraded and there is no liquidity in the secondary market. Georg Grodzki, head of credit research at Legal & General, says investors are willing to exchange well below par value because they want to reduce their banking sector exposure or are worried about price erosion later. But he also says some investors have been unhappy about the "selfish terms" offered by a few issuers. Others remain firmly focused on the opportunities. Typically, once an issue is identified for tender, it tends to trade up in price. Vaibhav Piplapure, head of structured and illiquid credit at Avoca Capital, says: "If an issuer is going to go through the process of launching a tender offer, they generally try to do so at a premium to the market price so as to incentivise holders to sell the bonds back to the issuer rather than to continue to hold them. Investors that anticipate tenders and acquire securities that may be tendered can make a quick profit if they play their strategy correctly.