Fixed Income Research

Investment Grade

A Refresher Guide to Bank Capital

22 July 2005

Contacts:
Tom Jenkins
Credit Research
+44 20 7085 2552
tom.jenkins@rbos.com
Corinne Cunningham Michelle Roarty
Credit Research Credit Research
+44 20 7085 4646 +44 20 7085 8491
corinne.cunningham@rbos.com michelle.roarty@rbos.com www.rbsmarkets.com

The Capital Thermometer
Introduction
Capital, in a generic sense, is a bank’s loss-absorption cushion. In 1988 the Basle
Committee highlighted the differing qualities of capital that can be called upon to
cushion a bank in distress, outlining the structure and features of regulatory capital.
Since then, the increasing sophistication of the capital markets has led to greater
stratification of subordinated capital instruments.

This paper is not designed to provide an exhaustive analysis of every capital

15% Hybrid Tier 1 instrument; rather we will focus on some of the prevailing salient issues and examine
< 15% the relative risks of these structures.

NB ‘hybrid’ capital refers to innovative Tier 1. Not to be confused with insurance

hybrid, which is considered any subordinated debt instrument

Definition Description Benchmarks Debt Component

Tier One Core Capital Minimum 4% of risk Pref Stock; Debt - perpetual,
50% Non- weighted assets subordinated, min 5 yr call,
principle deferral, coupon
innovative deferral non-cumulative
Tier 1 < 35%
Upper Tier 2 Supplementary Tier 2 cannot exceed Subordinated, perpetual but
Capital Tier 1. LT2 cannot be principal/interest deferral
more than 50% of T1 cumulative
Lower Tier 2 Subordinated and dated

Tier 3 Market Risk NB Tier 1 must cover Subordinated with principal

Capital 28.6% of market risk and interest deferral but
shorter date (2 year plus)
Total Capital Sum of Tiers 1-3 Minimum 8%. Total
of Tier 2+3 cannot
exceed Tier 1

100% Core equity Feature Step T1 Non-step T1 TPS UT2 LT2

Tier 1 >
50% Bullet 2 2 9 9/2 9/2
Step-up 9 2 2 9 9
Coupon Deferral 9 9 9 9 2
Cumulative 2 2 9 9 2
Loss absorption 9 9 9 9 2
Basic guide only, please refer to page 9 for detail
 A Refresher Guide to Bank Capital Page 2/15

TIER 1 Tier 1
Qualifying components:
„ Paid-up share capital/common stock;

„ Preference stock;

„ Reserves (less revaluation reserves);

The Debt/Equity
„ Retained earnings;
Staircase: Ranking Tier 1
(hybrid & non-innovative)
on liquidation
„ Equity minority interests;
Trust
Preferred „ Innovative (hybrid) Tier 1 capital instruments (to 15%); and,
Securities

„ Perpetual, non-cumulative preference shares (non-innovative) Tier 1 capital

Upper Tier 2
instruments (to 35%).

Tier 1 capital excludes goodwill and other intangible assets, as well as certain equity
Lower Tier 2
investments in inter-group insurance companies and other financial institutions.

Certain tier 1 structures enable banks to deduct coupon payments against tax, thus
cutting the cost burden of preference share dividend payments which are post-tax. As
per the ‘Thermometer’ diagram on page one Tier 1 capital instruments can comprise
together 50% of regulatory Tier 1 capital:

„ Innovative Tier 1 capital is subject to a limit of 15% of total Tier 1 capital (after Tier
The Debt/Equity
1 deductions).
Staircase: Tier 1
(hybrid & non-innovative)
Increasing equity
characteristics of z Innovative Tier 1 is perpetual subordinated debt with a step-up at the call date
debt
and a tax deductible coupon. They can be directly issued from the opco, but are
Upper Tier 2
more typically issued through a tax-efficient SPV.

Trust „ Non-innovative Tier 1 capital plus Innovative Tier 1 capital is subject to a limit of
Preferred
Securities 50% of total Tier 1 capital (after deductions). Non-innovative T1 would typically not
comprise more than 35% of regulatory Tier 1 capital, considering the cheaper
Lower Tier 2 funding costs of innovative Tier 1.

z Non-innovative Tier 1 issuance is characterised as non-cumulative, non-step up

preference shares. It ranks pari passu with other Tier 1 instruments in the event
of liquidation. However, there is a false perception that they would rank junior to
innovative Tier 1 in bankruptcy proceedings.

The reason that we are seeing the popularity once again of the non-innovative Tier 1
instrument is because many banks have filled up the 15% ‘bucket’. As a consequence,
we believe we will see increasing levels of interest in this style of deal, while banks are
still able to issue at such competitive levels.

It is important to remember that National regulators have slightly differing

interpretations which can affect the size an structure of an issue - for example, in
Spain, if any portion of an innovative T1 issue breaches the 15% of tier 1 capital limit,
then none of the issue can be included.

The Royal Bank of Scotland

 A Refresher Guide to Bank Capital Page 3/15

‘HYBRID’ T1 Innovative Tier 1 Capital

Typical features

1. Step-up at call: creates a soft-maturity, and incentive to call at the issue at the call
date;

2. Exceptional (mandatory) deferral of coupon: if a payment would result in a breach of

minimum regulatory capital. Any deferred coupons are non-cumulative;

3. General (optional) deferral of interest: interest can be deferred at any time, but
deferred payment will bear interest;

4. Dividend stopper: the issuer cannot pay dividends on its ordinary shares while
coupons are deferred;

5. Alternative coupon satisfaction mechanism (ACSM) - most likely stock settlement:

Should the issuer defer a coupon, it will be required to sell sufficient common stock to
raise cash to pay investors;

6. Status: Typically rank pari passu with other T1 securities and non-innovative
preference shares;

„ In April 2000, the UK regulator allowed a directly-issued Tier 1 structure that was
tax-deductible and classified as innovative capital: Barclays’ RCI (Reserve Capital
Instrument). Other European regulators have used elements of the structure to
create their own directly-issued transactions.

„ Central to the way in which the structure of the RCI works is the treatment of
interest deferral. Coupon payments are cumulative from the perspective of the
issuer if it opts to defer with no obligation to pay cash, and non-cumulative if it is
forced to defer, and are thus able to be classified as Tier 1. However, stock
settlement is employed to make deferred payments cumulative from the investors’
standpoint, giving weight to the argument that the instrument is debt and, therefore,
the coupon be tax deductible. The stock settlement feature means that the Barclays
must satisfy the coupon payment through the issuance of common stock if it wants
to resume payment on the common stock dividend.

„ TONs, TOPICS, TONICS and PIBS (Permanent Interest Bearing Shares - the
equivalent structure for a mutual society) structures fall into this category.

„ With most innovative structures, typically there is an issuer’s call after 10 years or
longer (particularly in the sterling market). If the issue is not called, the coupon
resets at either a fixed or (more likely) floating-rate at a spread over the prevailing
benchmark rate plus a step-up, usually 100bp over the initial credit spread, but
sometimes more for lower-rated issuers and sometimes less for the better credit
stories. The rationale is that that the issuing bank will probably be able to refinance
more cheaply at the call date and will, therefore, redeem the bonds. Market practice
also presently dictates that bonds will be called at the first call date, thus trying to
negate the element of reputational risk in not calling, and securities are priced to the
first call.

„ For indirectly issued structures (i.e. out of a tax efficient LLC) there is a limited
guarantee which must be sufficiently subordinate so as not to enhance the claims of
the security holders above preference shareholders of the bank.

The Royal Bank of Scotland

 A Refresher Guide to Bank Capital Page 4/15

NON-STEP T1 Non-Innovative Tier 1 - ‘Non-step Tier 1’

As previously noted, banks have increasingly filled up the innovative ‘bucket’, i.e. the
15% of Tier 1 capital which may be comprised of debt-like securities. Yet with relatively
stable earnings and slower growth some banks are aiming to increase the leverage in
their capital structures in order to boost RoE. The prospect of lower core capital
requirements under Basle II for some banks, added to generally robust balance
sheets, is supporting credit ratings despite the increased leverage and lower capital
ratios.

Lack of tax deductibility of the coupon used to be a feature of non-innovative Tier 1,

but for the recent non-step deals the regulators and tax authorities have been treating
it the same as innovative Tier 1, i.e. the regulator attributes it equity status, while the
tax authorities regard it as a bond. One way of doing this (as AIB did with the 4.781%
PnC 14) is to use a UK-based SPV to achieve tax deductibility.

As a rule, with non-innovative Tier 1, the following apply:

1. Status: In a winding up, preference shares rank pari passu with all other T1
instruments, ahead of equity but subordinated to both Upper and Lower Tier 2 debt;

2. Dividend/coupon payments: Dividends can only be paid if there are sufficient

distributable reserves. Obligors may not pay dividends if they fail to meet their capital
ratios. Unpaid dividends are non-cumulative;

3. Loss absorption: Preference shares are available to absorb losses;

4. Step-up: Typically not present;

5. Optional redemption: The terms of the prefs may include the option to redeem the
bonds.

The key difference between non-innovative Tier 1 and innovative Tier 1 is:
„ Step-up at call: the innovative Tier 1 typically has a step-up, providing an
economic incentive to call the bond. Non-innovative deals do not have a step-up,
and investors have to rely on either the prevailing economic environment at the call
date being such that there is no disincentive to call, or the reputational risk to the
obligor to call the paper, or both.

The Royal Bank of Scotland

 A Refresher Guide to Bank Capital Page 5/15

TRUST PREFERRED Trust Preferred Securities - are they Tier 1?

SECURITIES
Background
The US-style Trust Preferred Security (TPS) is in many ways similar to the typical UK-
style hybrid Tier 1. However, there are fundamental differences that offer elements of
structural seniority, and point towards a debt-like (rather than equity-like structure) not
least of which is the various ratings agencies’, and the Fed’s, decisions not to allocate
the same capital credit to the instruments, and instead to treat TPS as subordinated
debt in some instances.

In part, at least, the rationale behind the Federal Reserve Board’s recent (Feb 2005)
move to treat Trust Preferred Securities more harshly from a regulatory capital
standpoint is predicated upon a review of TPS’ principal characteristics. The US does
not allow a distinction between LT2 and UT2 debt.

In February 2005, the Fed announced that it would continue to allow TPS to be
counted in tier 1 capital, subject to stricter quantitative limits. There were several
reasons why the Fed proposed to continue the tier 1 capital treatment for TPS. First,
while the accounting designation has changed, the structure and substance of the
securities have not. TPS continue to offer material equity-like features - ultra long
maturities, deferral rights, and loss absorbency. They also do not affect the banks’
liquidity positions, are easier and more cost-efficient to issue and manage, and are
more transparent and better understood by the market. The Fed was also aware that
foreign banks have issued similar tax-efficient tier 1 capital instruments, so large U.S.
financial institutions could have a competitive disadvantage if they were unable to
count a certain percentage of TPS in tier 1 capital.

The regulatory reporting of TPS reflects GAAP accounting requirements. Originally

TPS were accounted for as minority interests – they are now shown in consolidated
accounts as subordinated loans although this does not change the regulatory
treatment. The Fed is not bound by GAAP accounting in its definition of tier 1 or tier 2
capital, because these are regulatory constructs designed to ensure the safety and
soundness of banking organizations.

Previously the TPS’ limit was 25% of tier 1 capital (essentially core capital less
goodwill). This has since been limited to 15% for ‘internationally active’ bank holding
companies, in line with EU guidelines. Any issuance in excess of Fed limits is treated
as tier 2 capital.

The most common Trust Preferred structure, devised for US banks, has been to issue
from a finance subsidiary (LLC) with a subordinated guarantee from the parent bank
holding company, the so-called trust preferred structure. Typically, the issuer, i.e. the
LLC, is located in a non taxpaying jurisdiction. The subsequent subordinated inter-
company loan back to the parent bank created a tax deduction.

Additionally, the payments on the preferred securities are cumulative, and rely on
interest paid on the underlying subordinated notes, which are in turn on-lent by a tax-
efficient LLC to end investors, and the support/guarantee of the originating bank.
There are no mandatory restrictions on payment of interest or principal although in the
case of severe financial difficulties, the Fed would be likely to pressure the bank into
passing coupon payments.

The Royal Bank of Scotland

 A Refresher Guide to Bank Capital Page 6/15

TIER 2 CAPITAL Tier 2 Capital

Tier 2 capital is classified as supplementary capital under Basle I. It ranks lower than
Tier 1 in the debt/equity ‘staircase’ given its inability to absorb losses as effectively and
its more debt like characteristics. Tier 2 capital cannot exceed Tier 1 capital.

Tier 2 capital comprises:

„ Revaluation reserves and hidden asset values but discounted to 45% of value.

„ Collective Impairment Provision (to a maximum 1.25% of RWA)

„ Subordinated debt

„ Deductions currently include capital required to support other businesses (e.g.

insurance) - likely to change under Basle II with equal deductions from tier 1 and
tier 2 capital.

The ratings of these instruments differ to that of the counterparty’s rating to reflect their
su7bordination. UT2 debt is generally rated between 1-2 notches lower than senior
debt by Moody’s and Fitch (1 notch where the bank is rated above A3/A or where the
Financial Strength Rating is better than C respectively) and 2 notches by S&P while
LT2 debt is rated 1 notch lower by all agencies. Rating agencies do not classify LT2 in
their supplementary capital calculations as this tier of capital does not provide loss
absorption capabilities.

As with Tier 1, the exact nature of the instruments has been left to the discretion of the
local bank regulators and thus their ranking in the event of insolvency and some
characteristics of UT2 and LT2 issues can vary by country. Some examples:

„ LT2 takes priority in liquidation in the UK but ranks alongside UT2 in Germany

„ Some countries permit long dated (as opposed to undated) subordinated debt to be
treated as UT2 and in some cases Tier 1 (e.g. the US via Trust Preferred
Securities)

„ Denmark has only one level of Tier 2 capital.

UPPER TIER 2 Upper Tier 2

UT2 debt is more equity like, it is subordinated to LT2 but ranks ahead of Tier 1 and
equity and its is normally undated but incorporates an optional redemption feature for
the issuer (but only after a minimum of 5 years from issue and subject to regulatory
approval).

Interest and principal may be deferred at the discretion of the issuer but it is accrued –
and this is the key difference between UT2 and Tier 1. Deferral triggers include
insufficient distributable income, inadequate regulatory capital and/or non-payment of
dividends on ordinary shares. In this way, UT2 paper can have dividend
stopper/pusher features similar to Tier 1 but this is on a case by case basis. It is the
deferral language which provides the rationale for the rating agencies notching
differential between UT2 and LT2 debt.

Both LT2 and UT2 will usually feature a step up. Regulators ensure that the step up is
reasonable so that the bank can continue to pay the coupon even if in distress. The
size of the step-up varies by local regulator but as a general rule of thumb for Tier 2
debt, the step up should be no higher than 50bps for the step ups within the first 10
years of the bond and no higher than 100bps over the life of the bond.

UT2 debt is issued less frequently than LT2 because of its higher relative cost and the
large degree of regulatory control. To summarise, the key features of UT2 capital are:

The Royal Bank of Scotland

 A Refresher Guide to Bank Capital Page 7/15

„ Subordinated

„ Perpetual

„ Callable – minimum 5 years

„ Step-up coupons – minimum 5 years

„ Interest/ principal deferral but cumulative

„ Loss absorption i.e. allows the bank to continue to operate as a going concern

„ Trades wider than LT2 due to the perpetual and interest/principal deferral features.

Some regional anomalies include (i) Italy which has a 10 year minimum call period and
no maximum step up; (ii) Germany has dated UT2 instruments with a minimum call
period of 5 years although these are rare and (iii) Denmark as previously mentioned
has only one level of Tier 2 capital which although dated has loss absorption and
interest deferral features more akin to UT2 and a minimum call period of 2 years. In
addition, some regulators are more severe than others in their treatment of UT2 capital
such that if the principle is written down, it cannot subsequently be written back up and
in some cases interest deferral is only at the behest of the regulator.

LOWER TIER 2 Lower Tier 2

LT2 debt is subordinated to senior debt but ranks ahead of UT2 and Tier 1 capital in
the event of liquidation. It can be bullet-dated with a minimum 5 year maturity or
callable, again only with a minimum call of 5 years from issue date and with the
agreement of the regulator. It may or may not have a coupon step up at call, but
frequently it will. When this debt reaches 5 years to maturity, the credit taken into the
BIS calculation is reduced by 20% per annum.

Unlike UT2, non-payment of interest/principal is an event of default and it cannot act

as a loss absorption buffer.

It is generally the most liquid and abundant in the market given its relative cheapness
to issue. Key features of Lower Tier 2:

„ Subordinated

„ Dated – minimum 5 years

„ Callable – minimum 5 years

„ Step-up coupons

„ Regulatory capital element must be amortised over last 5 years of issue (hence the
call is typically structured to fall 5 years before final maturity).

„ LT2 cannot exceed more than 50% of Tier 1

The Royal Bank of Scotland

 A Refresher Guide to Bank Capital Page 8/15

TIER 3 Tier 3
Tier 3 capital was created by the European Union's (EU) Capital Adequacy Directive
(CAD), which came into effect on 1 January 1996, and the Basel Committee on
Banking Supervision's 1996 equivalent 'Amendment to the Capital Accord to
Incorporate Markets Risks'.

Tier 3 bonds are typically shorter dated than other forms of bank capital, but must have
a minimum original maturity of two years. They are also subject to a lock-in clause that
stipulates that neither interest nor principal may be paid (even at maturity) if such
payment means that the bank falls below its overall minimum regulatory capital
requirement.

Tier 3 capital is mainly capped at 5/7ths of market risk exposure, therefore Tier 3 bonds
cannot be issued in as large amounts as other subordinated bonds, which are qualified
as Tier 2 capital.

Key points:Derived from both the CAD and Basle II, Tier 3 debt is specifically
designed to act as capital against the trading book (loosely defined as
encompassing financial instruments held for trading purposes or for hedging
exposures in the trading book).

„ The bond is however a general obligation of the bank and is not directly linked to
the performance of the bank’s trading book.

„ Tier 2 and Tier 3 capital may not exceed Tier 1.

„ Tier 3 is not part of a bank’s capital adequacy calculation with respect to its banking
book, calculated in the normal manner using Tier 1 and Tier 2 only.

„ Tier 3 is permitted to be issued by banks to cover up to 71% (5/7ths) of the

regulatory capital requirement for market risk. A minimum of 2/7ths must be covered
by tier 1 capital.

„ Key features:

o Subordinated, unsecured and fully paid-up;

o Ranks pari passu with LT2 on liquidation;

o Repayment prior to maturity is typically only allowed with the

agreement of the regulator;

o Interest and principal is deferrable, with interest being cumulative;

o Deferral is mandatory and would occur if the bank failed to meet its
minimum statutory capital levels (e.g. tier 1 ratio of 4%, total capital
ratio of 8%);

o The issue can be short dated (minimum 2 years); and,

o The capital treatment of the debt will not be amortised over its life.

The Royal Bank of Scotland

 A Refresher Guide to Bank Capital Page 9/15

Feature Innovative T1 Non-innovative T1 Trust Preferred Upper T2 Lower T2

Perpetual with Perpetual with

Typically perpetual
optional call after optional call after Bullet maturity,
1 with a call date (min 5
specified period - this specified period - this minimum 30 years Dated with optional
Maturity or 10 yrs), but can be
can only be redeemed can only be redeemed n.b. counts as tier 2 call
dated in certain
with the approval of with the approval of for last 5 yrs of life
jurisdictions
the regulator the regulator

Step-up at call. But

No step up at call
step up will not be Normally a feature of
date. Relies on
accepted by regulator UT2. Size of step-up
Step-up economic incentive No step up Yes
if considered too high, at call dependant on
and/or goodwill of
i.e. leaving bank no regulator
issuer to call.
option but to call

Optional and subject

to suspension of
ordinary stock
Mandatory or optional Mandatory or optional
dividend payments.
Coupon deferral based on a variety of based on a variety of Optional. No
No mandatory stopper
tests tests
for interest or principal
repayment. Max 5 yr
interest deferral

Cumulative and
Non-cumulative & interest bearing. All
often accompanied by Non-cumulative accrued amounts
Cumulative or Non- 2 Cumulative and
ACSM (interest (interest bearing on must be paid before N/A
cumulative deferral 2 interest bearing.
bearing on optional optional deferral) resuming dividend
3
deferral) payment. Cash
settlement of coupons

Loss absorption Can absorb loss Can absorb loss Can absorb loss Can absorb loss No

Ranks senior to
equity, prefs, Tier 1
Ranks senior to
Ranks junior to all Ranks junior to all Ranks junior to all instruments. Junior to
equity, prefs and all
senior, LT2 and UT2 senior, LT2 and UT2 senior and vanilla T2 all LT2, T3 and Senior
Tier 1 & UT2
Liquidation securities. Ranks pari securities. Ranks pari securities. Ranks issues. In some
instruments. Typically
passu with other passu with other senior to perpetual jurisdictions UT2 may
pari passu with T3.
tier1/pref structures tier1/pref structures preferred shares. rank pari passu with
Junior to senior debt
LT2 (France,
Germany)

Typical notching R Rating (notching R Rating (notching R Rating (notching R Rating (notching R Rating (notching
4
from senior rating from senior) from senior) from senior) from senior) from senior)

S&P 2 2 2 1-2 1

Moody’s 2 2 1 1 1

Fitch 1 1 1 1 1

N.B. - Please note that regulators differ in the finer points of capital treatment and applying criteria. As a result, this comparison list cannot
be taken as an exact guide, rather a theoretical analysis.

1 Retail targeted deals typically have a call after 5 years

2 ACSM = Alternative Coupon Settlement Mechanism
3 i.e. the interest on the deferred coupons rolls up, even though the coupon itself does not
4 Refers to notching from a senior rating that is at least A- or equivalent

The Royal Bank of Scotland

A Refresher Guide to Bank Capital Page 10/15

Relative Value - Why invest in non-step T1?

At the time of writing, we recommend overweight the non-step Tier 1. The rally that
was seen from the start of the 2005 came to an abrupt halt in late March and the non-
step Tier 1’s - Euro deals only outstanding at that time - manifestly underperformed the
rest of the asset class in the ensuing spread weakness.

Within a ‘financials’ context, these are high beta bonds; and as such they will tend to
exhibit greater volatility, especially in the early life of this emergent asset class as an
institutional investment. Nevertheless we see a compelling rationale for holding these
investments.

Although investors have come to believe that issues with the soft-maturity feature will
almost certainly be called on the first call date, they do require a certain risk premium.
For those issues that do not have a step-up at call - so-called Non-Innovative Tier 1 -
and which are de facto perpetual non-cumulative preference shares, the premium
should thus be even greater. It must be noted that there is absolutely no legal or
regulatory compunction for the obligor to call these issues. For deals with a step-up it
may make economic sense to redeem at call, but for non-step up deals the incentive is
lower, and in investors’ minds is typically predicated on a loss of reputation for the
obligor if it does not do so. However, there is an indirect economic incentive in that
failure to call certain structures (and here we think of the Barclays TON structure)
would result - in most cases - in the necessity to issue new equity at each coupon
settlement date. This is inherently more expensive than refinancing in the debt
markets.

Additionally, provided the prevailing economic environment at the call date is not
materially different then the argument for protecting reputation is rather strong, as
these banks have a frequent need to tap the capital markets at levels that are not
prohibitive. As it is impossible to predict the state of the global economy or to forecast
the future interest rate environment in 2014 or beyond, the risk that the bond is not
called should not feature heavily in the investment decision at this stage in the life of
the bond.

Furthermore, we foresee two reasons for substantial further issuance which will serve
to deepen the liquidity, familiarity and the confidence in the non-step bonds although
supply may temporarily weigh on spreads. As this occurs, we anticipate a greater
confidence in the sub-market and, coincidentally, lower volatility. Firstly, with many
banks approaching, or already having reached, the limit on the 15% ‘bucket’, the non-
step institutional pref. will become an increasingly visible asset class for increasing
regulatory T1 capital. Secondly, and perhaps less obviously, as growth across the
mature banking sectors diminishes, and current high RoE’s become increasingly
difficult to sustain, banks will seek to gear up balance sheets in order to undertake
share buybacks to keep shareholders content.

We consider an extra yield spread as self-evident given the additional embedded

optionality in the bonds, but we do not see a 100bp differential (coincidentally, the
typical step-up at the call date) which we saw in mid-June before the recent rally
started up again, or even half that, as being valid for the 10 yr curve.

The Royal Bank of Scotland

 Example 2: Tier One Notes - TONs - and Tier One Preferred Income Capital Securities
Example 1: Reserve Capital Instrument - RCI - TOPICS

Barclays Bank plc: BACR 7.5% Euro-denominated Perpetual non-call 15 Dec Barclays Bank plc: BACR 6% GBP-denominated Perpetual non-call 15 Jun 2032
2010 (TONs)
Abbey National plc: ABBEY 6.984% GBP-denominated Perpetual non-call 9 Feb 2018
(TOPICS)

Yes. In whole at par after 10 years, and on every coupon Yes. In whole at par on 15/06/2032 (02/09/2018 for TOPICS), and on
Call Call
payment date thereafter. every coupon payment date thereafter.

No, but coupon payments after the first call date may only be settled
Step-up Yes, at the call date. 100bp to 3mo Euribor +295bp. Step-up through the equity settlement mechanism with investors receiving cash.
Thus economic incentive does exist to call TONs and TOPICS.

Annually payable at 7.5%. Cumulative in the event of optional Annually payable at 6% (6.984% for TOPICS). Cumulative in the event
Coupon Coupon

A Refresher Guide to Bank Capital

deferral. Tax deductible. of mandatory deferral, but not interest bearing. Tax deductible.

May opt to defer coupon, but the deferred coupon will then be
settled under ACSM (see below) bearing interest of 200bp over TONs have no optional deferral clause, only mandatory5. TOPICS have
Deferral
coupon rate. Exceptional (mandatory) deferral may occur if the Deferral Terms both. The deferred coupon must be settled under equity settlement.
Terms
Bank falls below regulatory capital minima. Exceptional deferred Deferred coupons are non interest-bearing.
coupons are non-interest bearing, but are cumulative.

Yes. In this instance, common stock settlement. Important difference

Yes. In this instance, common stock settlement of coupon (but
ACSM ACSM with RCIs is deferred TON and TOPICS coupons can only be paid on
not principal).
redemption and only via ACSM.

Dividend Yes. Neither common stock dividends, nor preference share Dividend Yes. Neither common stock dividends, nor RCIs, nor pref share
Stopper dividends, may be paid while deferred coupons are outstanding. Stopper dividends, may be paid while deferred coupons are outstanding.

For both tax and regulatory reasons. If tax deductibility is no
longer germane, or should the terms of Tier 1 eligibility change,
Redemption
then the Bank is able to modify the language on the instruments
to allow them to qualify as Upper Tier 2.
The Royal Bank of Scotland
For both tax and regulatory reasons. If tax deductibility is no longer
germane, or should the terms of Tier 1 eligibility change, then the Bank
Redemption
is able to modify the language on the instruments to allow them to
qualify as Upper Tier 2, or redeem at par.

Regulatory Regulatory
Included in 15% innovative Tier bucket Included in 15% innovative Tier bucket
‘Bucket’ ‘Bucket’

Ranks junior to Senior and Tier 2 securities and pari passu with Rank junior to Senior and Tier 2 securities and pari passu with other
Subordination Subordination
other Tier 1 instruments and preference shares. Tier 1 instruments, RCIs and preference shares.

Page 11/15
5
No explicit language on stipulating that there is no optional deferral, but deferral language is linked to regulatory capital
 Example 3: Tier One Non-Innovative Capital Securities - TONICs
Example 4: Institutionally-targeted, non-innovative, non-step perpetual securities
Anglo Irish Bank Corp: ANGIRI 7.625% GBP-denominated Perpetual non-call
Barclays Bank plc: BACR 4.875% Euro-denominated Perpetual non-call 15 Dec 2014
23 Jul 2027

Yes. In whole at par on 23/07/2027, and on every coupon Yes. In whole at par after 10 years, and on every coupon payment date
Call Call
payment date thereafter. thereafter.

Step-up No. At call date reverts to 6mo Libor +240bp. Step-up No. Coupon reverts to 3mo Euribor +105bp.

Annually payable at 7.625%. Cumulative in the event of optional

Coupon Coupon Payable annually at 4.875%. Non-cumulative in the event of deferral.
deferral. Tax deductible.

A Refresher Guide to Bank Capital

May opt to defer coupon at any time without reason, but the
deferred coupon may be repayed at any time thereafter. These Optional deferral at any time. Mandatory deferral may occur if the Bank
Deferral deferred coupons are cumulative and will bear interest. falls below regulatory capital minima, if the payment is greater than
Deferral Terms
Terms Mandatory deferral will occur if the Bank falls below regulatory distributable reserves, or if the regulator instructs the Bank not to make
capital minima. Mandatory deferred coupons are non-interest payment.
bearing, but are cumulative.

Yes. In this instance, common stock settlement but only

ACSM mandatory for coupons after first call date. Coupons deferred ACSM No
prior to this date may be settled via ACSM if desired.

Yes. Neither common stock dividends, nor preference share

Dividend Dividend Yes. Neither common stock dividends, nor other preference share
dividends, may be paid out while deferred coupons are
Stopper Stopper dividends, may be paid out while deferred coupons are outstanding.
outstanding.

For both tax and regulatory reasons. If tax deductibility is no

longer germane, or should the terms of Tier 1 eligibility change,
Redemption
then the Bank is able to modify the language on the instruments
to allow them to qualify as Upper Tier 2. Regulatory
35% bucket for non-innovative Tier 1 and preference shares
‘Bucket’
Regulatory
The Royal Bank of Scotland

Included in 15% innovative Tier bucket

‘Bucket’

Ranks junior to Senior and Tier 2 securities and pari passu with Ranks pari passu with other prefs, RCIs and TONs. Junior to Tier 2 and
Subordination Subordination
other Tier 1 instruments and preference shares. Senior debt.

Page 12/15
 Important Disclosure Information for Research Recommendations

RBS Credit Research alone has discretion over the contents of a research recommendation and the timing of publication. Generally, reports will be published as
a result of market events rather than on a regular rolling basis and therefore forthcoming coverage cannot be predicted.

Definition of RBS Recommendations

Recommendations Definition
We recommend investors adopt an underweight position versus the corporate bond market in the relevant currency as
Underweight
we expect spreads to underperform the market over a three month time frame.
We recommend investors adopt a neutral position versus the corporate bond market in the relevant currency as we
Neutral
expect spreads to perform in line with the market over a three month time frame.
We recommend investors adopt an overweight position versus the corporate bond market in the relevant currency as we
Overweight
expect spreads to outperform the market over a three month time frame.

RBS Recommendation tables - Financials

These tables details past and present research recommendations made by RBS in the past 12 months and their respective dates of publication.
See overleaf for full detail.
RBS Recommendation table – Banks & Insurance
RBS Recommendations RBS Recommendations
€ £ € £
Date/ of Date/ of Date/ of
As of Change/s Date/ of chnge/s As of Change/s chnge/s Change/s chnge/s Change/s chnge/s
1 July since since 1 July since 1 Jul since As of since since As of since since
Issuers Current 04 1 Jul 04 1 July 04 Current 04 04 1 july 04 Issuers Current 1 Jul 04 1 July 04 1 July 04 Current 1 Jul 04 1 July 04 1 July 04
Insurance
Aegon N N N N Hannover Re N U U-N Jul 04
AIG N N N-O, O-N Oct 04, Jan 05 N N N-O, O-N Oct 04, Jan05 ING Groep N N N N
Allianz O O O-N, N-O Sept 04, Mar 05 L&G U # N-U Jul 05 U N N-U Jul 05
O-N , N- Sept04,
Axa N N N-U, U-N Jul 04, Mar 05 N N Munich Re N O O,O-N Mar 05, Jul 05 N O O-N Jul 05
Aviva O N N-O Apr 05 O O O-N, N-O Aug 04,Mar 05 Old Mutual N N U # N-U Jun 05
AMP N N N N Prudential N N N N N-O,O-N Sept04,Jan 05
Jul+Nov04
N-O,O-N,N- Jan+Jun05,
Clerical Medical N U U-N Sept 04 O N O-N Jun 05 RSA O N N-O, O-U Mar 05,Jun 05 O N O,O-U,U-O July 05
Mar 05, July
Fortis N N Soc of Lloyds N # O-N, O-U 05 O 0-N, N-O Mar05,Apr 05
N-U, U-N, Sep 04, Oct
Friends Provident U N N-U Jun 05 Standard Life O N N-O 04, Mar 05 O N N-O Jan 05
Generali N U U-N Mar 05 Unipol U #
Zurich O N N-O O N N-O Aug 04
Banks
Australia Italy
ANZ N N N N Banca Intesa N O O-N Jul 04 O O
CBA N N BPM N N
Macquarie Bank O # Pop. Milano N N
NAB N N N-U, U-N July 04, Sept 04 N N BPU N N
Westpac N N N N MPS N N
Benelux BNL N U U-N Jan 05
ABN Amro N N N N BPL U U U-N, N-U Jan05, Apr 05
Dexia N N N N Capitalia N N
ING Bank N N N N Sanpaolo IMI N N O O
KBC Bank N N N N Unicredito N N N N
Rabobank N N N N
SNS Bank N #
France Nordic
BFCM N N N N Danske Bank N N N N
BNP Paribas N N N N DnB NOR N N N N
CDEE N N N N Nordea N N N N
Crédit Agricole N N N SEB N N N N
Natexis N N N N Handelsbanke N N N N
Société Générale N N N N Swedbank N N N O O-N Oct 04
Recommendations: O = Overweight, N = Neutral, U = Underweight # Recommendation not released at this time
RBS Recommendation table – Banks & Insurance
RBS Recommendations RBS Recommendations
€ £ € £
Date/ of Date/ of Date/ of Date/ of
As of Change/s chnge/s Change/s chnge/s Change/s chnge/s Change/s chnge/s
1 Jul since since As of since since As of since 1 Jul since As of since since
Issuers Current 04 1 July 04 1 July 04 Current 1 Jul 04 1 July 04 1 July 04 Issuers Current 1 Jul 04 04 1 July 04 Current 1 Jul 04 1 July 04 1 July 04
Germany UK
Commerzbank N N Abbey N U U-N Jul 04 N U U-N
Deutsche Bank N O O-N Aug 04 N N ALLNCE N N N N
Dresdner Bank N O O-N Oct 04 N O O-N Jul 04 Barclays Bank N N N N
Eurohypo U N N-U Feb 05 N N B&B N U U-N Feb 05 N N
HVB O N N-O Jul 05 N N Egg N N N N
Iberia HBOS N U U-N Jul04 O N N-O Jan 05
BBVA N N HSBC Holdings N N N-O, O-N 08+22Jul04 N N N-O, O-N 08+22Jul04
BCP N O O-N Oct 04 N N LLOYDS N O O-N Jul 04 N O O-N Jul 04
BES N O O-N Oct 04 Nationwide N N N N
Banco Sabadell N O O-N Oct 04 Northern Rock N N N N
Caja Madrid N N N N RBS N N N N
CGD N N STANLN N N N N
ESFG N N
Santander N N US
Ireland Bank of America N N N N
AIB N N N N Bear Stearns N N N N
Anglo Irish N # N O O-N Nov 04 Citigroup N N N N
Bank of Ireland N N N N Goldman Sachs N N N O
Irish L&P N N N N JPM U N O-N, N-U Sep04, Jul05 U N N-U Jun 05
Switzerland Lehman N N N N
CRDSUI N N O O Merrill Lynch N N N N
UBS N N N N Morgan Stanley U N N-U Jun 05 U N N-U Jun 05
Recommendations: O = Overweight, N = Neutral, U = Underweight # Recommendation not released at this time

RBS Recommendation table - Supranationals

RBS Recommendations RBS Recommendations
Date/s Date/s
As of Change/s of change/s As of Change/s of change/s
Issuers Current 1 July 04 since 1 July 04 since 1 July 04 Issuers Current 1 July 04 since 1 July 04 since 1 July 04
EIB O O L-Bank O #
Freddie Mac (in €) U U NRW Bank O #
IBRD O O Rentenbank O #
Italy U U World Bank O O
KFW O O O-U, U-O Mar 05, Jun 05
Recommendations: O = Overweight, N = Neutral, U = Underweight # Recommendation not released at this time
 Credit Strategy
Kit Juckes +44 20 7085 1304 kit.juckes@rbos.com
Owen Gallimore Asia +81 (0)3 6266 3854 owen.gallimore@rbos.com
Juan Esteban Valencia +44 20 7085 8432 juan.valencia@rbos.com
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Investment Grade Credit Research
Corinne Cunningham Financials +44 20 7085 4646 corinne.cunningham@rbos.com
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ABS and Structured Credit Research
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