Basel III Spurs More Banks to Consider Subordinated Debt

Community bankers facing tougher capital requirements under Basel III are evaluating all available options for raising capital, including an historically overlooked instrument: subordinated debt.

Subordinated debt has its fair share of proponents, who say that issuing debt protects stock values for shareholders, and critics who argue that a limited market for reselling the debt makes it less liquid than common stock.

Still, more bankers are looking into debt issuance, including Doug Hultquist, the president and chief executive of the $2.1 billion-asset QCR Holdings in Moline, Ill. Avoiding shareholder dilution is "at the top of my list," for considering subordinated debt, Hultquist says.

Subordinated debt ranks behind senior debt for legal claims on an issuer's earnings or assets. As a result, subordinated debt typically has a lower credit rating but generates a higher yield for investors than senior debt.

Subordinated debt has been far less common, compared to equity or senior debt, as a vehicle for raising capital. Through Oct. 19, senior debt comprised 59% of all capital raised by banks in 2012, according to SNL Financial in Charlottesville, Va.

Equity, both common and preferred securities, made up 36%. Subordinated debt made up just 5% of all capital raises, at $2 billion.

Industry observers typically point to subordinated debt's complex structures and relative illiquidity to explain the trends. Those challenges could prevent bankers from fully embracing subordinated debt issuance despite concerns about Basel III.

"I don't think that community banks are going to flock to" subordinated debt, says Ron Riggins, a consultant at RP Financial in Arlington, Va. "Most community banks . . . are thinking about equity."

Some investors are optimistic that more banks will consider the instrument as concerns over Basel III implementation mount, including Frank Reppenhagen, who has raised $50 million for subordinated debt investments in community banks.

"This opens up a new realm for what regulators see as common capital," says Reppenhagen, the founder of Community BanCapital in Portland, Ore. "In the conversations we've had with regulators, they see this as good, quality capital."

At the bank holding company level, capital from subordinated debt is counted as Tier 2, or supplemental capital, says Allan Landon, a former chairman and chief executive of Bank of Hawaii and a partner at Community BanCapital. When a parent company transfers the funds to its banking unit, the debt is counted as Tier 1 capital.

"Because you don't have collateral or restrictive covenants, [regulators] allow you to count it as Tier 1 capital at the bank level," says Landon, who is also a director of the $9.8 billion-asset MidFirst Bank of Oklahoma City.

The $13.3 billion-asset PrivateBancorp in Chicago issued $125 million of subordinated debt in mid-October, along with $75 million in common stock, to exit the Troubled Asset Relief Program.

Texas Capital Bancshares in Dallas issued $111 million in subordinated debt in September to increase its holdings of total regulatory capital. The $9.9 billion-asset company's Tier 1 capital ratio rose to 10.4% at Sept. 30 from 9.5% on June 30.

Basel III would also phase out trust-preferred shares as qualified regulatory capital, making subordinated debt a more-attractive option, says Norman Miller, a lawyer at Winstead who advised Texas Capital. "Interest rates are historically low ... and subordinated debt can be a source of stable long-term funding," he says.

Debt is preferable to equity for banks that have cleaned their balance sheets of problematic loans but have not yet seen a recovery in the price of their common stock, Landon says. "For those banks, it's very expensive to issue common stock at a price below book value," he says.

Subordinated debt can also be appealing for privately held banks, and could be used to fund acquisitions or refinance other securities, Reppenhagen says.

A number of privately held banks have recently issued subordinated debt, including include $10.2 billion-asset First National Bank in Omaha, Neb.; the $3.8 billion-asset Johnson Bank in Racine, Wis.; and the $354 million-asset Catskill Hudson Bank in Monticello, N.Y.