Dexia Gets EU’s Approval to Convert Preference Shares into Ordinary Shares, a Credit Positive
Last Tuesday, Dexia Credit Local (Baa3/Baa3 stable, b23 ) announced that the European Commission had approved the bank’s plan to convert preference shares held by the Belgian and French governments into ordinary shares. Under Basel III rules, the preference shares would be reclassified as Tier 2 capital from higher-quality common equity Tier 1 (CET1) capital starting 1 January 2018. The conversion plan would bolster Dexia’s core capital buffer and strengthen its loss-absorption capacity, both of which are positive for the bank’s creditors. The European Union’s (EU) sovereign debt crisis of 2011-12 negatively affected Dexia and led the European Commission in December 2012 to approve resolution and recapitalization plans that included the issuance of €5.5 billion of preference shares. Those shares diluted existing shareholders and gave France and Belgium a preference right on future dividends and potential liquidation surpluses, in accordance with the EU’s regulation on state aid. Under Basel III rules, preference shares subscribed by Belgium (53% of the total amount issued) and France (47%) would no longer qualify as CET1 capital after a transitional period that expires on 31 December 2017. To avoid the reclassification of all preference shares (equaling 94% of total shares) as Tier 2 capital, which would materially affect the bank’s CET1 ratio, Dexia and the French and Belgian governments submitted to the European Commission a plan to convert the preference shares into ordinary shares that would be fully eligible in CET1 capital. The plan would preserve some preference rights for the Belgian and French governments on future dividends (which are unlikely) and liquidation surplus. The European Commission has accepted the plan, which awaits approval by the European Central Bank (ECB), Dexia’s supervisor. The ECB currently sets Dexia’s minimum required capital at 9.9% of risk-weighted assets, and breaching that threshold risks prompting the French and Belgian government to further recapitalize the bank to protect its senior unsecured creditors from losses and avoid a default on the debt guaranteed by those governments (which equals 85% of the bank’s total senior unsecured debt). However, such a scenario would cast some doubt on the bank’s capacity to perform its orderly resolution and raise questions about the French and Belgian governments’ ability and willingness to support the bank. Additionally, Dexia’s capital is subject to volatility because of the bank’s low earning-generation capacity, credit spreads affecting accounting reserves deducted from CET1 capital, and credit cost relating to large exposures to the public sector. These factors have led the bank to maintain a buffer above its minimum capital requirement. As of June 2017, Dexia’s CET1 ratio was 17%, but we estimate (using the bank’s June 2017 financial statement) that level could fall to about 11% should the preference shares be reclassified as Tier 2 capital, leaving less headroom above the minimum requirement.
