Philippine banks are likely to issue more Basel III-compliant Tier 2 instruments, which will be mostly targeted at the domestic market. The issuance will be largely driven by the need to refinance legacy instruments and support growth.

There has been over 50 billion pesos (US$1.15 billion) of Basel III Tier 2 instruments issued to date in the Philippine banking system. This followed the Bangko Sentral ng Pilipinas's (BSP, the country's central bank) unveiling of new Basel III capital rules in January 2013. Government-owned Development Bank of the Philippines (DBP, BB+/Stable) was the first to issue Basel III-compliant securities in November 2013, with its 10 billion peso Tier 2 instrument. Activity picked up following Basel III implementation in January 2014, with issuance to date limited to the local market amid more favourable pricing for the banks and healthy domestic demand from institutional investors and trust accounts.

The issuance of these new types of instruments compares with the over 120 billion pesos in legacy Basel II-Tier 2 capital outstanding, which must be replaced eventually.

Issuance of Basel III Tier 2 securities is also being driven by rapid balance sheet growth in a buoyant economy, where loan growth has averaged 15% recently. The banking system is considered well capitalized with healthy capital buffers above the BSP's Basel III requirements of 8.5% common equity Tier 1 capital adequacy ratio (CAR) and 10% total CAR, but these buffers may erode in a rapidly growing system.

Fitch's approach to rating Basel III capital instruments is to notch down from an issuer's anchor rating based on incremental non-performance and loss severity risks. In the Philippines, the anchor rating is expected to be the viability rating or the equivalent point on the national rating scale. As Basel III-Tier 2 instruments specify that losses are triggered only at the point of non-viability (PONV), the non-performance risk of these securities is judged to be broadly similar to that of senior debt, and therefore Fitch does not apply any incremental notching for non-performance risk for these instruments.

The non-viability trigger in the Philippines is at the BSP's discretion, and includes scenarios such as the injection of public funds to prevent bank failure, or the closure of the bank. Upon non-viability, the loss-absorbing feature of these securities reduces their recovery prospects relative to senior debt. Basel III-Tier 2 securities issued in the Philippines to date incorporate partial, albeit permanent, write-down clauses. As a result, Fitch's base case notching for loss severity risk would be one notch below the bank's anchor rating.

For instance, Metropolitan Bank & Trust Company's (Metrobank, BBB-/Stable) US dollar Basel III-Tier 2 notes, proposed in late 2013, were assigned an expected rating of 'BB(EXP)'. This was one notch below the bank's 'BB+' anchor rating at the time. Metrobank ultimately issued in the domestic market following BSP approval for a peso instrument, raising 16 billion pesos in early 2014. The peso notes are not rated by Fitch.

In the case of subsidiary banks, where Fitch considers it highly likely that the parent bank would provide pre-emptive support to prevent non-viability, the anchor rating applied would be the subsidiary's Issuer Default Rating, which is likely to incorporate some probability of parent support. A case in point is Philippines Savings Bank (PSBank; Not Rated), which issued 3 billion pesos in Basel III-Tier 2 securities in May 2014. PSBank is a 76%-owned subsidiary of Metrobank.

Elaine Koh is a director, financial institutions, at Fitch Ratings