Basel III rules are being finalized around the world, and investors will have to come to terms with a new, complicated $1 trillion debt market as banks start to issue new hybrid debt. “A new era of bank hybrid capital is dawning,” writes Citi analyst Hans Lorenzen. “Banks will still have a strong regulatory incentive to issue hybrid debt – indeed, for US banks it is arguably stronger than previously.” Lorenzen estimates that the total market for new hybrid debt to be $1 – $1.4 trillion, with a 40-60 split between AT1 and Tier 2 debt.

Hybrid debt markets 1113 Basel III

Basel III capital requirements

Minimum capital requirements are increasing under the new regime, but banks that hover just above the minimum may be punished by shareholders and bondholders who worry that the bank may be less able to continue payouts and normal operations during the next downturn. Lorenzen admits that trying to guess total issuances worldwide is quite complicated, with lots of “moving parts” but at the end of the day he thinks the hybrid debt market will stay more or less the same size, though more complex.

Basel ii v Basel iii

“The new market will be every bit as, if not even more, complicated than the one it replaces. And unless you’ve spent the last five years living and breathing every regulatory twist and turn, then really getting to grips with it now is a tall order,” he writes.

New way to deal with systematic risks

Aside from trying to navigate a complicated new asset class, people will also need to come to terms with the new system in order to accurately gauge the financial system’s overall health. The basic idea behind Basel III is to force banks to have more of a cushion (in the form of capital and liquidity) in case of another systemic shock. But some critics think the details have derailed the entire effort.

As one example, sovereign debt is considered to be safe under Basel III rules, so banks don’t have to freeze cash to hedge against those agreements. Even if the U.S. debt ceiling debate hasn’t rattled you, the idea that a Spanish bank can take on as much sovereign Spanish debt as it pleases without increasing its liquidity or holdings is troubling.