Archive for the ‘Contingent Capital’ Category

S&P Revises Bank Outlook to Stable on Federal Complacency

Saturday, December 12th, 2015

Standard & Poor’s has announced:

  • •We continue to evaluate the likelihood, degree, and timeframe with respect to which the default risk of systemically important Canadian banks may change as a result of the government’s progress toward introducing a bank bail-in framework.
  • •We now expect that the timeframe could be substantially longer than we had previously assumed. We see the absence of the topic from the new government’s Dec. 4 Speech from the Throne as recent, incremental evidence in this regard.
  • •We now do not expect to consider the removal of rating uplift for our expectation of the likelihood of extraordinary government support from the issuer credit ratings (ICRs) on systemically important Canadian banks until a point beyond our standard two-year outlook horizon for investment-grade ratings, if at all.
  • •When and if we remove such uplift, the potential ratings impact will also consider uplift for additional loss-absorbing capacity, as well as any changes to our stand-alone credit profiles on these banks.
  • •As a result, we are revising our outlooks on all systemically important Canadian banks to stable from negative.

RATING ACTION
On Dec. 11, 2015, Standard & Poor’s Ratings Services revised its outlooks on the Canadian banks that it views as having either “high” (Bank of Montreal, The Bank of Nova Scotia, Canadian Imperial Bank of Commerce, Royal Bank of Canada, The Toronto-Dominion Bank), or “moderate” (Caisse centrale Desjardins and National Bank of Canada) systemic importance, to stable from negative (see ratings list). The issuer credit ratings (ICRs) on the banks are unchanged.

RATIONALE
We believe that the potential negative ratings impact of a declining likelihood of extraordinary government support, at least within our standard two-year outlook horizon, has subsided. This reflects our updated view that there could be an extended implementation timetable–2018 or later–for the proposed Canadian bail-in framework. Importantly, at the point we would consider removing any uplift from the likelihood of extraordinary government support from our ratings, we would also consider the potential ratings impact of any uplift for additional loss-absorbing capacity (ALAC), as well as any
changes to our stand-alone credit profiles (SACPs) on these banks. In our view, the extended timetable introduces some potential that either the presence of ALAC or fundamental changes in credit quality at individual banks might come into play more than under the previously contemplated timetable.

We had revised our outlooks on systemically important Canadian banks to negative chiefly in reaction to the former government’s “Taxpayer Protection and Bank Recapitalization Regime” consultation paper of Aug. 1, 2014, as we then expected a bail-in regime could be fully implemented by 2016 (see “Outlook On Six Big Canadian Banks Revised To Negative Following Review Of Bail-In Policy Proposal,” published Aug. 8, 2014, on RatingsDirect). A number of subsequent developments have caused us to re-evaluate this expectation:

  • •In its April 2015 budget proposal, the former government affirmed its intention to introduce a bank bail-in regime in Canada, but it provided only very limited additional information relative to what it had outlined in its 2014 consultation paper; nor did the government make substantial subsequent public statement on the topic; nor did it specify timing for the announcement of its fully-developed (post-consultation) legislative proposal.
  • •The Oct. 19 federal election changed the party in government to Liberal (center-left), from Conservative (center-right). The former government’s proposed bail-in regime did not feature prominently in election debates.
  • •The new government’s Dec. 4 Speech from the Throne made no mention of the proposed bail-in framework, nor were any of the legislative priorities enumerated therein closely related, in our opinion. We believe this indicates the introduction of a bail-in framework is not among the immediate priorities of the new government.

Moreover, with Canada experiencing no government bank bail-outs, nor large bank failures, for decades, we believe the political incentive to rapidly end “too-big-to-fail” is less in Canada than in the U.S. and several EU countries, which are jurisdictions under which we have already removed uplift for our expectation of the likelihood of extraordinary government support from our ratings (see “U.S. Global Systemically Important Bank Holding Companies Downgraded Based On Uncertain Likelihood Of Government Support,” and “Most European Bank Ratings Affirmed Following Government Support And ALAC Review,” both published Dec. 2, on RatingsDirect). We will take this factor into consideration as we continue to evaluate our view on the likelihood of extraordinary government support in Canada relative to not only the U.S. and Europe, but also other jurisdictions where we maintain a government support assessment of “supportive” or “highly supportive” under our criteria (such as for many countries in Latin America and Asia-Pacific; see “Banking Industry Country Risk Assessment Update: November 2015,” published Nov. 27).

We now believe the procedural hurdles to passing legislation and related regulations (the latter after passage of the former) for a bail-in regime will alone require a minimum of one-to-two years, after the new government decides on a final legislative framework to propose to Parliament. Considering all of this, we now expect the eventual date for initial implementation of the bail-in regime (that is, banks issuing bail-inable debt) could be in 2018 or later.

In addition, and in contrast to bail-in frameworks outlined by U.S. authorities or in European countries like Germany, Canadian officials’ statements have made clear that only debt issued or renegotiated after an initial implementation date would be subject to conversion. It will take some time for the banks to issue or renegotiate bail-inable debt. We believe this means it could take several years after the initial implementation date before we would consider a Canadian bail-in regime effective, so as to provide a viable alternative to the direct provision of extraordinary government support.

As well, and again in contrast to the U.S. and EU jurisdictions, Canadian governments have made no attempt to limit their ability to provide direct extraordinary support to their banks, if needed. We expect bailing in senior creditors to be the first Canadian policy response in the face of a crisis. At the same time, we believe Canadian governments would be likely to consider all policy options, in such a circumstance. It is therefore not certain that the introduction of a bail-in regime would of itself result in our revising our government support assessment on Canada to “uncertain” from the current “supportive” and the removal of rating uplift for our view on the likelihood of extraordinary government support from our ICRs on systemically important Canadian banks. Rather, our decision would depend, among other factors, on the details of the eventual bail-in regime, including the extent to which bail-inable and unbail-inable senior debt is distinguishable.

Partly to honor G-20 and other international commitments, the Canadian government will, we expect, present a finalized legislative proposal for the bail-in framework in 2016 or 2017. However, we expect an implementation date that could be in 2018 or later, and we think it could take at least one and possibly several years more for substantial bail-in eligible debt to be in place. With a runway that long, the potential ratings impact from removing uplift for the likelihood of extraordinary government support is beyond our standard two-year outlook horizon for investment-grade ratings, and could by then be more meaningfully affected by either ALAC uplift (from the bail-inable debt, assuming our related criteria are met) or SACP changes, than under the previously contemplated timetable.

When the government presents the detailed provisions of the framework, along with a more specific timeframe, we will review the applicable notching for various bank liabilities, taking into account the framework’s implications on different instruments. We expect that issue ratings on new bail-inable instruments will be at a level that is notched in reference to banks’ SACPs, while ratings on non-bailinable senior debt may continue to incorporate rating uplift above the banks’ SACPs, based on our expectation of the likelihood of extraordinary government support, or ALAC.

OUTLOOK
Our outlooks on the systemically important Canadian banks are stable, based on our reassessment of the likelihood, degree, and timeframe with respect to which the default risk of systemically important Canadian banks may change as a result of the government’s progress toward introducing a bank bail-in framework. We believe that the likelihood of extraordinary government support will continue to be a factor in systemically important Canadian bank ratings throughout the current outlook period.

Moreover, we believe these banks will continue to exhibit broad revenue diversification, conservative underwriting standards, and strong overall asset quality. Our current view is that the impact of low oil prices on their profitability and credit quality will be contained, given the modest direct exposure of the banks to the oil and gas sector, and the limited knock-on impact so far on consumer credit in regional economies affected by low oil prices.

On the other hand, we continue to monitor a number of key downside risks to our ratings on these banks, including low margins, high Canadian consumer leverage, residential real estate prices we believe are at least somewhat inflated in some parts of Canada, a Canadian macroeconomic outlook that is very tentative, and the higher-risk nature of certain recent foreign acquisitions.

The August 2014 imposition of Outlook-Negative was reported on PrefBlog, as was the federal consultation on the recapitalization regime. As far as I can tell, the comments received on the consultation paper have not been published; I believe this is because Canadians are too stupid to understand smart stuff like legislation and parliament and all that – if given a pile of comments to work through, we’d probably try to eat them.

Issues affected are:

BMO.PR.K, BMO.PR.L, BMO.PR.M, BMO.PR.Q, BMO.PR.R, BMO.PR.S, BMO.PR.T, BMO.PR.W, BMO.PR.Y and BMO.PR.Z

BNS.PR.A, BNS.PR.B, BNS.PR.C, BNS.PR.D, BNS.PR.L, BNS.PR.M, BNS.PR.N, BNS.PR.O, BNS.PR.P, BNS.PR.Q, BNS.PR.R, BNS.PR.Y and BNS.PR.Z

CM.PR.O, CM.PR.P and CM.PR.Q

NA.PR.Q, NA.PR.S and NA.PR.W

RY.PR.A, RY.PR.B, RY.PR.C, RY.PR.D, RY.PR.E, RY.PR.F, RY.PR.G, RY.PR.H, RY.PR.I, RY.PR.J, RY.PR.K, RY.PR.L, RY.PR.M, RY.PR.N, RY.PR.O, RY.PR.P RY.PR.W and RY.PR.Z

TD.PF.A, TD.PF.B, TD.PF.C, TD.PF.D, TD.PF.E, TD.PF.F, TD.PR.S, TD.PR.T, TD.PR.Y and TD.PR.Z

Update On OSFI Insurer Regulation

Thursday, December 10th, 2015

OSFI Assistant Superintendent Neville Henderson gave a speech to the 2015 Life Insurance Invitational Forum:

Domestic Insurance Capital Standards

On the domestic front, we are still on track to implement OSFI’s new life insurance regulatory capital framework in 2018. The new capital framework will provide a superior risk based assessment methodology for determining capital requirements. The new test will make use of more current analysis and methodologies as well as explicitly taking into account mitigating actions and diversification benefits. It will allow our capital requirements to remain state of the art compared to those of other jurisdictions.

The capital changes in the new framework are explicitly calibrated to a consistent level of conditional tail expectation (CTE) across the various risks. Actuarial valuation of insurance company liabilities are explicitly intended to include conservative margins with the degree of conservatism varying across risks.

To help ensure that this approach results in consistent capital measures across companies, OSFI has asked the Canadian Institute of Actuaries and the Actuarial Standards Board to consider certain issues with a view to updating actuarial standards and /or guidelines if required.

To avoid double counting and inconsistent treatment of different risks, this new framework will include margins for adverse deviations as an available capital resource.

While we are awaiting the results of Quantitative Impact Study (QIS)7, we are in the process of planning to conduct two framework runs, one in 2016 followed by another one in 2017. These “test drives” will allow us to validate the new capital test and help insurers gear up for the updated regulatory compliance requirements under the new framework.

We should also have a final guideline ready for issue in July 2016, following input from the industry on the draft. Any anomalies uncovered in the testing will be taken into consideration prior to implementation. This will allow time for industry feedback and enable insurers to plan and prepare their systems for implementation of the framework in early 2018.

Global Insurance Capital Developments

While work continues on the domestic front, there are also developments in standards for internationally active insurers.

The International Association of Insurance Supervisors (IAIS) is refining the Basic Capital Requirement (BCR) and Higher Loss Absorbency (HLA) requirements for Global Systemically Important Insurers (GSIIs) for implementation in 2019. Work in this area is aimed at mitigating or avoiding risks to the global financial system.

To eventually replace the BCR, the IAIS is developing an internationally agreed upon risk based capital test. The Insurance capital standard (ICS 1.0) for the broader list of Internationally Active Insurance Groups (IAIG) will be ready by the end of 2016, for implementation in 2019.

OSFI looks carefully at the Canadian marketplace and Canadian requirements before deciding whether to adopt international standards. We will take ICS into consideration as we fine tune our current capital tests. The work we do on the OSFI life insurance framework already includes many of the changes stemming from these international standards and we don’t expect ICS 1.0 to be as sophisticated as our current Minimum Continuing Capital and Surplus Requirements (MCCSR) capital test. Consequently, we do not foresee a need to implement any significant changes.

The significant changes will likely come as ICS 2.0 is finalized. It may bring sufficient worldwide convergence for OSFI to start thinking about implementation.

The important thing about ICS is that this is what will determine whether or not preferred shares must be convertible into equity (or have other pre-bankruptcy capital loss absorption features) in order to be counted as Tier 1 capital. This proposal is outlined in the Consultation Paper “Risk-based Global Insurance Capital Standard” which is available in a ludicrously inconvenient manner, paragraph 92 with associated question 25:

92. The IAIS is considering a requirement for a principal loss absorbency mechanism to apply to Tier 1 instruments for which there is a limit. This principal loss absorbency mechanism would provide a means for such instruments to absorb losses on a going-concern basis through reductions in the principal amount in addition to cancellation of distributions.

Question 25. Should Tier 1 instruments for which there is a limit be required to include a principal loss absorbency mechanism that absorbs losses on a going-concern basis by means of the principal amount in addition to actions with respect to distributions (e.g. coupon cancellation)? If so, how would such a mechanism operate in practice and at what point should such a mechanism be triggered?

OSFI’s response to this question is available in the document “Compiled Responses to ICS Consultation 17 Dec 2014 – 16 Feb 2015”, which is also available in a ludicrously inconvenient manner:

No, OSFI does not support the inclusion of a principal loss absorbency mechanism on Tier 1 instruments for which there is a limit. Tier 1 instruments must be able to absorb losses on a going concern basis, which these instruments do through coupon cancellation.

Despite this, I expect that OSFI will adopt whatever ends up being in ICS, as in this way any future criticism will be deflected to the international body and they will be able to keep their jobs and continue angling for future employment with those whom they currently regulate.

OSFI’s response to this – and other – questions has never been explained to the Canadian public as far as I know, because we’re disgusting taxpayer and investor scum, not worth the dirt underneath our own fingernails.

Further discussion of the capital standard and my reasons for believing that the NVCC rule will be applied to insurers and insurance holding companies are provided in every edition of PrefLetter.

No CoCos, Please, We’re British

Tuesday, August 5th, 2014

Retail investors in the UK have been barred from buying Contingent Capital instruments:

The U.K.’s Financial Conduct Authority will ban firms from selling contingent convertible bonds to individual investors, saying they’re too complex and risky for the mass retail market.

From Oct. 1, the FCA will limit sales of CoCos to institutional, professional investors and high-net-worth individuals for 12 months, the London-based regulator said in a statement today. The FCA will publish a consultation paper on a set of permanent set of rules for CoCos in September.

“In a low interest rate environment, many investors might be tempted by CoCos offering high headline returns,” Christopher Woolard, the FCA’s director of policy, risk and research, said in a statement today. “However, they are complex and can be highly risky.”

“Every time a bank gets into trouble and you have retail investors in subordinated debt or CoCos, it gets difficult and embarrassing for the regulators,” said Mark Taber, who helped organize a group of individual holders of Co-Operative Bank Plc bonds when the British lender was restructured following a capital shortfall. “They don’t want to have that problem every time that happens. They want to be able to deal with banks.”

Their press release states:

Temporary product intervention rules are made without prior consultation and thus will not undergo the usual process for testing draft rules and receiving feedback from the public before they are made. While every effort has been made to ensure these temporary rules have the effect described in this communication, we remain aware of the possibility of unintended consequences.

In a linked document the European Securities and Markets Authority acknowledges (emphasis added):

Investors should fully understand and consider the risks of CoCos and correctly factor those risks into their valuation. To correctly value the instruments one needs to evaluate the probability of activating the trigger, the extent and probability of any losses upon trigger conversion (not only from write-downs but also from unfavourably timed conversion to equity) and (for AT1 CoCos) the likelihood of cancellation of coupons. These risks may be highly challenging to model. Though certain risk factors are transparent, e.g., trigger level, coupon frequency, leverage, credit spread of the issuer, and rating of instrument, if any, other factors are discretionary or difficult to estimate, e.g. individual regulatory requirements relating to the capital buffer, the issuers’ future capital position, issuers’ behaviour in relation to coupon payments on AT1 CoCos, and any risks of contagion. A comprehensive appreciation of the value of the instrument also needs to consider the underlying loss absorption mechanism and whether the CoCo is a perpetual note with discretionary coupons (AT1 CoCos) or has a stated maturity and fixed coupons (T2 CoCos). Importantly, as one descends down the capital structure to sub-investment grade where the majority of CoCos sit, the level of precision in estimating value when compared to more highly rated instruments, deteriorates. ESMA believes that this analysis can only take place within the skill and resource set of knowledgeble institutional investors.

The FCA action comes at a time when investor appetite is very high:

Denmark may be forced to amend its policy on how much hybrid debt banks can use to meet capital requirements after European regulators recommended limits.

The European Banking Authority in London is proposing that contingent convertible debt make up no more than 44 percent of the additional capital that national regulators tell the banks they oversee to hold. The so-called Pillar 2 capital is used to address risks not covered by minimum European Union requirements.


Nykredit said in May it expected its 600 million-euro ($805 million) Tier 2 CoCo to be eligible for use as both Pillar 1 and Pillar 2 capital. The lender said at the time it “may be tempted to sell more” following investor demand. The bond, which has a coupon of 4 percent, yielded 3.63 percent today in Copenhagen trading, little changed from yesterday.

Danske sold a 750 million-euro Additional Tier 1 note in March with the intention that the security could be used to meet Pillar 2 requirements, Claus Jensen, the bank’s chief investor relations officer, said by phone. The 5.75 percent note yielded 5.32 percent today, versus 5.33 percent yesterday.

In a Financial Times, piece, Alberto Gallo, head of macro-credit research at RBS, writes:

The worry is that some buyers may not understand the differences and risks of coco structures. Around a fifth of buyers are private clients, and this proportion could rise as the market goes mainstream: the first bond index for cocos was recently initiated by Bank of America Merrill Lynch.

In its last Financial Stability Report, the Bank of England mentioned the investor base for cocos had broadened, but warned that “investors were placing insufficient weight on the likelihood of a conversion being triggered”.

An analysis of existing coco bonds published by RBS shows prices only compensate for the coupon deferral risk, not for potential losses from conversion. Finally, Tobias Berg of Bonn University and Christoph Kaserer of Munich Technical University recently suggested cocos could push banks to take more risk, given their asymmetric risk-return profile with losses skewed towards investors.

No one really knows what would happen if a bank were to suspend its coupon payments, or worse, had to convert its cocos. Several investors fear this could compound volatility or even disrupt the whole market: some already predict 10 percentage point price drops the first time a bank hits a trigger on its cocos.

Regulators must act now to avoid waking up to these problems when it is too late. The first thing to do is flag clearly that cocos are not regular bonds, before investors unaware of the risks start buying. The case of Bankia’s bail-in in Spain highlighted the social pain of pushing losses on to bonds held by retail investors. Cocos can expose holders to cliff-like losses: they are not for orphans or widows.

Second, regulators need to create standards and reduce complexity across jurisdictions, clarifying how triggers and conversion mechanisms really work in a crisis. In doing so, they should favour instruments where the risks and rewards are aligned with shareholders, like cocos that convert into and dilute equity in case of losses, and discourage writedown cocos, where bondholders crystallise losses but get no upside.

All this is happening as Barclays starts marketing a CoCo index:

“CoCo issuance has steadily grown in recent years and we anticipate further expansion of this market as financial institutions issue these bonds to help achieve required regulatory capital ratios,” said Brian Upbin, Head of Benchmark Index Research at Barclays. “Though CoCos are not eligible for broad-based bond indices such as the Global Aggregate, there are debt investors who hold these securities as out-of-index investments and need a benchmark of asset class risk and returns.”

The Barclays Global Contingent Capital Index includes hybrid capital securities with explicit equity conversion or writedown loss absorption mechanisms that are based on an issuer’s regulatory capital ratio or other explicit solvency-based triggers. Subindices by currency, country, credit quality, and capital security type are available as part of this family. Bespoke credit and high-yield indices that include traditional hybrid capital as well as contingent capital securities are also now available with this expanded security coverage. The inception date of this index is May 1, 2014, and the index universe contains 65 CoCo issues with a market value of $98bn as of May 31, 2014.

Barclays also indicates:

“Though CoCos are not eligible for broad-based bond indices such as the global aggregate, there are debt investors who hold these securities as out-of-index investments and need a benchmark of asset class risk and returns,” he [Brian Upbin, head of benchmark index research at Barclays] said.

Barclays plans to exclude securities with conversion features based solely on the discretion of local regulators, those that have an additional equity conversion option based on regulatory or solvency criteria, inflation-linked bonds and floating-rate issues, private placements and retail bonds, and illiquid securities with no available internal or third-party pricing source.

Update, 2014-8-14: It has just occurred to me that this is somewhat akin to Canadian ABCP – where vendors (completely voluntarily and not with a regulatory gun to their heads at all, definitely not) compensated retail investors who lost money. At least the FCA has the decency to ban things before they go wrong … even though it means won’t get a Canadian-style slush fund out of it.

Feds Consulting on Bank Recapitalization Regime

Tuesday, August 5th, 2014

The Ministry of Finance has announced:

a public consultation on a key element of the Government’s comprehensive risk management framework for Canada’s domestic systemically important banks.

The proposed regime focuses on a specific range of liabilities and excludes deposits. In addition, insured deposits will continue to be guaranteed by the Canada Deposit Insurance Corporation.

Comments on the attached draft consultation paper can be submitted to the Department of Finance at ConsultationsFSS-SSF@fin.gc.ca or to the address below. The closing date for comments is September 12.

I think the first thing to observe from this announcement is that this is a deliberate slap in the face to OSFI and an indicator, yet again, of the politicization of the bank regulatory framework.

The consultation paper claims as its objective:

The Taxpayer Protection and Bank Recapitalization regime for Canada’s D-SIBs would allow for the expedient conversion of certain bank liabilities into regulatory capital when a D-SIB fails (i.e., at the point when the institution becomes non-viable). It would thus enable a resolution strategy that protects taxpayers by ensuring that losses are borne by shareholders and creditors of the failed bank while preserving the same legal entity and contracts of the bank (i.e., keeping it open or “continuing”) and, in turn, maintaining the critical services the bank provides to its customers.

… and hints at a favourable view towards a holdco/opco bank structure:

The bail-in (or equivalent) powers introduced or planned in other jurisdictions reflect the way that major banks in those jurisdictions are structured. For example, the U.S. and U.K. have large banking groups that are organized with a non-operating holding company at the top of the group, and operating bank subsidiaries underneath. In contrast, Canadian banks are organized with an operating bank as the top-tier parent company. The Government welcomes views on the potential merits of a holding company model (similar to that of other major jurisdictions) in the context of reforms to strengthen Canada’s bank resolution framework.

It is not clear whether this would or could involve a decrease in the protectionism that has given rise to the Big 6 oligopoly.

… and summarizes:

The purpose of this consultation paper is to set out the major features of a proposed Taxpayer Protection and Bank Recapitalization regime for Canada. The overarching policy objective that drives the design of the regime is to preserve financial stability while protecting taxpayers. This objective is supported by the Taxpayer Protection and Bank Recapitalization regime by:
  • ◾Reducing the likelihood of a D-SIB failure by enhancing market discipline, limiting moral hazard and constraining incentives for excessive risk-taking by ensuring that bank creditors and capital providers bear losses in the event of a D-SIB becoming non-viable;
  • ◾Ensuring that, in the event that a D-SIB experiences severe losses leading to non-viability, it can be quickly restored to viability with no or minimal taxpayer exposure to loss through a resolution strategy which enables conversion of certain liabilities into additional equity capital; and,
  • ◾Supporting D-SIBs’ ability to provide critical services to the financial system and economy during normal times and in the event that a D-SIB experiences severe losses.

First, they want statutory conversion power:

The Government proposes that the cornerstone of the Taxpayer Protection and Bank Recapitalization regime be a statutory power allowing for the permanent conversion—in whole or in part—of specified eligible liabilities into common shares of a bank (see Scope of Applicationbelow) designated as a D-SIB by OSFI,[6] following certain preconditions (see Sequencing and Preconditionsbelow). The power would also allow for (but not require) the permanent cancellation, in whole or in part, of pre-existing shares of the bank. [Footnote]

[Footnote reads]: For greater certainty, this power would only be applied to common shares of the bank which were outstanding prior to the point of non-viability

Two pre-conditions would exist before this statutory conversion:

First, there must be a determination by the Superintendent of Financial Institutions that the bank has ceased, or is about to cease, to be viable. Second, there must be a full conversion of the bank’s NVCC instruments.[8]

Note that these are necessary, but not sufficient, preconditions for the exercise of the conversion power. Authorities would retain the discretion to not exercise the conversion power even if the preconditions had been met. For example, authorities may decide not to exercise the power if conversion of NVCC instruments were deemed to be sufficient to adequately recapitalize the bank.

This would apply to new senior debt; existing senior debt will be grandfathered.

In order to allow for a smooth transition for affected market participants and to maximize legal clarity and enforceability of the Taxpayer Protection and Bank Recapitalization regime, the Government proposes that the conversion power only apply to D-SIB liabilities that are issued, originated or renegotiated after an implementation date determined by the Government. The regime would not be applied retroactively to liabilities outstanding as of the implementation date.

The Government proposes that “long-term senior debt”—senior unsecured debt[9] that is tradable and transferable with an original term to maturity of over 400 days—be subject to conversion through the exercise of the statutory conversion power.[10] Authorities would also have the ability to cancel, in whole or in part, the pre-existing common shares of the bank in the context of exercising the conversion power. This scope of application would minimize the practical and legal impediments to exercising a conversion in a timely fashion. It would also minimize any potential adverse impacts on banks’ access to liquidity under stress and support financial stability more broadly.

They would choose the proportion of senior debt converted, and there would be no ‘cram-down’ on more junior instruments other than common shares:

The Government proposes that authorities have the flexibility to determine, at the time of resolution, the portion of eligible liabilities that is to be converted into common shares in accordance with the conversion power. All long-term senior debt holders would be converted on a pro rata basis—that is, each of these creditors would have the same portion (up to 100 per cent) of the par value of their claims converted to common shares.

Authorities’ determination of the total amount of eligible liabilities to be converted would be based on ensuring that the D-SIB emerges from a conversion well-capitalized, with a buffer of capital above the target capital requirements set by OSFI.

Conversion of eligible liabilities would respect the hierarchy of claims in liquidation on a relative, not absolute, basis. For example, for every dollar of their claim that is converted, long-term senior debt holders would receive economic entitlements (in the form of common shares) that are more favourable than those provided to former NVCC subordinated debt investors, but NVCC subordinated debt investors would not be subject to 100 per cent losses in the context of exercising the conversion power.

Conversion terms would be similar in form to NVCC conversion:

Building on this approach, and to provide greater certainty and transparency to investors and creditors that may be subject to the statutory conversion power, the Government proposes to link the conversion terms it would apply with respect to eligible liabilities to those of outstanding NVCC instruments. Specifically, the number of common shares that would be provided for each dollar of par value of a claim that is converted would be tied to the conversion formulas of any outstanding NVCC instruments.

This approach would be communicated to all market participants in advance, and would be applied as follows: long-term senior debt holders would receive, for each dollar of par value converted, an amount of common shares determined as a fixed multiple, X,of the most favourable conversion formula[12] among the bank’s NVCC subordinated debt instruments (or, if none exists, the bank’s NVCC preferred shares[13]).[14]

As with the overall approach, the fixed conversion multiplier, X, would be set in advance by public authorities through regulation or guidance (and would thus be public information).[Footnote]

[Footnote reads:] For example, a potential range for the conversion multiplier would be 1.1 to 2.0.

As discussed in the post Royal Bank Issues NVCC-Compliant Sub-Debt, the conversion multiplier is essentially affects the floor conversion price of the common (which may be assumed to be very low in a non-viability situation); $5 for preferred shares, For sub-debt, the formula is:

The “Contingent Conversion Formula” is (Multiplier x Note Value) ÷ Conversion Price = number of Common Shares into which each Note shall be converted.

The “Multiplier” is 1.5.

The “Note Value” of a Note is the Par Value plus accrued and unpaid interest on such Note.

The “Conversion Price” of each Note is the greater of (i) a floor price of $5, and (ii) the Current Market Price of the Common Shares.

If they want to keep the senior debt senior to the sub-debt, the conversion multiplier may have to be more than 1.5! However, they’re also giving themselves the ability to cancel existing common, so it doesn’t really matter what the multiplier is.

In a startling nod to the rule of law, there is actually an intention to allow access to the courts to complain!

The Government proposes that shareholders and creditors subject to conversion be entitled to be made no worse off than they would have been if the bank had been resolved through liquidation. The Government further proposes that the process for determining and, if necessary, providing compensation to shareholders and creditors that have been subject to conversion build on existing processes set out in subsections 39.23 to 39.37 of the Canada Deposit Insurance Corporation Act.

The Canada Deposit Insurance Corporation Act contains the usual bafflegab, but essentially allows dissenting bond-holders to take their case for additional compensation to court.

There will be a minimum amount of convertible instruments:

The Government therefore proposes that D-SIBs be subject to a Higher Loss Absorbency (HLA) requirement to be met flexibly through the sum of regulatory capital (i.e., common equity and NVCC instruments) and long-term senior debt (see Scope of Applicationabove) that is directly issued by the parent bank.

The Government proposes that the HLA requirement be set at a specific value (as opposed to a range). The Government further proposes that this value be between 17 and 23 per cent of risk-weighted assets (RWA). For example, a HLA requirement at the low end of this range (17 per cent of RWA) would ensure that banks could absorb losses of 5.5 per cent of RWA and emerge from a conversion with common equity of 11.5 per cent of RWA (Basel III minimum Total Capital Ratio of 10.5 per cent plus a buffer of 1 per cent).

They state an intention to fiddle with deposit insurance:

The Government is committed to ensuring that Canada’s deposit insurance framework adequately protects the savings of Canadian consumers. In this regard, deposits will be excluded from the Taxpayer Protection and Bank Recapitalization regime. As announced in Economic Action Plan 2014, the Government plans to undertake a broad review of Canada’s deposit insurance framework by examining the appropriate level, nature, and pricing of protection provided to deposits and depositors.

This is very mysterious, but I assume that uninsured deposits – and deposit notes! – will be senior to senior debt. I just hope to bloody hell they resolve the BA vs. BDN mystery.

Finally, they list the specific questions they want to pretend to address:

Questions for Consultation

1.Is the proposed scope of securities and liabilities that would be subject to the conversion power appropriate? Why / why not?

2.Is the proposed minimum term to maturity at issuance of 400 days appropriate for the purpose of differentiating between short-term and long-term liabilities?

3.Does the proposed regime strike the correct balance between flexibility for authorities and clarity and transparency for market participants?

4.Is the proposal for a fixed conversion multiplier appropriate? Why / why not? What considerations should be taken into account when setting the value of a fixed conversion multiplier as proposed?

5.Is the proposed form of the Higher Loss Absorbency requirement appropriate? What considerations should be taken into account when setting this requirement?

6.Should authorities have the flexibility to provide compensation to written-down creditors in the form of preferred shares in the bank (i.e., instead of common shares)? Why / why not?

7.What would be an appropriate transition period for implementation of the Taxpayer Protection and Bank Recapitalization regime?

8.Are the proposed objectives for the review of existing resolution powers and incorporation of the conversion power into Canada’s bank resolution framework appropriate? What additional considerations should be taken into account to maximize the effectiveness of the conversion power as part of the overall resolution framework?

9.Could a holding company model provide advantages in the application of the bridge bank powers (i.e., akin to the U.S. approach) or conversion powers (i.e., akin to the U.K. approach)?

As usual, there are two fundamental objections to the proposed scheme: firstly, these are all low-trigger conversions, which might be good enough to resolve a crisis, but do not even attempt to avert a crisis; secondly, it gives powers formerly held by a bankruptcy court to a handful of highly politicized, unscrutinized bureaucrats in the CDIC.

I see the whole thing as a lot of flim-flam; a fig-leaf over the ravaging of the rule of law. In any future horrific scenario, there will be so much uncertainty regarding the fate of capital instruments that a bank in dire straits simply will not be able to issue anything.

Royal Bank Issues NVCC-Compliant Sub-Debt

Friday, July 11th, 2014

Royal Bank of Canada has announced:

an inaugural Basel III-compliant offering of $1 billion of subordinated debentures (“the Notes”) through its Canadian Medium Term Note Program.

The Notes bear interest at a fixed rate of 3.04 per cent per annum (paid semi-annually) until July 17, 2019, and at the three-month Banker’s Acceptance Rate plus 1.08 per cent thereafter until their maturity on July 17, 2024 (paid quarterly). The expected closing date is July 17, 2014 and RBC Capital Markets is acting as lead agent on the issue.

The bank may, at its option, with the prior approval of the Office of the Superintendent of Financial Institutions Canada, redeem the Notes on or after July 17, 2019 at par, in whole at any time or in part from time to time, on not less than 30 days and not more than 60 days notice to registered holders.

We routinely undertake funding transactions to maintain strong capital ratios and a cost effective capital structure. Net proceeds from this transaction will be used for general business purposes.

It’s not clear to me how the floating rate of BAs+108bp was calculated. The Canada 10-year is trading at around 2.20%, the five year around 1.55% and three-month BAs a little above 1.20%. None of these values fits very well with the 3.04% initial rate to provide a 108bp increment.

However, the important thing – for some – is the fact that a clear demarcation exists between the five-year pretend-maturity and the ten-year actual maturity. This will make it easier for the sleazy to sell the debt to the stupid.

Not much meat on those bones. The heart of the matter is the conversion feature, as noted by Moody’s:

Moody’s assigned a rating of Baa1 (hyb) to Royal Bank of Canada’s (RBC, Aa3 Negative, C+/a2 Stable) 3.04% CAD1 billion Basel III compliant NVCC subordinated debt. Proceeds from the issuance will be added to the bank’s general funds and utilized for general banking purposes. The NVCC subordinated debt provides loss absorption as it is subject to automatic conversion into common shares, based on a predetermined conversion formula, at the point of non-viability, as defined by the Office of the Superintendent of Financial Institutions Canada (OSFI), subject to regulatory discretion. This incremental loss absorption feature is credit positive for holders of senior securities of RBC, as a layer of loss absorbing securities will reduce the risk of losses incurred higher in the capital hierarchy if the bank gets into financial distress.

This marks the first issuance in Canada of contractual non-viability subordinated debt. The rating is positioned 2 notches below the a2 adjusted baseline credit assessment (adjusted BCA) of RBC, in line with Moody’s standard notching guidance for contractual non-viability subordinated debt. An additional notch is added relative to the notching for “plain vanilla” subordinated debt with normal loss severity (currently 1 notch below adjusted BCA) to capture the potential uncertainty related to the timing of loss absorption.

By way of comparison, Moody’s has the NVCC-compliant Royal Bank preferreds at Baa3:

This marks the first issuance in Canada of contractual non-viability preferred securities. The rating is positioned 4 notches below the a2 adjusted baseline credit assessment (adjusted BCA) of RBC, in line with Moody’s standard notching guidance for contractual non-viability preferred securities. An additional notch is added relative to the notching for legacy Canadian non-cumulative preferred shares (currently 3 notches below adjusted BCA) to capture the potential uncertainty related to the timing of loss absorption.

Standard and Poor’s explains what makes them more creditworthy than preferreds (bolding added):

The ‘A-‘ rating is two notches below the stand-alone credit profile (SACP), incorporating:
  • •A deduction of one notch from the SACP for subordination, reflecting our belief that the Canadian legal and regulatory framework insulates senior debt from defaults on the subordinated debt; and
  • •The deduction of an additional notch to reflect that the subordinated notes feature a mandatory contingent conversion trigger provision. Should a trigger event occur (as defined by The Office of the Superintendent of Financial Institutions’ [OSFI] guideline for Capital Adequacy Requirements, Chapter 2), each subordinated note outstanding will automatically and immediately be converted, without the holder’s consent, into a number of fully paid and freely tradable common shares of the bank, determined in accordance with a conversion formula.

The following constitute trigger events:

  • •OSFI publicly announces it has advised RBC that it believes the bank has ceased, or is about to cease, to be viable and that, after converting the preferred shares and all other contingent instruments RBC has issued, and taking into account any other relevant factors, it is reasonably likely that the bank’s viability will be restored or maintained; or
  • •The federal government or a provincial government in Canada publicly announces that RBC has accepted a capital injection, or equivalent support, from a government or agency, without which the bank would be nonviable, according to OFSI.

Because we expect this instrument’s conversion to occur at or near the point of the banks’ nonviability, we view this mechanism as a nonviability trigger.

We expect to assign “minimal” (as our criteria describe the term) equity content to these subordinated notes because we do not consider notes that have only nonviability features to be able to absorb losses prior to the bank’s point of nonviability.

By way of comparison, S&P has the NVCC-compliant preferreds at BBB+, one notch lower on the global scale than the Sub-Debts A-.

So OSFI gets a lot of discretion in determining conversion – surprise, surprise! Since bond management firms are typically much larger than preferred share management firms (I believe there’s only one of these in Canada!), and since bond investors are typically much bigger than preferred share investors (aka, “retail scum”) I believe that in a crisis there will be frenzied and successful lobbying of OSFI personnel by their future employers to convert preferreds but to ‘just wait a bit’ before forcing sub-debt conversion.

Blair Keefe, David Seville and Thomas Yeo of Tory’s Law Firm recently wrote an article titled The Preferred Share Market Finally Re-Opens For Canadian Banks:

The market is still waiting for the first offering of NVCC subordinated debt. There are a few reasons why the banks have remained hesitant to tap that market. One reason relates to changes in capital ratios mandated by Basel III, which reduce the need for subordinated debt on a bank’s balance sheet. Prior to the introduction of Basel III, subordinated debt could account for almost one-third of the total capital of a bank. With the new minimum total capital requirement of 10.5%2 (including a countercyclical capital buffer of 2.5%) of risk-weighted assets and a 8.5% minimum for tier 1 capital, effectively the most that can be satisfied with subordinated debt is 2% of the bank’s risk-weighted assets. As well, under Basel III, most deductions from capital must be made from common share equity, whereas in the past, certain deductions could be made from total capital. Effective January 1, 2015, the leverage or asset-to-capital ratio in Canada will be based on tier 1 capital as opposed to total capital. This requirement is particularly important for smaller deposit-taking institutions because they tend to be limited by their asset-to-capital multiples. As a result, we expect that subordinated debt will be eliminated from the capital structure of many smaller institutions—and will form a significantly smaller portion of the capital structure of larger institutions than it has historically.

Market uncertainty also remains over how the proposed “bail-in” debt regime will interact with NVCC instruments. In October 2011, the Financial Stability Board issued a paper providing that regulators should have the power to convert (or write off) all or part of the unsecured and uninsured creditor claims of a financial institution under resolution into equity or other ownership instruments. It was proposed that such a conversion would be done in a manner that respects the hierarchy of claims in liquidation. The 2013 Canadian federal government budget includes a proposed plan to implement a “bail-in” regime for systemically important banks3; Canadian banks and the market generally are still waiting for details as to how the federal government intends to implement this regime. The institutional investors that make up the vast majority of the market for subordinated debt are particularly concerned with how the bail-in regime will function and the effect of further dilution after NVCC instruments are converted, resulting in a “wait-and-see” approach to investor interest in NVCC subordinated debt offerings.

The precise conversion formula to be adopted by the banks for NVCC subordinated debt is not yet known. Under OSFI’s requirements, conversion formulas for both NVCC preferred shares and subordinated debt need to be set to ensure respect for the relative hierarchy of claims between the two types of instruments in the event of a triggering event. In other words, since debt ranks ahead of equity in the traditional capital structure, in the event of a triggering event, holders of subordinated debt should receive more common shares on conversion than holders of preferred shares on a dollar-for-dollar basis. The banks have put substantial effort in the development of a formula used in the preferred share offerings which addresses concerns about potential market manipulation and death spirals in situations where conversion appears to be a possibility. As of the date this article was written, all offerings of NVCC preferred shares have used the same formula based on the issue price of the preferred shares, plus declared and unpaid dividends, divided by the volume- weighted average trading price over the 10 trading days before a triggering event, subject to a $5.00 floor price. It is unlikely that other banks will depart from this formula. The preferred share formula would suggest that the conversion formula for subordinated debt will use some multiple of the principal amount of the debt, together with accrued interest, to achieve the hierarchy of claims desired by OSFI. Issuers of NVCC subordinated debt should consider obtaining an advance income tax ruling from the Canada Revenue Agency confirming the deductibility by the bank of the interest payments, although we anticipate no difficulty in banks obtaining that ruling.

So my guess is that not only will the sub-debt benefit by delayed conversion, but the floor on the conversion price to equity will be lower – say, $3-4 instead of the now-standard $5 floor for preferreds. Senior “debt”, presumably, will be lower still.

The next matter of interest is whether this non-debt gets included in the bond indices; given that they’re bank issues, and the banks own TMX, and TMX runs the standard index (this arrangement has been blessed by the regulators, in exchange for regular payments), I’d say it’s a slam-dunk. But I have no information yet.

Update, 2014-7-12: OK, so I found the term sheet on SEDAR. It’s not under Prospectus, it’s under “Marketing Materials”, dated July 9. The conversion is:

The “Contingent Conversion Formula” is (Multiplier x Note Value) ÷ Conversion Price = number of Common Shares into which each Note shall be converted.

The “Multiplier” is 1.5.

The “Note Value” of a Note is the Par Value plus accrued and unpaid interest on such Note.

The “Conversion Price” of each Note is the greater of (i) a floor price of $5, and (ii) the Current Market Price of the Common Shares. The floor price of $5 will be subject to adjustment in the event of (i) the issuance of Common Shares or securities exchangeable for or convertible into Common Shares to all holders of Common Shares as a stock dividend, (ii) the subdivision, redivision or change of the Common Shares into a greater number of Common Shares, or (iii) the reduction, combination or consolidation of the Common Shares into a lesser number of Common Shares. The adjustment shall be computed to the nearest one-tenth of one cent provided that no adjustment of the Conversion Price shall be required unless such adjustment would require an increase or decrease of at least 1% of the Conversion Price then in effect.

“Current Market Price” of the Common Shares means the volume weighted average trading price of the Common Shares on the Toronto Stock Exchange (the “TSX”), if such shares are then listed on the TSX, for the 10 consecutive trading days ending on the trading day preceding the date of the Trigger Event. If the Common Shares are not then listed on the TSX, for the purpose of the foregoing calculation reference shall be made to the principal securities exchange or market on which the Common Shares are then listed or quoted or, if no such trading prices are available, “Current Market Price” shall be the fair value of the Common Shares as reasonably determined by the board of directors of the Bank.

It’s interesting that they’re implementing this with a conversion factor, rather than changing the floor price. Just what the implications of that might be is something that will bear thinking about.

Update, 2014-7-18: DBRS rates at A(low) [Stable].

Market-Based Bank Capital Regulation

Wednesday, March 5th, 2014

Assiduous Reader DR sent me the following query:

Today’s Financial Posts has an article “A better Basel mousetrap to protect taxpayers”, by Finn Poschmann regarding NVCC.

What is your opinion?

A short search brought up the article in question, A Better Basel Mousetrap to Protect Taxpayers, which in turn led me to the proposal by Jeremy Bulow and Paul Klemperer titled Market-Based Bank Capital Regulation:

Today’s regulatory rules, especially the easily-manipulated measures of regulatory capital, have led to costly bank failures. We design a robust regulatory system such that (i) bank losses are credibly borne by the private sector (ii) systemically important institutions cannot collapse suddenly; (iii) bank investment is counter-cyclical; and (iv) regulatory actions depend upon market signals (because the simplicity and clarity of such rules prevents gaming by firms, and forbearance by regulators, as well as because of the efficiency role of prices). One key innovation is “ERNs” (equity recourse notes — superficially similar to, but importantly distinct from, “cocos”) which gradually “bail in” equity when needed. Importantly, although our system uses market information, it does not rely on markets being “right.”

Our solution is based on two rules. First, any systemically important financial institution (SIFI) that cannot be quickly wound down must limit the recourse of non-guaranteed creditors to assets posted as collateral plus equity plus unsecured debt that can itself be converted into equity–so these creditors have some recourse but cannot force the institution into re-organization. Second, any debt guaranteed by the government, such as deposit accounts, must be backed by government-guaranteed securities. This second rule can only realistically be thought of as a very long-run ambition – our interim objective would involve a tight ring-fence of government-guaranteed deposits collateralized by assets that are haircut at rates similar to those applied by lenders (including central banks3 and the commercial banks themselves!) to secured borrowers.

Specifically: first, we would have banks replace all (non-deposit) existing unsecured debt with “equity recourse notes” (ERNs). ERNs are superficially similar to contingent convertible debt (“cocos”) but have important differences. ERNs would be long-term bonds, subject to certain term-structure requirements, with the feature that any interest or principal payments payable on a date when the stock price is lower than a pre-specified price would be paid in stock at that pre-specified price. The pre-specified price would be required to be no less than (say) 25 percent of the share price on the date the bond was issued. For example, if the stock were selling at $100 on the day a bond was issued and then fell below $25 by the time a payment of $1000 was due, the firm would be required to pay the creditor (1000/25) = 40 shares of stock in lieu of the payment. If the stock rebounded in price, future payments could again be in cash.

Crucially, for ERNs, unlike cocos:

  • any payments in shares are at a pre-set share price, not at the current share price or at a discount to it—so ERNs are stabilizing because that price will always be at a premium to the market
  • conversion is triggered by market prices, not regulatory values—removing incentives to manipulate regulatory measures, and making it harder for regulators to relax requirements
  • conversion is payment-at-a-time, not the entire bond at once (because ERNs become equity in the states that matter to taxpayers, they are, for regulatory purposes, like equity from their date of issuance so there is no reason for faster conversion)–further reducing pressures for “regulatory forbearance” and also largely solving a “multiple equilibria” problem raised in the academic literature
  • we would replace all existing unsecured debt with ERNs, not merely a fraction of it—ensuring, as we show below, that ERNs become cheaper to issue when the stock price falls, creating counter-cyclical investment incentives when they are most needed.

OK, so I have difficulties with all this. Their first point is that non-guaranteed creditors “cannot force the institution into re-organization.” Obviously there are many differences of opinion in this, but I take the view that being able to force a company into re-organization – which may include bankruptcy – is one of the hallmarks of a bond. For example, I consider preferred shares to be fixed income – as they have a cap on their total return and they have first-loss protection – but I do not consider them bonds – as they cannot force bankruptcy. The elimination of bankruptcy, although very popular among politicians (who refer to bankruptcy as a form of terrorism) is a very big step; bankruptcy is a very big stick that serves to concentrate the minds of management and directors.

Secondly, they want insured deposits to be offset by government securities. There’s an immediate problem about this in Canada, because insured deposits total $646-billion while government of Canada marketable debt totals $639-billion. You could get around this by saying the CMHC-guaranteed mortgages are OK, but even after years of Spend-Every-Penny pouring fuel on the housing fire, CMHC insurance totals only $559.8-billion (out of a total of $915-billion. At present, Canadian Chartered Banks hold only about $160-billion of government debt. So it would appear that, at the very least, this part of the plan would essentially force the government to continue to insure a ridiculous proportion of Canadian residential mortgages.

And, specifically, they want all (non-deposit) existing unsecured debt with “equity recourse notes”. OK, so how much is that? Looking at recent figures from RBC:

RBCBalanceSheet
Click for Big

So roughly a quarter of Royal Bank’s liabilities would become ERNs …. and who’s going to buy it? It’s forcibly convertible into equity long before the point of non-viability – that’s the whole point – so for risk management purposes it is equity. If held by another bank, it will attract a whopping capital charge (or if it doesn’t, it should) and it can’t be held by institutional bond portfolios (or if it is, it shouldn’t be). I have real problems with this.

The paper makes several entertaining points about bank regulation:

The regulatory system distorts incentives in several ways. One of the motivations for Citigroup to sell out of Smith, Barney at what was generally believed to be a low price, was that it allowed Citi to book an increase in regulatory capital. Conversely, selling risky “toxic assets” with a regulatory value greater than market is discouraged because doing so raises capital requirements even while reducing risk.[footnote].

[Footnote reads] : Liquidity reduction is another consequence of the current regulatory system, as firms will avoid price-discovery by avoiding buying as well as selling over-marked assets. For example, Goldman Sachs stood ready to sell assets at marks that AIG protested were too low, but AIG did not take up these offers. See Goldman Sachs (2009). For an example of traders not buying even though they claimed the price was too low, see the FCIC transcript of a July 30, 2007 telephone call between AIG executives. “We can’t mark any of our positions, and obviously that’s what saves us having this enormous mark to market. If we start buying the physical bonds back … then any accountant is going to turn around and say, well, John, you know you traded at 90, you must be able to mark your bonds then.” Duarte (2012) discusses the recent trend of European banks to meet their requirements to raise regulatory capital by repurchasing their own junk bonds, arguably increasing the exposure of government insurers.

However, don’t get me wrong on this: the basic idea – of conversion to a pre-set value of stock once the market breaches that pre-set value – is one that I’ve been advocating for a long time. They are similar in spirit to McDonald CoCos, which were first discussed on PrefBlog under the heading Contingent Capital with a Dual Price Trigger (regrettably, the authors did not discuss McDonald’s proposal in their paper). ERNs are ‘high-trigger’ instruments, and therefore will help serve to avert a crisis, rather than merely mitigate one, as is the case with OSFI’s NVCC rules; I have long advocated high triggers.

My basic problem is simply that the authors:

  • Require too many ERNs as a proportion of capital, and
  • Seek to Ban the Bond

However, it may easily be argued that these objections are mere matters of detail.

New RBC / NA / CWB reset prefs

Monday, February 3rd, 2014

I have been asked, in an eMail with the captioned title:

Not sure this is going to the right place. Can’t find anyone else to send these comments to.

I owned a number of bank “rate reset” prefs. In the past year, many have been redeemed, and a few have been reset for another 5 years.

There are 3 new issues that recently came out (RY / NA / CWB) with changes to factor in the new Basel capital requirements. My understanding is that basically, if real bad things happen to the bank, the shares can be converted to commons without the holders consent.

In my mind, this is a major negative change to an investor’s position compared to the previous reset prefs. But the pricing of these new issues (either the rate or reset premium) does not seem to give any value to the additional risk. In addition, there does not seem to be any discussion or commentary of the additional exposure anywhere. Is it possible that the people selling these new issues might have a bit of a conflict position (the brokerage houses are all owned by the banks).

Do you have any thoughts on this? If you agree, how does one convince the market that the pricing needs to be adjusted?

I would appreciate any comments you might have – maybe I’m missing something in my thinking. Thank you.

The new issues referred to are:

The desire for change is fueled by political resentment that European banks were bailed out while Tier 1 Capital note-holders were not wiped out and in some cases were unscathed (see my article Prepping for Crises; particularly the footnoted draft version. Or you could just google “burden sharing”).

As I have stressed in the past the big problem is that the Superintendent of Financial Institutions has a huge amount of discretion:

Principle # 3: The contractual terms of all Additional Tier 1 and Tier 2 capital instruments must, at a minimum Footnote 41, include the following trigger events:
  • a.
    the Superintendent of Financial Institutions (the “Superintendent”) publicly announces that the institution has been advised, in writing, that the Superintendent is of the opinion that the institution has ceased, or is about to cease, to be viable and that, after the conversion of all contingent instruments and taking into account any other factors or circumstances that are considered relevant or appropriate, it is reasonably likely that the viability of the institution will be restored or maintained; or
  • b. a federal or provincial government in Canada publicly announces that the institution has accepted or agreed to accept a capital injection, or equivalent support, from the federal government or any provincial government or political subdivision or agent or agency thereof without which the institution would have been determined by the Superintendent to be non-viable Footnote 42.

The term “equivalent support” in the above second trigger constitutes support for a non-viable institution that enhances the institution’s risk-based capital ratios or is funding that is provided on terms other than normal terms and conditions. For greater certainty, and without limitation, equivalent support does not include:

  • i. Emergency Liquidity Assistance provided by the Bank of Canada at or above the Bank Rate;
  • ii. open bank liquidity assistance provided by CDIC at or above its cost of funds; and
  • iii. support, including conditional, limited guarantees, provided by CDIC to facilitate a transaction, including an acquisition or amalgamation.

In addition, shares of an acquiring institution paid as non-cash consideration to CDIC in connection with a purchase of a bridge institution would not constitute equivalent support triggering the NVCC instruments of the acquirer as the acquirer would be a viable financial institution.

The first trigger is the tricky one, although there are also problems with number 2.

This uncertainty has led DBRS to rate these issues a notch lower than other bank issues (in line with S&P’s earlier decision), but there doesn’t appear to be any market recognition of this analysis.

This is precisely what the regulator wants – they have long been in favour of a low trigger for contingent conversion, in opposition to much of the rest of the world. As discussed on October 27, 2011 (the internal link is broken as part of OSFI’s policy to discourage public discussion of their pronouncements), OSFI dismissed high-triggers; while there were lots of rationalizations in their NVCC roadshow, the real reason was articulated by Ms. Dickson in a speech:

The conversion trigger would be activated relatively late in the deterioration of a bank’s health, when the supervisor has determined that the bank is no longer viable as currently structured. This should result in the contingent instrument being priced as debt. Being priced as debt is critical, as it makes it far more affordable for banks, and therefore has the benefit of minimizing the impact on the costs of consumer and business loans.

So to hell with high-trigger CoCos and their potential to avert a crisis! In normal times, it will be cheaper for the banks to issue low-trigger CoCos and thereby be able to pay their directors more, particularly the ones who are ex-regulators.

So that’s the background. With respect to the reader’s question:

If you agree, how does one convince the market that the pricing needs to be adjusted?

Well, you can’t, really. I get a lot more requests to recommend bank issues, good solid Canajun banks, none of this insurance or utility garbage, on the grounds of “safety”, than I get requests to comment on risk factors particularly applicable to bank issues.

All you can do is make your own assessment of risk and your own assessment of reward, feed all your analysis into the sausage-making machine, hope you’ve made fewer analytical errors than other market participants and that the world doesn’t change to such a degree that analysis was useless anyway. Which isn’t, perhaps, the most detailed advice I have ever given, but it’s the best I can do.

Contingent Capital: The Case for COERCs

Saturday, April 6th, 2013

A question in the comments to my old post A Structural Model of Contingent Bank Capital led me to look up what Prof. George Pennacchi has been doing lately; together with Theo Vermaelen and Christian C. P. Wolff he has written a paper titled Contingent Capital: The Case for COERCs:

In this paper we propose a new security, the Call Option Enhanced Reverse Convertible (COERC). The security is a form of contingent capital, i.e. a bond that converts to equity when the market value of equity or capital falls below a certain trigger. The conversion price is set significantly below the trigger price and, at the same time, equity holders have the option to buy back the shares from the bondholders at the conversion price. Compared to other forms of contingent capital proposed in the literature, the COERC is less risky in a world where bank assets can experience sudden, large declines in value. Moreover, the structure eliminates concerns of an equity price “death spiral” as a result of manipulation or panic. A bank that issues COERCs also has a smaller incentive to choose investments that are subject to large losses. Furthermore, COERCs reduce the problem of “debt overhang,” the disincentive to replenish shareholders’ equity following a decline.

The basic justification for the COERCs is:

In contrast to the Credit Suisse coco bond [with accounting and regulatory triggers], the trigger is based on market value based leverage ratios, which are forward looking, rather than backward looking, measures of financial distress. It also means that at the time of the triggering event the stock price is known, unlike in the case of coco bonds with accounting based capital ratio triggers. As the trigger is driven by the market and not by regulators, regulatory risk is avoided. The conversion price is set at a large discount from the market price at the time of conversion, which means that conversion would generate massive shareholder dilution. However, in order to prevent this dilution, shareholders have an option to buy back the shares from the bondholders at the conversion price. In practice, what will happen is that when the trigger is reached, the company will announce a rights issue with an issue price equal to the conversion price and use the proceeds to repay the debt. As a result, the debt will be (almost) risk-free. In our simulations, we show that it is possible to design a COERC in such a way that the fair credit spread is 20 basis points above the risk-free rate. So although the shareholders are coerced to repay the debt, the benefit from this coercion is reflected in the low cost of debt as well as the elimination of all direct and indirect costs of financial distress. Although at the time of the trigger, the company will announce an equity issue, there is no negative signal associated with the issuance as the issue is the automatic result of reaching a pre-defined trigger.

Market based triggers are generally criticised because they create instability: bond holders have an incentive to short the stock and trigger conversion. Moreover, the fear of dilution may encourage shareholders to sell their shares so that the company ends up in a self-fulfilling death spiral. However, because in a COERC shareholders have pre-emptive rights in buying the shares from the bondholders, they can undo any conversion that is result of manipulation or unjustified panic. Moreover, because bondholders will generally be repaid, they have no incentive to hedge their investment by shorting the stock when the leverage ratio approaches the trigger, unlike the case of coco bonds where bondholders will become shareholders after the triggering event. The design of the contract also discourages manipulation by other bondholders. Bolton and Samama (2010) argue that other bond-holders may want to short the stock to trigger conversion, in order to improve their seniority. However, because the COERCs will be repaid in these circumstances such activity will not improve other bondholder’s seniority.

Further justification is given as:

Our objective is to propose an alternative, an instrument that a value maximizing manager would like to issue, without being forced by regulators. Companies are coerced to issue equity and repay debt by fear of dilution, not by the decision of a regulator. Imposing regulation against the interest of the bank’s shareholders will encourage regulatory arbitrage and may also reduce economic growth.6 If bankers, on the other hand, can be convinced that issuing contingent capital increases shareholder value, then any regulatory “encouragement” to issue these securities will be welcomed. Our proposal is therefore more consistent with a free market solution to the general problem that debt overhang discourages firms from recapitalizing when they are in financial distress. Hence the COERC should be of interest to any corporation where costs of financial distress are potentially important.

It seems like a very good idea. One factor not considered in the paper is the impact on equity investors.

Say you have an equity holding in a bank that has a stock price (and the fair value of the stock price) slightly in excess of the trigger price for its COERCs. At that point, buyers of the stock (and continuing holders!) must account for the probability that the conversion will be triggered and their will be a rights issue. Therefore, in order to avoid dilution, they must not only pay the fair market value for the stock, but they must also have cash on hand (or credit lines) available that will allow them to subscribe to the rights offering; the necessity of having this excess cash will make the common less attractive at its fair market value. This may serve to accelerate declines in the bank’s stock price.

It is also by no means assured that shareholders will be able to sell the rights anything close to their fair value.

A Goldman Sachs research report titled Contingent capital Possibilities, problems and opportunities is also of interest. Canadians panic-stricken by the recent musings in the federal budget (see discussion on April 1, April 2 and April 5) will be fascinated by:

Bail-in is a potential resolution tool designed to protect taxpayer funds by converting unsecured debt into equity at the point of insolvency. Most bail-in proposals would give regulators discretion to decide whether and when to convert the debt, as well as how much.

There is an active discussion under way as to whether bail-in should be a tool broadly applicable to all forms of unsecured credit (including senior debt) or whether it should be a specific security with an embedded write-down feature.

Naturally, this discussion is not being held in Canada; we’re too stupid to be allowed to participate in intelligent discussions.

As might be expected, GS is in favour of market-based solutions and consequent ‘high-trigger’ contingent capital:

Going-concern contingent capital differs substantially from the gone-concern kind. It is designed to operate well before resolution mechanisms come into play, and thus to contain financial distress at an early stage. The recapitalization occurs at a time when there is still significant enterprise value, and is “triggered” through a more objective process with far less scope for regulatory discretion. For investors to view objective triggers as credible, however, better and more-standardized bank disclosures will be needed on a regular basis. Because this type of contingent capital triggers early, when losses are still limited, it can be issued in smaller tranches. This, in turn, allows for greater flexibility in
structuring its terms.

When the early recapitalization occurs, control of the firm can shift from existing shareholders to the contingent capital holders, and a change in management may occur. The threat of the loss of control helps to strengthen market discipline by spurring the firm to de-risk and de-leverage as problems begin to emerge. As such, going-concern contingent capital can be an effective risk-mitigating tool.

GS further emphasizes the need to appeal to fixed income investors:

Contingent capital will only be viable as a large market if it is treated as debt

Whether “going” or “gone,” contingent capital will only be viable as a large market if it is treated as debt. This is not just a question of technical issues like ratings, inclusion in indices, fixed income fund mandates and tax-deductibility, though these issues are important. More fundamentally, contingent capital must be debt in order to appeal to traditional fixed income investors, the one market large enough to absorb at least $925 billion in potential issuance over the next decade.

Surprisingly, GS is in favour of capital-based triggers despite the problems:

A capital-based trigger would force mandatory conversion if and when Tier 1 (core) capital fell below a threshold specified either by regulators (in advance) or in the contractual terms of the contingent bonds. We think this would likely be the most effective trigger, because it is transparent and objective. Investors would be able to assess and model the likelihood of conversion if banks’ disclosure and transparency are enhanced. Critically, a capital-based trigger removes the uncertainty around regulatory discretion and the vulnerability to market manipulation that the other options entail.

Capital-based triggers are also vulnerable to financial reporting that fails to accurately reflect the underlying health of the firm. Lehman Brothers, for example, reported a Tier 1 capital ratio of 11% in the period before its demise – well above the regulatory minimum and a level most would have considered healthy. The same was true for Bear Stearns and Washington Mutual before they were acquired under distress. We think this issue must be resolved for investors to embrace capital-based triggers.

Fortunately there are several ways to make capital ratios more robust, whether by “stressing” them through regulator-led stress tests or by enforcing more rigorous and standardized disclosure requirements that would allow investors to better assess the health of the bank. Such standardized disclosures could relieve regulators of the burden of conducting regular stress tests, and would significantly enhance transparency. The value of stress testing and greater disclosures is one lesson from the financial crisis. The US Treasury’s 2009 stress test illustrates this point vividly. While not perfect, it offered greater
transparency and comparability of bank balance sheets than investors were able to derive from public filings. With this reassurance, investors were willing to step forward and commit capital. The European stress test proves the point as well: it did not significantly improve transparency and thus failed to reassure investors or attract capital.

That is the crux of the matter and I do not believe that the Gordian Knot can be cut in the real world. The US Treasury made their stress test strict and credible because it knew in advance that its banks would pass. The Europeans made their stress test ridiculous and incredible because they knew in advance that their banks would fail.

I liked their succinct dismissal of regulatory triggers:

While flexibility can be helpful, particularly given that no two crises are alike, recent experience shows that some regulators may be hesitant to publicly pronounce that a financial firm is unhealthy, especially during the early stages of distress. There is, after all, always the hope that the firm’s problems will be short-lived, or that an alternative solution to the triggering of contingent capital can be found. Thus a regulator may be unlikely to pull the trigger – affecting not only the firm and all of its stakeholders, but also likely raising alarm about the health of other financial firms – unless it is certain of a high degree of distress. By then, losses may have already risen to untenable levels, which is why this type of trigger is associated with gone-concern contingent capital.

GS emphasizes the importance of the indices:

The inclusion of contingent capital securities in credit indices will also be an important factor, perhaps even more important than achieving a rating. This is because the inclusion itself would attract investors, who otherwise might risk underperforming benchmarks by being underweight a significant component of the index. Credit indices currently do not include mandatorily convertible equity securities, although they can include instruments that allow for loss absorption through a write-down feature. This again contributes to the appeal of the write-down feature (rather than the simple conversion to equity) to most fixed income investors. If contingent capital securities were included in credit indices, this addition would be likely to drive a substantially deeper contingent capital market.

Here in Canada, of course, the usual benchmark is prepared by the TMX, which the regulators allowed to become bank-owned on condition that it improved the employment prospects for regulators. It’s a thoroughly disgraceful system which will blow up in all our faces some days and then everybody will pretend to be surprised.

GS is dismissive of regulatory triggers and NVCC:

A discretionary, “point of non-viability” trigger would likely be attractive to many regulators as it helps them to preserve maximum flexibility in the event of a financial crisis. This can be useful given that no two crises are exactly alike. It could also allow regulators to consider multiple factors – including the state of the overall financial system – when making the decision to pull the trigger. Discretion also gives regulators the opportunity to exercise regulatory forbearance away from the public spotlight.

Yet we believe this preference for discretion and flexibility makes it difficult for regulators to meet one of their most important – yet mostly unspoken – goals, which is to develop a viable contingent capital market. Regulators have certainly solicited feedback from investors, but some seem to believe that simply making contingent capital mandatory for issuers means that investors will buy them. However, from conversations with many investors, we believe that regulators may need to move toward a more objective trigger; if not, the price of these instruments may be prohibitive.

There is another set of participants in a potential contingent capital market: taxpayers. Regulators represent taxpayers’ interests by promoting systemic stability and requiring robust loss-absorption capabilities at individual banks. But the interests of regulators and taxpayers may not always be fully aligned. If taxpayers’ principal goal is to avoid socializing private-sector losses, and to prevent the dislocation of a systemic crisis even in its early stages, then they should want a stringent version of contingent capital – one that converts to equity at a highly dilutive rate, based on an early and objective trigger. The discretion and flexibility inherent in regulatory-triggered gone-concern contingent capital may have less appeal to taxpayers. From their standpoint, gone-concern contingent capital might well have allowed a major financial firm to fail, causing job losses and other disruptions across the financial system. Taxpayers may find the potential risk-reducing incentives created by going-concern contingent capital to be a more robust answer to the problem of too big to fail.

Goldman’s musings on investor preference can be taken as an argument in favour of COERCs:

Traditional fixed-income investors will likely want contingent capital to have a very low probability of triggering, which leads them to prefer an objective, capital-based and disclosure-enhanced trigger. Many investors have indicated their concerns about the challenges of modeling a discretionary trigger: it is very difficult to model the probability of default, the potential loss given default or even the appropriate price to pay for a security that converts under a discretionary and opaque process. Greater transparency is a prerequisite for a capital-based trigger to be seen as credible by investors, because they will need to have greater confidence that banks’ balance sheets reflect reality. We also believe that investors would be more likely to embrace a capital-based trigger if the terms were quite stringent, thereby lowering the probability of conversion.

Credit Suisse to Issue High-Trigger CoCos

Wednesday, July 18th, 2012

Under pressure from the Swiss bank regulator Credit Suisse is issuing High-Trigger CoCos:

Credit Suisse today announced a number of measures to accelerate the strengthening of its capital position in light of the current regulatory and market environment. An immediate set of actions will be implemented to increase the capital by CHF 8.7 billion. Additional capital actions and earnings related impacts are to increase the capital by a further CHF 6.6 billion by year-end 2012.

The measures will result in an expected end-2012 look-through Swiss Core Capital Ratio of 9.4%, compared to the 2018 requirement of 10%. Look-through Swiss Core Capital includes look-through Basel III Common Equity Tier 1 (CET1) and existing participation securities (“Claudius notes”) that qualify as part of the Swiss equity requirement in excess of the 8.5% Basel III G-SIB Common Equity Tier 1 (CET1) ratio.

The measures will result in an expected look-through Swiss Total Capital Ratio of 10.8% at end 2012. This broadly compares to the figure of 5.9% calculated by the Swiss National Bank (SNB) at the end of 1Q12 and published in its 2012 Financial Stability Report. Look-through Swiss Total Capital includes look-through Basel III CET1 and the participation securities (“Claudius notes”). Additionally it includes the Group’s Buffer Capital Notes (“CoCos with high trigger”).

There are no details available on the projected notes, but they have some Tier 2 Buffer Capital Notes outstanding.

For example, there is a USD 2-billion issue of 7.875 per cent. Tier 2 Buffer Capital Notes due 2041:

Interest on the BCNs will accrue from and including 24 February 2011 (the ‘‘Issue Date’’) to (but excluding) 24 August 2016 (the ‘‘First Optional Redemption Date’’) at an initial rate of 7.875 per cent. per annum, and thereafter at a rate, to be reset every five years thereafter, based on the Mid Market Swap Rate (as defined herein) plus 5.22 per cent.

If a Contingency Event or a Viability Event (each as defined herein) occurs, the BCNs shall, subject to the satisfaction of certain conditions, mandatorily convert into Ordinary Shares (as defined herein) which shall be delivered to the Settlement Shares Depository (as defined herein) on behalf of the Holders, as more particularly described in ‘‘Terms and Conditions of the BCNs—Conversion’’. In the event of a Contingency Event Conversion (as defined herein), such Ordinary Shares may, at the election of CSG, be offered for sale in a Settlement Shares Offer as described herein.

Contingency Event means that CSG has given notice to the Holders that CSG’s Core Tier 1 Ratio (prior to the Basel III Regulations Date) or the Common Equity Tier 1 Ratio (on or after the Basel III Regulations Date) is below 7 per cent. as at the date of the financial statements contained in a Quarterly Financial Report and that a Contingency Event Conversion will take place.

Viability Event means that either: (a) the Regulator has notified CSG that it has determined that Conversion of the BCNs, together with the conversion or write off of holders’ claims in respect of any other Buffer Capital Instruments, Tier 1 Instruments and Tier 2 Instruments that, pursuant to their terms or by operation of laws are capable of being converted into equity or written off at that time, is, because customary measures to improve CSG’s capital adequacy are at the time inadequate or unfeasible, an essential requirement to prevent CSG from becoming insolvent, bankrupt or unable to pay a material part of its debts as they fall due, or from ceasing to carry on its business; or (b) customary measures to improve CSG’s capital adequacy being at the time inadequate or unfeasible, CSG has received an irrevocable commitment of extraordinary support from the Public Sector (beyond customary transactions and arrangements in the ordinary course) that has, or imminently will have, the effect of improving CSG’s capital adequacy and, without which, in the determination of the Regulator, CSG would have become insolvent, bankrupt, unable to pay a material part of its debts as they fall due or unable to carry on its business.

The BCNs will be converted into a number of Ordinary Shares determined by dividing the principal amount of each BCN by the Conversion Price in effect on the relevant Conversion Date. ‘‘Conversion Price’’ means (i) at any time when the Ordinary Shares are admitted to trading on a Recognised Stock Exchange, in respect of any Conversion Date, the greatest of (a) the Reference Market Price of an Ordinary Share on the fifth Zurich Business Day prior to the date of the relevant Contingency Event Notice or, as the case may be, the Viability Event Notice translated into United States dollars at the Exchange Rate, (b) the Floor Price on the fifth Zurich Business Day prior to the date of the Contingency Event Notice or, as the case may be, the Viability Event Notice; and (c) the nominal value of each Ordinary Share on the Share Creation Date (being, at the Issue Date, CHF 0.04) translated into United States dollars at the Adjusted Exchange Rate, or (ii) without prejudice to ‘‘Takeover Event and De-listing’’ below, at any time when the Ordinary Shares are not admitted to trading on a Recognised Stock Exchange by reason of a Non-Qualifying Takeover Event or otherwise, the greater of (b) and (c) above.

Very good. There’s a high trigger and conversion at market price. The part I dislike is that the conversion trigger is a regulatory ratio – we found during the crisis that regulatory ratios aren’t worth much in the course of a panic. Still – much better than anything we’re ever likely to see in Canada!

BCBS Discusses Contingent Capital

Friday, November 4th, 2011

The Basel Committee on Banking Supervision has released the Global systemically important banks: assessment methodology and the additional loss absorbency requirement, which contains a series of points regarding Contingent Capital.

The idea of using the low-trigger contingent capital so beloved by OSFI (see the discussion of the NVCC Roadshow on October 27) was shot down in short order:

B. Bail-in debt and capital instruments that absorb losses at the point of nonviability (low-trigger contingent capital)

81. Given the going-concern objective of the additional loss absorbency requirement, the Basel Committee is of the view that it is not appropriate for G-SIBs to be able to meet this requirement with instruments that only absorb losses at the point of non-viability (ie the point at which the bank is unable to support itself in the private market).

Quite right. An ounce of prevention is worth a pound of cure!

To understand my remarks on their view of High-Trigger CoCos, readers might wish to read the posts BoE’s Haldane Supports McDonald CoCos. Hedging a McDonald CoCo, A Structural Model of Contingent Bank Capital and the seminal Contingent Capital with a Dual Price Trigger.

High-Trigger Contingent Capital is introduced with:

C. Going-concern contingent capital (high-trigger contingent capital)

82. Going-concern contingent capital is used here to refer to instruments that are designed to convert into common equity whilst the bank remains a going concern (ie in advance of the point of non-viability). Given their going-concern design, such instruments merit more detailed consideration in the context of the additional loss absorbency requirement.

83. An analysis of the pros and cons of high-trigger contingent capital is made difficult by the fact that it is a largely untested instrument that could potentially come in many different forms. The pros and cons set out in this section relate to contingent capital that meets the set of minimum requirements in Annex 3.

However, the discussion is marred by the regulators’ insistence on using accounting measures as a trigger. Annex 3 includes the criteria:

Straw man criteria for contingent capital used to consider pros and cons

1. Fully convert to Common Equity Tier 1 through a permanent write-off or conversion to common shares when the Common Equity Tier 1 of the banking group subject to the additional loss absorbency requirement falls below at least 7% of risk-weighted assets;

Naturally, once you define the trigger using risk-weighted assets or other accounting measures, you fail. Have the regulators learned nothing from the crisis? Every bank that failed – or nearly failed – was doing just fine in their reporting immediately before they got wiped out.

Risk-Weighted Assets are a fine thing in normal times and give a good indication of how much capital will be required once things turn bad – but as soon as there’s a paradigm shift, they stop working. Not to mention the idea that regulators like to manipulate Risk-Weights just as much as bank managers do – by, for instance, risk weighting bank paper according to its sovereign and by considering Greek paper as good as German.

The only trigger mechanism I consider acceptable is the common equity price (your bank doesn’t have publicly traded common equity? That’s fine. But you cannot issue Contingent Capital). For all the problems this comes with, it comes with a sterling recommendation: it will work. If a bank is in trouble, but the conversion has not been triggered – well then, by definition the bank’s common will be priced high enough that they can issue some.

But anyway, we have a flaw in the BCBC definition that renders the rest of the discussion largely meaningless. But what else do we have?

84. High-trigger going-concern contingent capital has a number of similarities to
common equity:

(a) Loss absorbency – Both instruments are intended to provide additional loss absorbency on a going-concern basis before the point of non-viability.

(b) Pre-positioned – The issuance of either instrument in good times allows the bank to absorb losses during a downturn, conditional on the conversion mechanism working as expected. This allows the bank to avoid entering capital markets during a downturn and mitigates the debt overhang problem and signalling issues.

(c) Pre-funded – Both instruments increase liquidity upon issuance as the bank sells the securities to private investors. Contingent capital does not increase the bank’s liquidity position at the trigger point because upon conversion there is simply the exchange of capital instruments (the host instrument) for a different one (common equity).

Fair enough.

85. Pros of going-concern contingent capital relative to common equity:

(a) Agency problems – The debt nature of contingent capital may provide the benefits of debt discipline under most conditions and help to avoid the agency problems associated with equity finance.

(b) Shareholder discipline – The threat of the conversion of contingent capital when the bank’s common equity ratio falls below the trigger and the associated dilution of existing common shareholders could potentially provide an incentive for shareholders and bank management to avoid taking excessive risks. This could occur through a number of channels including the bank maintaining a cushion of common equity above the trigger level, a pre-emptive issuance of new equity to avoid conversion, or more prudent management of “tail-risks”. Critically, this advantage over common equity depends on the conversion rate being such that a sufficiently high number of new shares are created upon conversion to make the common shareholders suffer a loss from dilution.

I have no problem with this. However, the last sentence makes it possible to speculate that the UK authorities have recognized the lunatic nature of their decision to accept the Lloyds ECN deal.

(c) Contingent capital holder discipline – Contingent capital holders may have an extra incentive to monitor the risks taken by the issuing bank due to the potential loss of principal associated with the conversion. This advantage over common equity also depends on the conversion rate. However, in this case the conversion rate would need to be such that a sufficiently low number of shares are created upon conversion to make the contingent capital holders suffer a loss from conversion. The conversion rate therefore determines whether the benefits of increased market discipline could be expected to be provided through the shareholders or the contingent capital holders.

I don’t think this makes a lot of sense. Contingent capital holders are going to hold this instrument because they want some degree of first loss protection. On conversion, they’re going to lose the first loss protection at a time when, by definition, the bank is in trouble. Isn’t that enough?

However, I am prepared to listen to arguments that if the conversion trigger common price is X, then the conversion price should be X+Y. In my preferred methodology, Y=0, but like I said, I’ll listen to proposals that Y > 0 is better … if anybody ever makes such an argument.

(d) Market information – Contingent capital may provide information to supervisors about the market’s perception of the health of the firm if the conversion rate is such that contingent capital holders suffer a loss from conversion (ie receive a low number of shares). There may be incremental information here if the instruments are free from any too-big-to-fail (TBTF) perception bias in other market prices. This could allow supervisors to allocate better their scarce resources and respond earlier to make particular institutions more resilient. However, such information may already exist in other market prices like subordinated debt.

Don’t you just love the advertisement for more funding implicit in the phrase “scarce resources”? However, it has been found that sub-debt prices don’t reflect risk. However, I will point out that hedging the potential conversion will affect the price of a McDonald CoCo; it is only regulators who believe that a stop-loss order constitutes a perfect hedge.

(e) Cost effectiveness – Contingent capital may achieve an equivalent prudential outcome to common equity but at a lower cost to the bank. This lower cost could enable banks to issue a higher quantity of capital as contingent capital than as common equity and thus generate more loss absorbing capacity. Furthermore, if banks are able to earn higher returns, all else equal, there is an ability to retain those earnings and generate capital internally. This, of course, depends on other bank and supervisory behaviours relating to capital distribution policies and balance sheet growth. A lower cost requirement could also reduce the incentive for banks to arbitrage regulation either by increasing risk transfer to the shadow banking system or by taking risks that are not visible to regulators.

Lower Financing Costs = Good. I’m fine with this.

86. Cons of going-concern contingent capital relative to common equity:

(a) Trigger failure – The benefits of contingent capital are only obtained if theinstruments trigger as intended (ie prior to the point of non-viability). Given that these are new instruments, there is uncertainty around their operation and whether they would be triggered as designed.

I can’t see that there’s any uncertainty if you use a reasonably high common equity trigger price (I have previously suggested half of the issue-time common price). That’s the whole point. It’s only when you have nonsensical triggers based on accounting measures that you have to worry about this stuff.

(b) Cost effectiveness – While the potential lower cost of contingent capital may offer some advantages, if the lower cost is not explained by tax-deductibility or a broader investor base, it may be evidence that contingent capital is less loss absorbing than common equity.26 That is, the very features that make it debt-like in most states of the world and provide tax-deductibility, eg a maturity date and mandatory coupon payments prior to conversion, may undermine the ability of an instrument to absorb losses as a going concern. For example, contingent capital with a maturity date creates rollover risk, which means that it can only be relied on to absorb losses in the period prior to maturity. Related to this, if the criteria for contingent capital are not sufficiently robust, it may encourage financial engineering as banks seek to issue the most cost effective instruments by adding features that reduce their true loss-absorbing capacity. Furthermore, if the lower cost is entirely due to tax deductibility, it is questionable whether this is appropriate from a broader economic and public policy perspective.

This paragraph illustrates more than anything else the regulators’ total lack of comprehension of markets. CoCo’s will be cheaper than common equity because it has first loss protection, and first loss protection is worth a lot of money – ask any investor! When CIBC lost a billion bucks during the crisis, who took the loss? The common shareholders, right? Did investors in other instruments take any of that loss? No, of course, not. They had first loss protection, and were willing to ‘pay’ for that with the expectation of lower returns.

(c) Complexity – Contingent capital with regulatory triggers are new instruments and there is considerable uncertainty about how price dynamics will evolve or how investors will behave, particularly in the run-up to a stress event. There could be a wide range of potential contingent capital instruments that meet the criteria set out in Annex 3 with various combinations of characteristics that could have different implications for supervisory objectives and market outcomes. Depending on national supervisors’ own policies, therefore, contingent capital could increase the complexity of the capital framework and may make it harder for market participants, supervisors and bank management to understand the capital structure of G-SIBs.

It is this complexity that makes the specifications in Annex 3 so useless. A McDonald CoCo can be hedged with options and we know how options work.

(d) Death spiral – Relative to common equity, contingent capital could introduce downward pressure on equity prices as a firm approaches the conversion point, reflecting the potential for dilution. This dynamic depends on the conversion rate, eg an instrument with a conversion price that is set contemporaneously with the conversion event may provide incentives for speculators to push down the price of the equity and maximise dilution. However, these concerns could potentially be mitigated by specific design features, eg if the conversion price is pre-determined, there is less uncertainty about ultimate creation and allocation of shares, so less incentive to manipulate prices.

Well, sure. How many times can I say: “This objection is met by a McDonald CoCo structure, rather than an idiotic Annex 3 structure,” before my readers’ eyes glaze over?

(e) Adverse signalling – Banks are likely to want to avoid triggering conversion of contingent capital. Such an outcome could increase the risk that there will be an adverse investor reaction if the trigger is hit, which in turn may create financing problems and undermine the markets’ confidence in the bank and other similar banks in times of stress, thus embedding a type of new “event risk” in the market. The potential for this event risk at a trigger level of 7% Common Equity Tier 1 could also undermine the ability of banks to draw down on their capital conservation buffers during periods of stress.

Well, sure, which is just another reason why the 7% Common Equity trigger level of Annex 3 is stupid. I should also point out that as BoE Governor Tucker pointed out, a steady incidence of conversion is a Good Thing:

Moreover, high-trigger CoCos would presumably get converted not infrequently which, in terms of reducing myopia in capital markets, would have the merit of reminding holders and issuers about risks in banking.

(f) Negative shareholder incentives – The prospect of punitive dilution may have some potentially negative effects on shareholder incentives and management behaviour. For example, as the bank approaches the trigger point there may be pressure on management to sharply scale back risk-weighted assets via lending reductions or assets sales, with potential negative effects on financial markets and the real economy. Alternatively, shareholders might be tempted to ‘gamble for resurrection’ in the knowledge that losses incurred after the trigger point would be shared with investors in converted contingent instruments, who will not share in the gains from risk-taking if the trigger point is avoided.

Well, the first case, reducing risk, is precisely the kind of behaviour I thought the regulators wanted. The second sounds a little far-fetched, particularly if (one last time) the trigger event is a decline in the common price.

Anyway, having set up their straw-man argument against High-Trigger CoCos, the regulators made the decision that I am sure their political masters told them to reach:

D. Conclusion on the use of going-concern contingent capital

87. Based on the balance of pros and cons described above, the Basel Committee concluded that G-SIBs be required to meet their additional loss absorbency requirement with Common Equity Tier 1 only.

88. The Group of Governors and Heads of Supervision and the Basel Committee will continue to review contingent capital, and support the use of contingent capital to meet higher national loss absorbency requirements than the global requirement, as high-trigger contingent capital could help absorb losses on a going concern basis.