Archive for the ‘Contingent Capital’ Category

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.

DBRS To Rate NVCC Preferreds

Wednesday, August 17th, 2011

Following the finalization of the OSFI NVCC Advisory and basically simultaneously with the Review-Negative slapped on NVCC-eligible extant preferreds, DBRS has announced that it:

has concluded today that it expects it can rate Canadian subordinated debt with a non-viability contingent capital clause (sub debt NVCC) and Canadian preferred shares with a non-viability contingent capital clause (pref NVCC) following the review of the Office of the Superintendent of Financial Institutions Canada (OSFI) Advisory on Non-Viability Contingent Capital, issued on August 16, 2011 (NVCC Advisory).

In this document, all references to non-viability contingent capital (NVCC) instruments are based on our expectations that non-viability (as determined by OSFI) is the only contingent event, that the contingent event triggers permanent conversion to common equity and that over time, as NVCC becomes the major instrument with respect to subordinated debt and preferred shares, any trigger event for sub debt NVCC holders would cause these holders to become meaningful owners of the bank in question. These considerations are also consistent with our ability to rate the NVCC instruments. According to DBRS criteria, the triggers are well defined and permit an assessment of the risks.

Both the sub debt NVCC and pref NVCC ratings will have wider notching, based on the global standard notching for preferred shares, because of additional risk associated with tripping the trigger. The expected losses resulting from tripping the trigger would have an impact on the relative rating of sub debt NVCC and pref NVCC. As guidance, sub debt NVCC will likely be rated no higher than the standard rating for preferred shares and the pref NVCC will likely be rated one notch below the standard rating for preferred shares.

For clarity, global standard notching for preferred shares means the starting point for notching preferred share ratings is the intrinsic assessment (IA) rating rather than the final senior debt rating, and the degree of notching from the IA rating to the preferred share rating widens to reflect our perception of the increased risk in these capital instruments. The base notching policy is three notches for AA, four notches for “A” and five notches for BBB and lower IA ratings. Note that when DBRS initiated the criteria on June 29, 2009, most banks in Canada had their preferred share ratings downgraded to only one notch above the global standard notching for preferred shares

DBRS has determined that the likelihood of tripping the trigger event (i.e., non-viability as determined by OSFI) would be very hard or remote. DBRS’s decision was based on the assessment of the criteria to be considered in triggering conversion of NVCC instruments that was spelled out in the NVCC advisory by OSFI. Lower-rated banks suggest an increased probability of conversion as a result of tripping the trigger given the greater need for a bank to generate regulatory capital. This would result in higher notching from the intrinsic assessment, as set out in the DBRS methodology Rating Bank Preferred Shares and Equivalent Hybrids. As such, both the sub debt NVCC and pref NVCC ratings would be tied to the preferred share rating of the bank.

The expected losses as a result of the conversion would affect the rating for sub debt NVCC relative to pref NVCC. It is the economic entitlement each receives post-trigger that is the significant factor in the relative ratings as opposed to the host security’s pre-trigger features. This economic entitlement can be assessed only after terms are provided in a contractual agreement between the issuing bank and the purchaser.

OSFI Finalizes NVCC Advisory

Wednesday, August 17th, 2011

OSFI has released a final Advisory on NVCC, with some changes from the draft advisory which was discussed on PrefBlog. The draft advisory has been removed from OSFI’s website in accordance with their policy to ensure that the rationale behind their policies and their development is not understood by investors. Naturally, no comment letters have been published, nor have any documents been referenced that might provide any vestiege of support for their arbitrary and capricious rule-making.

The final advisory begins with a non-sequiter that would not be tolerated in Grade 4:

All regulatory capital must be able to absorb losses in a failed financial institution. During the recent crisis, however, this premise was challenged as certain non-common Tier 1 and Tier 2 capital instruments did not absorb losses for a number of foreign financial institutions that would have failed in the absence of government support.

Principle 3 from the draft advisory, giving the Superintendent the right to trigger conversion if she feels like it, with no appeal, has been retained. Banks are urged to hire lots of former OSFI employees.

There is now a requirement that there be a floor on the conversion price – this did not exist before:

Principle # 4: The conversion terms of new NVCC instruments must reference the market value of common equity on or before the date of the trigger event. The conversion method must also include a limit or cap on the number of shares issued upon a trigger event.

On the one hand, this will prevent so-call “death spirals”. On the other hand, it may make NVCC instruments harder to issue during times of crisis. The necessity of such an unprincipled principle is necessary due to OSFI’s insistence on “low-trigger” NVCC, at a time when the rest of the world has determined that “high-trigger” NVCC is the way to go (see, for example, statements by officials of S&P, more from S&P, Switzerland, the UK, respected academics, and other respected academics, and an equivocal view from IMF staff).

Principal #8, which throws contract law into the same garbage bin as bankruptcy law, has been retained:

Principle # 8: The terms of the NVCC instrument should include provisions to address NVCC investors that are prohibited, pursuant to the legislation governing the DTI, from acquiring common shares in the DTI upon a trigger event. Such mechanisms should allow such capital providers to comply with legal prohibitions while continuing to receive the economic results of common share ownership and should allow such persons to transfer their entitlements to a person that is permitted to own shares in the DTI and allow such transferee to thereafter receive direct share ownership.

Section 2 seeks to ensure permanent employment and many future job opportunities for OSFI employees:

Section 2: Information Requirements to Confirm Quality of NVCC Instruments

While not mandatory, DTIs are strongly encouraged to seek confirmations of capital quality from OSFI’s Capital Division prior to issuing NVCC instruments11. In conjunction with such requests, the DTI is expected to provide the following information….

Capital Surcharges for Globally Important Investment Banks

Monday, June 27th, 2011

The Bank for International Settlements has announced:

the Group of Governors and Heads of Supervision (GHOS), the oversight body of the Basel Committee on Banking Supervision (BCBS), agreed on a consultative document setting out measures for global systemically important banks (G-SIBs). These measures include the methodology for assessing systemic importance, the additional required capital and the arrangements by which they will be phased in. These measures will strengthen the resilience of G-SIBs and create strong incentives for them to reduce their systemic importance over time.

The GHOS is submitting this consultative document to the Financial Stability Board (FSB), which is coordinating the overall set of measures to reduce the moral hazard posed by global systemically important financial institutions. This package of measures will be issued for consultation around the end of July 2011.

The assessment methodology for G-SIBs is based on an indicator-based approach and comprises five broad categories: size, interconnectedness, lack of substitutability, global (cross-jurisdictional) activity and complexity.

The additional loss absorbency requirements are to be met with a progressive Common Equity Tier 1 (CET1) capital requirement ranging from 1% to 2.5%, depending on a bank’s systemic importance. To provide a disincentive for banks facing the highest charge to increase materially their global systemic importance in the future, an additional 1% surcharge would be applied in such circumstances.

The higher loss absorbency requirements will be introduced in parallel with the Basel III capital conservation and countercyclical buffers, ie between 1 January 2016 and year end 2018 becoming fully effective on 1 January 2019.

The GHOS and BCBS will continue to review contingent capital, and support the use of contingent capital to meet higher national loss absorbency requirements than the global minimum, as high-trigger contingent capital could help absorb losses on a going concern basis.

I have mixed views on this. I reported last August that the push towards surcharges was gaining ground and have been advocating surcharges based on size since (at least!) March 2009.

However, I am unfavourably disposed towards the narrow focus of the plan, which affects only “global systemically important banks” as defined by the regulators and then uses an as-yet untested formula “based on an indicator-based approach and comprises five broad categories: size, interconnectedness, lack of substitutability, global (cross-jurisdictional) activity and complexity” to assess the surcharge imposed. There’s a lot of room for error there, and a lot of room for lobbying. There’s also a lot of cliff effect: what will be the effect on the markets when a bank’s G-SIB status is changed? What if it changes during the height of a crisis? What if a well capitalized medium sized bank is interested in purchasing a failing medium sized bank during a crisis? We saw that during the crisis, a lot of the American banks bulked up – will they be willing to bid next time? And finally, of course, the subjective nature of the G-SIB status determination opens up the door for a lot of lobbying and corruption.

I would be much happier with a system that was formula-based and applied to all banks on a progressive basis.

I was very pleased to see that the committees “support the use of contingent capital to meet higher national loss absorbency requirements than the global minimum, as high-trigger contingent capital could help absorb losses on a going concern basis”. The critical part of that phrase is high-trigger contingent capital, which is really one in the eye for those morons at OSFI, who have decided that the lowest possible trigger is the best. However, the “low-trigger” policy was enacted during the reign of the Assistant Croupier; now that he has departed for a greener pastures with a company he used to regulate (see June 14), the new incumbent may have different ideas.

BoE's Haldane Supports McDonald CoCos

Monday, March 28th, 2011

I use the term “McDonald CoCo” to describe a hybrid security that is initially debt-like coverts into equity when the issuer’s common equity price declines below a preset floor. The conversion is performed at the equity trigger price.

I will note immodestly that, were there any justice in the world, they would be called Hymas CoCos, since I published first, but there ain’t no justice and McDonald has the union card.

Anyway, Andrew G Haldane, Executive Director of the Bank of England, has published remarks based on a speech given at the American Economic Association, Denver, Colorado, 9 January 2011:

For large and complex banks, the number of risk categories has exploded. To illustrate, consider the position of a large, representative bank using an advanced internal set of models to calibrate capital. Its number of risk buckets has increased from around seven under Basel I to, on a conservative estimate, over 200,000 under Basel II. To determine the regulatory capital ratio of this bank, the number of calculations has risen from single figures to over 200 million. The quant and the computer have displaced the clerk and the envelope.

At one level, this is technical progress; it is the appliance of science to risk management. But there are costs. Given such complexity, it has become increasingly difficult for regulators and market participants to vouch for the accuracy of reported capital ratios. They are no longer easily verifiable or transparent. They are as much an article of faith as fact, as much art as science. This weakens both Pillars II and III. For what the market cannot observe, it is unlikely to be able to exercise discipline over. And what the regulator cannot verify, it is unlikely to be able to exercise supervision over. Banks themselves have recently begun to voice just such concerns.

… and complexity is Bad:

This evidence only provides a glimpse at the potential model error problem viewed from three different angles. Yet it suggests that model error-based confidence intervals around reported capital ratios might run to several percentage points. For a bank, that is the difference between life and death. The shift to advanced models for calibrating economic capital has not arrested this trend. More likely, it has intensified it. The quest for precision may have come at the expense of robustness.

Hayek titled his 1974 Nobel address “The Pretence of Knowledge”. In it, he highlighted the pitfalls of seeking precisely measurable answers to questions about the dynamics of complex systems. Subsequent research on complex systems has confirmed Hayek’s hunch. Policy predicated on over-precision risks catastrophic error. Complexity in risk models may have perpetuated Hayek’s pretence in the minds of risk managers and regulators.

Like, for instance, in the run-up to the height of the crisis:

To see that, consider the experience of a panel of 33 large international banks during the crisis. This panel conveniently partitions itself into banks subject to government intervention in the form of capital or guarantees (“crisis banks”)
and those free from such intervention (“no crisis banks”).

Chart 5 plots the reported Tier 1 capital ratio of these two sets of banks in the run-up to the Lehman Brothers crisis in September 2008. Two observations are striking. First, the reported capital ratios of the two sets of banks are largely indistinguishable. If anything, the crisis banks looked slightly stronger pre-crisis on regulatory solvency measures. Second, regulatory capital ratios offer, on average, little if any advance warning of impending problems. These conclusions are essentially unchanged using the Basel III definitions of capital.


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Got any better ideas?

What could be done to strengthen the framework? As a thought experiment, consider dropping risk models and instead relying on the market. Market-based metrics of bank solvency could be based around the market rather than book value of capital. The market prices of banks are known to offer useful supplementary information to that collected by supervisors when assessing bank health.8 And there is also evidence they can offer reliable advance warnings of bank distress

To bring these thoughts to life, consider three possible alternative bank solvency ratios based on market rather than accounting measures of capital:

  • Market-based capital ratio: the ratio of a bank’s market capitalisation to its total assets.
  • Market-based leverage ratio: the ratio of a bank’s market capitalisation to its total debt.
  • Tobin’s Q: the ratio of the market value of a bank’s equity to its book value.

The first two are essentially market-based variants of regulatory capital measures, the third a well-known corporate valuation metric. How do they fare against the first principles of complex, adaptive systems?


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Having set the stage, he starts talking about CoCos:

Alongside equity, banks would be required to issue a set of contingent convertible instruments – so-called “CoCos”. These instruments have attracted quite a bit of attention recently among academics, policymakers and bankers, though there remains uncertainty about their design. In particular, consider CoCos with the following possible design
characteristics.
  • Triggers are based on market-based measures of solvency, as in Charts 6–8.
  • These triggers are graduated, stretching up banks’ capital structure.
  • On triggering, these claims convert from debt into equity.

Although novel in some respects, CoCos with these characteristics would be simple to understand. They would be easy to monitor in real time by regulators and investors. And they would alter potentially quite radically incentives, and thus market dynamics, ahead of banking stress becoming too acute.

He points out:

CoCos buttress market discipline and help lift the authorities from the horns of the timeconsistency dilemma. They augment regulatory discretion at the point of distress with contractual rules well ahead of distress. Capital replenishment is contractual and automatic; it is written and priced ex-ante and delivered without temptation ex-post. Because intervention would be prompt, transparent and rule-based, the scope for regulatory discretion would be constrained. For that reason, the time-consistency problem ought to be reduced, perhaps materially. A contractual belt is added to the resolution braces.

These are the most important things. As investors, we want as much certainty as possible. Contractual conversion with a preset trigger and conversion factor removes the layer of regulatory uncertainty that bedevils most other approaches.

He highlights one concern that has been of interest to the Fed, and which seems to be the thing that industry professionals focus on when I discuss this with them:

If such a structure is for the best in most states of the world, why does it not already exist? At least two legitimate concerns have been raised. First, might market-based triggers invite speculative attack by short-sellers? The concern is that CoCo holders may be able to shortsell a bank’s equity to force conversion, then using the proceeds of a CoCo conversion to cover their short position.

There are several practical ways in which the contract design of CoCos could lean against these speculative incentives. Perhaps the simplest would be to base the conversion trigger on a weighted average of equity prices over some prior interval – say, 30 days. That would require short-sellers to fund their short positions for a longer period, at a commensurately greater cost. It would also create uncertainty about whether conversion would indeed occur, given the risk of prices bouncing back and the short-seller suffering a loss. Both would act as a speculative disincentive.

A second potential firewall against speculative attack could come from imposing restrictions on the ability of short-sellers to cover their positions with the proceeds of conversion.

I like the first solution and am particularly gratified that he chose essentially the same VWAP measurement period that I chose as a basis for discussion.

I don’t like the second firewall. Stock is stock is stock. Everybody knows you can’t cheat an honest man, right? Well, you can’t manipulate a healthy stock, either. Not on the scale of a 30-day VWAP, you can’t.

A related concern is that CoCos alter the seniority structure of banks’ capital, as holders of CoCos potentially suffer a loss ahead of equity-holders. But provided the price at which CoCos convert to equity is close to the market price, conversion does not transfer value between existing equity-holders and CoCo investors. And provided conversion is into equity it need not imply investor loss. If a market move really is unjustified, prices will correct over time towards fundamentals. The holder of a converted CoCo will then garner the upside.

I don’t understand this bit. As long as the trigger/conversion price is set well below the market price at CoCo issue time (I suggested that “half” was a good figure), then CoCos will retain significant first-loss protection.

BoE Deputy Governor Tucker Supports High Trigger for CoCos

Tuesday, March 8th, 2011

Mr Paul Tucker, Deputy Governor of the Bank of England, made a speech at the Clare Distinguished Lecture in Economics, Cambridge, 18 February 2011 titled Discussion of Lord Turner’s lecture, “Reforming finance – are we being radical enough?”:

But none of what I have said makes a case for placing all of our eggs in the resolution basket. Switching metaphors, we need belt and braces. Which is why the G20 agreed that the so-called Global Systemically Important Financial Institutions (G-SIFIs) should carry greater loss absorbing capacity (or GLAC) than implied by Basel III.

First best would be equity. Indeed, Adair has argued this evening that ideally Basel 3 would have set a higher equity requirement. But that did not happen. In practice, we are going to have to be open-minded, but also principled, about quasi-equity instruments contributing to GLAC for SIFIs (sorry about the acronyms!). Currently, the leading candidate is so-called Contingent Capital bonds (CoCos), which convert from debt into equity in certain states of the world. It seems to me that to serve the purpose of GLAC for large and complex firms, such instruments would need to convert when a firm was still fundamentally sound, which is to say that they should have high capital triggers. For a large and complex firm, a low capital trigger would be dangerous, as funders and counterparties would be likely to flee before reaching the point at which the firm would be recapitalised through the CoCos’ conversion.

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.

Lord Turner’s speech discusses a particular hobby-horse of mine:

It is therefore crucial that our answers to the SIFI problem cover also the more difficult but more likely scenario of multiple bank systemic stress. And in such conditions, bail-inable bonds will only enable us to avoid the dilemma of Autumn 2008, if the following vital conditions are met:
  • • If regulators could be confident that those bonds are held outside the banking system; and
  • • in addition, confident that the bonds are held by investors who have so arranged their assets and liabilities that they could face the imposed losses without that in turn inducing systemic effects.

And it may be very difficult to be confident that those conditions we met.

There are two ways to gain that confidence – the first relies on empirical observation, the second on an assumption of fully informed investor rationality. Neither route may be entirely robust.

  • • The first way to seek such confidence, would be for regulators to understand, or to regulate, which investors hold bank medium-term debt. Our information on this today is imperfect. We believe a significant proportion is initially held by other banks, and a larger proportion still by a broadly defined group of ‘fund managers’. (Slide 7). But ownership after secondary market trading could be significantly different. And some of these ‘fund managers’ may be in turn financed by banks (e.g. hedge funds by prime brokers), or linked to the banking system by complex repo and derivative relationship so that losses suffered by one bank, could indirectly impose losses or confidence shocks on others. And our ability to track these complex inter-connections, and as a result to predict the knock-on consequences of initial losses in conditions of systemic fragility is imperfect today and likely to remain so. We need to improve our understanding of the complex interconnections of our financial system: but it is unclear that understanding will ever be good enough for us confidently to impose large losses simultaneously on the senior debt of multiple large banks (or indeed multiple small banks), in conditions of macro-systemic stress.
  • • The other route to confidence, would be based on faith in market and investor rationality, assuming axiomatically that investors who buy bail-inable bonds will only do so on the basis of rational assessments of their ability to absorb risks in all possible future states of the world, including those of macroeconomic stress. As Section 3 will discuss, this axiomatic assumption was at the core of the pre-crisis conventional wisdom, the reason why public authorities thought they could sleep easy in the face of an explosive growth in financial scale, complexity and interconnectedness. But it relies on an assumption of fully informed rationality, which may be simply untrue, and indeed impossible. For as Andrei Shleifer et al (2010) have argued in an extremely perceptive recent paper, it may be inherent to human nature that in the good times investors systematically fail to take rational account of the tail of low probability adverse events.

A bail-inable bond will have a highly skewed probability distribution of pay-outs. (Slide 8 ) Over a long period of time, only the zero-loss segment of the distribution will be observed. A low probability of significant loss continues to exist, but Gennaioli, Shleifer and Vishay argue that that low probability will be wholly discounted through a behavioural process which they label ‘local thinking’ – the reality, deeply rooted in human nature, that not all contingencies are represented in decision makers’ thought processes. After a period of good times, investors will assume that senior bank debt is effectively risk-free: as indeed they did, in the years before the crisis (Slide 9). Regulators cannot therefore rely on free-market discipline to ensure that the debt is only held by investors who can suffer loss without that causing knock-on systemic disruption.

If therefore we can neither perfectly and continuously monitor or regulate who owns bail-inable debt, nor rely on free-market discipline to ensure that it is always appropriately held, contractually bail-inable debt and technical resolvability will be valuable but still imperfect solutions to the ‘too big to fail’ problem. We can only be sure that losses can be smoothly absorbed if we are sure that the investors who provide funds do not suffer from ‘local thinking’ but remain perpetually aware of the full distribution of possible results. Subordinated debt which can convert to equity well before potential failure (‘early trigger CoCos’) may approach what is required since the price will presumably vary with probabilistic expectations of future conversion. But only with pure equity can we be fully confident that the dangers of ‘local thinking’ will not creep in over time, and that investors, facing day-by-day price movements up and down will remain continually aware that they hold a potentially loss absorbing instrument. The implication of Shleifer’s ‘local thinking’ theory is that if investors are to remain continuously aware of the full frequency distribution of objectively possible results the observed frequency distribution of returns needs to include negatives and well as positives. This is achieved by equity returns but not by low risk debt.

OSFI, in its infinite wisdom, is going in entirely the opposite direction: the lowest possible conversion triggers for CoCos, and seeking to include CoCos in the regular bond indices so that investors will be fooled into buying them.

Credit Suisse Contingent Capital

Monday, February 14th, 2011

Credit Suisse is issuing contingent capital:

The bank agreed to sell $3.5 billion of contingent convertibles with a coupon of 9.5 percent, and 2.5 billion francs with a coupon of 9 percent, it said. The sale will happen no earlier than October 2013, which is the first call date on $3.5 billion of 11 percent and 2.5 billion francs of 10 percent Tier 1 capital notes the bank sold in 2008.

The notes will convert into shares if the bank’s Basel III common equity Tier 1 ratio falls below 7 percent. The conversion price will be the higher of the floor price of $20 or 20 francs per share or the daily weighted average sale price of ordinary shares over the trading period preceding the notice of conversion, the bank said.

The transaction is subject to the implementation of Swiss regulations and the approval of shareholders, the bank said. The Swiss committee proposed that the country’s two biggest banks should hold common equity equal to at least 10 percent of their assets, weighted according to risks. In addition, the companies may hold up to 3 percent in so-called high-trigger CoCos that would convert into shares if the bank’s common equity ratio falls below 7 percent, plus 6 percent in CoCos that would convert at a 5 percent trigger.

Credit Suisse said the 6 billion-franc sale would satisfy about 50 percent of the high-trigger requirement. The bank said it would like to see the market for contingent convertible bonds expand to a wider group of buyers and is pursuing an additional offering of such notes to potential investors outside the U.S. and certain other countries.

On the positive side, conversion occurs well before the the point of non-viability. On the negative – the trigger is based on Capital Ratios, which I have strongly criticized in the past and continue to criticize.

The Financial Times comments:

Switzerland’s other big bank, UBS, takes a diametrically opposed view to Credit Suisse, on cocos, arguing that they will be excessively expensive because no one knows how to price them properly. UBS prefers the “haircut bond” as an instrument.

But investors believe that other UK banks, such as HSBC, could be drawn to cocos. “That would really seal cocos’ reputation,” said one London-based investor. “But in the meantime, we expect the Nordics, particularly Sweden, to be big issuers. We also think this will take off in the US.” In spite of a lack of enthusiasm from US regulators, the likes of Morgan Stanley and Goldman Sachs are privately intrigued by cocos.

Senior bankers at BNP and Société Générale have similarly signalled a willingness to consider coco issuance to finance buffers. Analysts at Barclays Capital said the market for European cocos alone could be close to €700bn ($945bn) by 2018.

Many traditional fixed-income investors are barred from owning instruments such as cocos that can convert into equity.

Update, 2011-2-23: The deal was a huge success:

Investors rushed to take up the benchmark issue by Credit Suisse of a new financial instrument hailed by regulators as a key tool for rebuilding the capital strength of banks, placing orders of $22bn – 11 times the $2bn on offer.

The deluge of orders represented a big vote of confidence in the nascent market for contingent capital bonds, dubbed cocos.

Asset managers took about two-thirds of Credit Suisse’s cocos, while private banks took a third on behalf of their clients. A total of 550 different investors – an unusually large number – put in orders for the bonds. The strong demand from asset managers was particularly important since they will form the backbone of any sustainable market for the products.

Credit Suisse’s deal was helped by the fact the bank anchored its coco deal by simultaneously announcing a agreement to swap $6.2bn of its existing hybrid debt for cocos – covering in one go about half the total cocos the bank needs to issue.

OSFI Releases Contingent Capital Draft Advisory

Friday, February 4th, 2011

OSFI has released a Draft Advisory titled Non-Viability Contingent Capital (NVCC):

OSFI has determined that, effective January 1, 2013 (the Cut-off Date), all non-common Tier 1 and Tier 2 capital instruments issued by DTIs must comply with the following principles to satisfy the NVCC requirement:

Principle # 1: Non-common Tier 1 and Tier 2 capital instruments must have, in their contractual terms and conditions, a clause requiring a full and permanent conversion [Footnote 4] into common shares of the DTI upon a trigger event.[Footnote 5] As such, original capital providers must not have any residual claims that are senior to common equity following a trigger event.

Footnote 4: The BCBS rules permit national discretion in respect of requiring contingent capital instruments to be written off or converted to common stock upon a trigger event. OSFI has determined that conversion is more consistent with traditional insolvency consequences and reorganization norms and better respects the legitimate expectations of all stakeholders.

Footnote 5 The non-common capital of a DTI that does not meet the NVCC requirement but otherwise satisfies the Basel III requirements may be, as permitted by applicable law, amended to meet the NVCC requirement.

Some extant contingent capital has a “write-up” clause, whereby amounts written down can be recovered if the company squeaks through its troubles.

The minimum condition reveals that OSFI is more interested in political posturing than averting a crisis. If they wanted to avert a crisis, they would insist that conversion took place long before the point of non-viability, when the common still had value.

Principle # 3: All capital instruments must, at a minimum, include the following trigger events:

  • a. the Superintendent of Financial Institutions (the “Superintendent”) advises the DTI, in writing, that she is of the opinion that the DTI has ceased, or is about to cease, to be viable and that, after the conversion of all contingent capital instruments and taking into account any other factors or circumstances that she considers relevant or appropriate, it is reasonably likely that the viability of the DTI will be restored or maintained; or
  • b. a federal or provincial government in Canada publicly announces that the DTI has accepted or agreed to accept a capital injection, or equivalent support [Footnote 6], from the federal government or any provincial government or political subdivision or agent or agency thereof without which the DTI would have been determined by the Superintendent to be non-viable [Footnote 7]

    Footnote 6: OSFI, after consulting with its FISC partner agencies, will provide guidance to DTIs upon request whether a particular form of government support being offered to such DTI is considered equivalent to a capital injection. For example, the Bank of Canada’s Emergency Liquidity Assistance (ELA) does not constitute equivalent support as it is targeted at solvent institutions experiencing temporary liquidity problems.

    Footnote 7: Any capital injection or equivalent support from the federal government or any provincial government or political subdivision or agent or agency thereof would need to comply with applicable legislation, including any prohibitions related to the issue of shares to governments.

So the Superintendent, an employee of the federal Ministry of Finance, has absolute power – there is no appeal. There is nothing to prevent the Superintendent from saying tomorrow that the Royal Bank is non-viable, the Government is buying a hundred-billion shares for a dollar, fuck you suckers, goodbye. Five hundred years of bankruptcy law out the window.

Principle # 8: The issuing DTI must provide a trust arrangement or other mechanism to hold shares issued upon the conversion for non-common capital providers that are not permitted to own common shares of the DTI due to legal prohibitions. Such mechanisms should allow such capital providers to comply with such legal prohibition while continuing to receive the economic results of common share ownership and should allow such persons to transfer their entitlements to a person that is permitted to own shares in the DTI and allow such transferee to thereafter receive direct share ownership.

Since we’re ignoring bankruptcy law, why not ignore every other law and contract while we’re at it?

Section 3: Issuance of Capital Instruments prior to the Cut-off Date

3. DTIs are encouraged to consider amending the terms of existing non-common instruments that do not comply with the NVCC requirement to thereby achieve compliance, or to otherwise take actions, including exchange offers, which would mitigate the effects of such non-compliance.

It’s possible that some issuers might try this, but it’s awfully hard to imagine the kind of coercion that would be required to get something like this to pass for a PerpetualDiscount, given the reasonable expectation of redemption at par within ten-odd years.

Section 4: Criteria to be considered in Triggering Conversion of NVCC

In triggering the conversion of NVCC, the Superintendent will exercise his or her discretion to maintain a financial institution as a going-concern where it would otherwise become non-viable. In doing so, the Superintendent will consider the below list of criteria and any other relevant OSFI guidance [Footnote 16]. These criteria may be mutually exclusive and should not be viewed as an exhaustive list.[Footnote 17]

The exercise of discretion by the Superintendent will be informed by OSFI’s interaction with the Financial Institutions Supervisory Committee (FISC)[Footnote 18] (and any other relevant agencies the Superintendent determines should be consulted in the circumstances). In particular, the Superintendent will consult with the FISC member agencies and the Minister of Finance prior to making a non-viability determination.

Footnote 16: See, in particular, OSFI’s Guide to Intervention for Federally-Regulated Deposit-Taking Institutions.

Footnote 17: The Superintendent retains the flexibility and discretion to deal with unforeseen events or circumstances on a case-by-case basis.

Footnote 18: Under the OSFI Act, FISC comprises OSFI, the Canada Deposit Insurance Corporation, the Bank of Canada, the Department of Finance, and the Financial Consumer Agency of Canada. Under the chairmanship of the Superintendent of Financial Institutions, these federal agencies meet regularly to exchange information relevant to the supervision of regulated financial institutions. This forum also provides for the coordination of strategies when dealing with troubled institutions.

Full discretion, no judiciary, no appeal. Goodbye Canada, hello Soviet Union.

Update, 2011-2-7: DBRS says:

OSFI has also issued a draft advisory on non-viable contingent capital. Again, the draft advisory was consistent with the BCBS’s release on minimum requirements to ensure loss absorbency at the point of non-viability (January 13, 2011). The NVCC Draft Advisory sets out the governing principles, information requirements and criteria to be considered in triggering a conversion of non-viable contingent capital. DBRS will state its views on non-viable contingent capital when OSFI publishes a final release of the advisory, expected in 2011.

Notwithstanding the NVCC Draft Advisory, DBRS’s global bank rating methodology continues to deem the five largest Canadian banks (Bank of Montreal, Bank of Nova Scotia, Canadian Imperial Bank of Commerce, Royal Bank of Canada, and The Toronto-Dominion Bank) systemically important in Canada, which positively impacts DBRS’s senior and subordinated debt ratings of these banks.

OSFI Announcement on Non-Qualifying Capital Instruments

Friday, February 4th, 2011

OSFI has announced:

Media are invited to participate in a briefing via teleconference with the Office of the Superintendent of Financial Institutions (OSFI) on two Advisories relating to BASEL III: Treatment of non-qualifying capital instruments under Basel III and Non-Viability Contingent Capital.

Mark White, Assistant Superintendent, Regulation Sector, will provide a brief overview and will be available to answer questions.

Media who wish to participate must confirm their attendance with Léonie Roux, Communications and Consultations.

Please note that all details are subject to change. All times are local.

DATE: Friday February 4, 2011
TIME: 4:00 PM
PLACE: 613-960-7518 (Ottawa)
1-888-265-0903
Participant pass code: 725300

Update, 4:21pm: Good old OSFI, hopelessly incompetent and secretive as always!

I notified Ms. Roux of my intent to participate and was answered with:

Good afternoon,
Please note that today’s conference call is for media only.

A separate conference call is being set up for analyts and investors that may wish to participate.

The conference call will take place on Monday morning at 11:30AM, an advisory will be issued shortly.

I responded:

I represent media via my blog at http://www.prefblog.com

No response. So I called in at about 4:01pm and got some fragments of seemingly random open-mike buzz.

OSFI has deleted the original advisory and replaced it with one that does not include a telephone number or pass code.

OSFI: The dumbest shits on the planet.

OSFI Seeking to Manipulate Bond Indices and Retail Investors?

Friday, February 4th, 2011

Barry Critchley of the Financial Post has written a piece titled Banks prepare for CoCos that contains the interesting assertion:

“We would expect that the banks would make use of the contingent market for the incremental 3.5% of their capital because holding the balance in common equity could potentially adversely affect profitability,” said Altaf Nanji, an analyst with RBC Capital Markets.

But lots of things have to be clarified before that issuance starts.

– The securities have to be rated. And that’s not a slam dunk given that the securities are convertible if certain trigger points are reached. So far, Fitch is the only ratings agency that has rated any of the securities, though Standard & Poor’s has issued a request for comment on them.

– The determination has to be made whether the securities should be in a bond index. Certainly OSFI wants them in the index and has make its plan very clear.

Shades of Hades, or at least the UK! Assiduous Readers will remember the tergiversations that were the topic of the post Merrill Keeps Lloyds ECNs out of UK Bond Indices that started when UK authorities made a similar attempt to debase the bond indices.

There’s only one teensy little problem with putting CoCos into bond indices: they’re not freaking bonds! If you don’t have the ability to bankrupt your debtor for being a day late or a dollar short, you’re not a bond-holder.

Canadian retail investors should be concerned, since bond ETFs are the most reasonable way for a bond investor to get exposure to bonds and there is already a high degree of aldulteration in bond ETFs, as I pointed out in my article Bond ETFs. On the positive side, there is the chance that a sharp divergence of opinion on the matter may lead to a wider variety of bond indices being marketted. REAL bond indices, I mean, not garbage like the DEX HYBrid index, discussed on September 30, 2010.

Update, 2011-2-7: A Reader has advised me (in rather polemical language!) that he considers my views on the DEX HYBrid Index to be significantly influenced by a conflict of interest, to wit: in late 2006, following the purchase by the TSX of the bond indices from Scotia Capital, it occurred to me that there was the potential for doing some kind of business with the Exchange based on my HIMIPref™ software, analytics, and indices (at that time, TXPR did not exist). I contacted them, they expressed curiosity and I made a presentation to them.

Sadly, nothing came of this attempt and my correspondent alleges that I have been left with a conflict of interest that renders it impossible for me to present my views on the DEX HYBrid Index as being independent.

I don’t see it. If I harboured such a violent grudge over every unsuccessful sales pitch I’ve made over the years, I wouldn’t have time for much else! However, given the nature of the allegations and the language used, I deem it proper to err on the side of disclosure. So make your own minds up regarding my motivation for disrespecting the DEX HYBrid Bond Index!

My correspondent has been invited to post a comment on the blog stating his views, or to provide me with a rebuttal that will be given equal time; to date, this invitation has been declined.