PrefBlog

The Bank for International Settlements has announced:

minimum requirements to ensure that all classes of capital instruments fully absorb losses at the point of non-viability before taxpayers are exposed to loss.

This is yet another example of bureaucrats ursurping the role of the courts:

The terms and conditions of all non-common Tier 1 and Tier 2 instruments issued by an internationally active bank must have a provision that requires such instruments, at the option of the relevant authority, to either be written off or converted into common equity upon the occurrence of the trigger event … Any compensation paid to the instrument holders as a result of the write-off must be paid immediately in the form of common stock (or its equivalent in the case of non-joint stock companies).
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4. The trigger event is the earlier of: (1) a decision that a write-off, without which the firm would become non-viable, is necessary, as determined by the relevant authority; and (2) the decision to make a public sector injection of capital, or equivalent support, without which the firm would have become non-viable, as determined by the relevant authority.

5. The issuance of any new shares as a result of the trigger event must occur prior to any public sector injection of capital so that the capital provided by the public sector is not diluted.

In a rational world, the issuing banks will include another trigger for conversion that occurs well before the point of non-viability can credibly be discussed by regulators, as I have urged in the past.

A trigger based on the price of the common stock would greatly reduce uncertainty in evaluating these instruments; allow hedging in the options market; provide a smoother transition of Tier 1 Capital to common equity; and, most importantly, provide far better protection of overall financial stability. It will be interesting to see if that happens – but frankly, I’m betting against it.

Update, 2011-1-14: There has been some speculation that the phase-out of the existing Tier 1 Capital rules will mean that extant PerpetualDiscounts will be redeemed (at par!). This is based on the section of the release titled “Transitional Arrangements”:

Instruments issued on or after 1 January 2013 must meet the criteria set out above to be included in regulatory capital. Instruments issued prior to 1 January 2013 that do not meet the criteria set out above, but that meet all of the entry criteria for Additional Tier 1 or Tier 2 capital set out in Basel III: A global regulatory framework for more resilient banks and banking systems, will be considered as an “instrument that no longer qualifies as Additional Tier 1 or Tier 2” and will be phased out from 1 January 2013 according to paragraph 94(g).

The linked document was discussed in the PrefBlog post Basel III. The relevant paragraph, 94(g), states in part:

Capital instruments that no longer qualify as non-common equity Tier 1 capital or Tier 2 capital will be phased out beginning 1 January 2013. Fixing the base at the nominal amount of such instruments outstanding on 1 January 2013, their recognition will be capped at 90% from 1 January 2013, with the cap reducing by 10 percentage points in each subsequent year. This cap will be applied to Additional Tier 1 and Tier 2 separately and refers to the total amount of instruments outstanding that no longer meet the relevant entry criteria. To the extent an instrument is redeemed, or its recognition in capital is amortised, after 1 January 2013, the nominal amount serving as the base is not reduced.

So the thinking is that extant PerpetualDiscounts will no longer qualify as Tier 1 capital and be considered by the banks to be too expensive to keep on the books.

The most recent OSFI speech was by Mark White and, as noted on January 12, didin’t really have much to say. With respect to new Tier 1 rules, he stated:

Existing non-common tier 1 and tier 2 instruments which do not meet the new requirements will, on an aggregate basis, be subject to an annual, steadily increasing phase-out from 2013 to 2023. To avoid the bail-out by taxpayers of capital in a failed bank, it is also expected that all non-common capital will ultimately be required to be written-off, or to convert to common shares, if a non-viable bank will receive an infusion of government capital.
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On December 16, 2010 OSFI responded to the release of the Basel III text to signal that work is continuing on the transition for non-qualifying capital instruments – and that further guidance will be issued as implementation progresses. We realize that many are anxiously awaiting guidance on how non-qualifying capital will be phased out in Canada. However, it could do a disservice if OSFI provides premature guidance before the minimum international requirements are set. Suffice it to say that OSFI currently expects, at a minimum, to follow the minimum transition requirements with respect to phasing-out disqualified capital. Our goals will be to maximize the regulatory capital in the system and, where practicable, to give effect to the legitimate expectations of the issuers and investors.

OSFI’s December 16 release was discussed briefly on the market update of that day.

Once the Basel III rules text governing NVCC requirements has been finalized by the BCBS, OSFI intends to issue guidance clarifying the phase-out of all non-qualifying instruments by DTIs, including OSFI’s expectations with respect to rights of redemption under regulatory event [footnote] clauses.

Footnote: In general, a regulatory event may be defined as receipt by the bank of a notice or advice by the Superintendent, or the determination by the bank, after consultation with the Superintendent, that an instrument no longer qualifies as eligible regulatory capital under the capital guidelines issued by OSFI. The definition of regulatory event is governed by the terms of the capital instrument and interested persons should refer to the relevant issuance documents.

So what do I think? Mainly I think it’s too early to tell.

First off, the preferred shares may be grandfathered, as previously speculated. OSFI has shown no hesitation in grandfathering instruments in the past – they did this with Operating Retractible issues. One argument in favour of this idea is that it’s relatively easy to come up with a coercive exchange offer: CIT did this, as discussed on October 2, 2009, as did Citigroup (see also the specific terms).

Another reason not to get too excited is the length of time involved. If the banks (and insurers) are forced to redeem their prefs over a ten year period, they’re not going to redeem the lowest coupon ones first! If you look at something priced at, say, $22, and consider you might have to wait until 2023 to get your money … that’s thirteen years, an increment of $0.23 p.a. Call it a 1% yield increment. Very nice – but you’re locked in for all that time and there’s a fair amount of uncertainty.