Contingent Capital Update

A Reuters columnist suggested Big banks winners from new contingent capital move:

Plans to make hybrid bond investors share the pain when banks run into trouble could polarise the financial sector into big firms that can afford to pay up for capital and smaller players that cannot.

But these plans from the Basel Committee on Banking Supervision could reinforce a pattern emerging in the aftermath of the crisis — a two-tier banking market with international banks that investors favour over smaller banks seen as riskier.

“It could polarise the market further in terms of issuer access and could shut out some smaller institutions and give larger firms a competitive advantage,” said one debt capital markets banker at a major international banking group.

I don’t think that this is necessarily the case. Small banks in the US have never been able to issue their own non-equity regulatory capital – it has all been repackaged into CDOs. This was one of the sideswipes of the Panic of 2007 – the CDO market froze up and these smaller banks were unable to issue.

Investors have mixed views on contingent capital. They would have problems with more issues along the lines of bonds sold by British bank Lloyds, which are designed to convert to equity in the early stages of a bank running into difficulties.

“We don’t think there is a large market for them, certainly among institutional bond investors,” said Roger Doig, credit analyst at Schroders. Analysts say that such issues are difficult for credit rating agencies to evaluate and many institutional credit investors are not mandated to hold equity.

Well, we will see. It’s not fair focussing on the poorly structure Lloyds ECN issue as that gave no first-loss protection to holders.

The McDonald CoCos are not only much better structured and better investments, but they will also work better in averting a crisis, rather than helping to clean up.

Stan Maes and William Schoutens provide Contingent Capital: An In-Depth Discussion:

Somewhat paradoxically, funded contingent capital or CoCos may actually increase the systemic risks they are intended to reduce. For example, whereas some banking regulators recorded CoCos as capital, some insurance regulators treated them as debt. Hence, significant amounts of CoCos were held by insurers, creating a risk of contagion from the banking sector to the insurance sector. Also a problem of moral hazard arises. Taking excessive risks (by for example buying additional risky assets) could lead to a triggering of the note and hence the wiping out of a lot of outstanding debt. Banks with contingent debt could therefore be tempted to seek additional risk near the trigger point (taking risk on the back of the CoCo holders and maybe taxpayers as well).

Finally, Hart and Zingales (2010) argue that contingent capital introduces inefficiency as conversion eliminates default, which forces inefficient businesses to restructure and incompetent managers to be replaced.

Allowing CoCos to be held as assets by other financial institutions and risk-weighted as debt is just stupid. I won’t waste time discussing stupidity.

Given the above, it may make a lot of sense to define triggers in terms of market based terms. Note however that a simple market based trigger may not be desirable as short sellers may be tempted to push down the stock price in order to profit from the resulting dilution of the bank’s stock following the conversion triggered by the stock price drop. Such a self-generated decline in shares prices is referred to as a “death spiral”. The above problem can be mitigated by making the trigger dependent on a rolling average stock price (say the average closing price of the stock over the preceding 20 business days, as Duffie (2010) and Goodhart (2010) propose). In fact, Flannery (2009) demonstrates that the incentive for speculative attack is lessened or even eliminated altogether by setting a sufficiently high contractual conversion price, such that the conversion becomes anti-dilutive (raising the price of the share rather than lowering it).

A market based trigger has the additional advantage that it limits the ability of management to engage in balance sheet manipulation. Also, it prevents forbearance on behalf of the regulators, as it eliminates regulatory discretion in deciding when the trigger should be invoked. Some analysts refer to the double trigger as the double disaster (regulatory discretion as well as politics).

My own preference is for the Volume Weighted Average Price over a relatively lengthy period (20 trading days?) to be the trigger.

If the conversion ratio is based on the stock price at the time of the triggering point, the amount of capital to be brought in can be very substantial and will make thecounterparty a major, if not the largest, shareholder. Original shareholders will be diluted. On the one hand, there is a clear potential dilution effect which could affect the bank’s equity price itself. On the other hand, CoCos may as well introduce a floor on the equity price in these situations.

When the conversion ratio is determined at the time of conversion and not at the time of issuance, the conversion is likely to be relatively generous to the holder of the contingent capital instrument. When the debt holders can expect to get out at close to par value, it would reduce the cost of the contingent capital instrument, making it a significantly cheaper form of capital than equity (of course its low coupon would reduce investors’ appetite).

The authors close with:

We close by raising concerns about the pricing of the instruments by highlighting the similarities between CoCos and equity barrier options and credit default swaps. These barrier-like features and the fact that CoCos are fat-tail event claims, in combination with calibration and model risks, imply that these contingent instruments are very hard to value under a particular model. Since CoCos are expected not to be highly liquid instruments (and until real market prices are widely available), the extreme complexity of mark to modeling CoCos will be a big disadvantage that may hamper their success.

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