Barry Critchley writes in today’s Financial Post:
Are so-called soft retractable preferred shares — a security that allows the issuer, at maturity, to pay in common shares or cash– the next type of Tier 1 capital financial institutions will be allowed to issue as part of the overall thrust of strengthening their balance sheets?
There is talk that the federal regulator, the Office of the Superintendent of Financial Institutions (OSFI), has been approached.
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Soft retractables come with features that make them akin to Tier 1 or permanent capital: They are noncumulative in relation to dividends, and they have a term to maturity that can be extended to perpetuity if the issuer decides to pay not in cash but in common shares. (If that did happen, the pref share issue would be dilutive.) And they have the ability to absorb losses. But rule changes a few years back mean the capital raised now counts as Tier 2 capital. Accordingly, they receive the same treatment as debt securities. Since those changes were implemented, no financial institution has issued soft retractables. “If you have soft retractables that count as debt and are dilutive, it’s the worst of both worlds,” noted one underwriter, who added OSFI has “never really liked soft retractables.”
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So how could OSFI make soft retractables more attractive for financial institutions to issue? The easiest way would be to overlook recent accounting changes and have the capital raised count as equity, not as debt.
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Certainly institutional investors would like the regulators to change the rules to allow soft retractables to count as Tier 1 capital. Institutions would be buying a term security, a feature that allows them to match the investment against a liability.
The crux of the issue is the last paragraph: pretend-managers wanting securities with pretend-maturities … just like Deutsche Bank’s sub-debt! I will certainly not deny that, should there be new bank OpRet issues, they will be included in the HIMIPref™ portfolio and they will be considered for recommendation to clients.
But from a public policy perspective, these issues would be a disaster. In times of trouble they will be dilutive to the shareholders and get the bank into even more trouble – as has happened recently with the Quebecor World issue, IQW.PR.C. This is not what tier 1 capital is supposed to do!
Tier 1 Capital must participate in losses and must not be procyclical – that seems to me to be quite intuitive. There has been quite enough debasement of bank capital quality recently, with the recent approval of a rule to allow cumulative innovative Tier 1 Capital.
Such tinkering may well meet the objective of decreasing the probability of trouble, by increasing the funding sources available for Tier 1 capital. But the piper must eventually be paid: the corollary is that in times of trouble you increase the potential for crowded trades and cliff risk.
Hat Tip: Assiduous Reader tobyone.
In the Dec. 18 Financial Post, Barry Critchley continues commentary on the OSFI and the idea of convertible prefs to boost Tier 1 capital.
In the same edition, T. Tedesco, J. Middlemiss et al report on the BCE lawsuit. Providence Capital, a former buyout partner, floats an “elegant solution” of at least $500M cash injection in BCE in return for 8% convertible prefs (and 2 board seats).
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