HM Treasury Responds to Turner Report

The Turner Report on Financial Regulation was reported on PrefBlog in March. The government has now taken some time off from its regularly scheduled banker-bashing to address the issues raised.

The response was released on July 8 with the admission:

There were many causes of the financial crisis:
  • first and foremost, failures of market discipline, in particular of corporate governance, risk management, and remuneration policies. Some banks, boards and investors did not fully understand the complexities of their own businesses;
  • second, regulators and central banks did not sufficiently take account of the excessive risks being taken on by some firms, and did not adequately understand the extent of system-wide risk; and
  • third, the failure of global regulatory standards to respond to the major changes in the financial markets, which have increased complexity and system-wide risk, or to the tendency for system-wide risks to build up during economic upswings.

… which is a lot more balanced than what they spout for the benefit of the man in the street.

The British firm Barrow, Lyde & Gilbert has prepared a precis of the government response; there are, however, two proposals in the full-length report worthy of highlighting for preferred share investors:

Box 6.C: New international ideas for improving access to funding markets

Two ideas to improve banks access to capital during downturns or crises are being aired in academic and policy circles. Both have merits although how they could be applied in practice is yet to be determined.

Capital insurance:Banks essentially face an insurance problem: when faced with a shortage of capital, rather than having to raise new capital at a high market cost it would be more efficient if banks were delivered capital at a pre-agreed (lower) price though a pre-funded insurance policy. Paying the insurance premium in an expansion would be one method of providing some cost to the expansion of credit in an upturn. However, in a systemic crisis the insurance policy would need to pay out to several banks together. In order to ensure that these obligations could always be met, the insurance would probably need to be run by the state sector.

Debt-equity conversion: When banks are forced to raise new equity capital the initial benefits are shared with the existing debt holders as they have a senior claim over equity in the event of liquidation. One solution would be to make some of the debt (perhaps the subordinated debt tranche only) convertible into equity in the event of a systemic crisis and on the authority of the financial regulator. This would immediately inject capital into the bank and reduce the need to raise any new equity capital. The holders of the debt would also have more incentive to impose market discipline on the banks.

The reference supplied for the second option is “Building an incentive-compatible safety net”, C. Calomiris, in Journal of Banking and Finance, 1999; this article is available for purchase from Science Direct and is freely available in HTML form from the American Enterprise Institute for Public Policy Research. Assuming that the AEI transcript is reliable, though, I see very little support for the idea in the Calomiris paper (Calomiris’ ideas are frequently discussed on PrefBlog, but I certainly don’t remember seeing this one).

Regardless of origin, I consider this a fine idea at bottom, although I am opposed to the idea that the triggering mechanism be a ruling by regulatory authorities. I suggest that greater certainty for investors, regulators and issuers could be achieved with little controversy if conversion were to be triggered instead by the trading price of the bank’s common.

In such a world, regulators approving a preferred share for inclusion in Tier 1 Capital would require a forced conversion at some percentage of the current common price if the volume-weighted trading price for a calendar month (quarter?) was below that conversion price. Thus, assuming the chosen percentage was 50%, if RY were to issue preferreds at $25 par value at a time when its common was trading at $50, there would be forced conversion of prefs into common on a 1:1 basis if the common traded below $25 for the required period.

This could bring about interesting arbitrage plays with options – so much the better!

One effect would be that as the common traded lower – presumably in response to Bad Things happening at the company – the preferred share would start behaving more and more like an equity itself – which is precisely what we want.

We shall see, but I hope this idea gains some traction in the halls of power.

Update: Dr. Calomiris has very kindly responded to my query:

Yes, the citation of my work is relevant to the proposal, although it takes a little explaining to see the connection. I have been advocating the use of some form of uninsured debt requirement as part of capital requirements for a long time. The conversion of hybrid idea is a new version of that, which has the advantages of my proposal and also some additional advantages that Mark Flannery and others have pointed to. I like the idea of requiring a minimal amount of “contingent capital” which would take the form of sub debt that converts into equity in adverse circumstances.

You may quote me.

10 Responses to “HM Treasury Responds to Turner Report”

  1. prefhound says:

    One potential issue with your proposed example for RY is that a lot can happen to the common over time (even 10 years). In this crisis, RY never traded below its high of 4-5 years ago (an estimate), although Citi, BAC, and other US banks did.

    Perhaps what you need instead is a >60-75% decline over a reference price defined as 1 year ago. In a period of inflation, bank prices would decline gradually over time as the inflation built up, but it would not trigger conversion.

    Also, is a forced conversion better than one with Board discretion?

  2. jiHymas says:

    We can look at one of the older PerpetualDiscounts, CM.PR.P, with a convenient prospectus dated 1997-10-6. If we look at the 1998 Annual Report we see that the common price in fiscal 1997 varied between 26.55 and 41.75, closing nearer the high end.

    Thus given that there have been no intervening splits, we can say that, under the 50% rule suggested above, CM.PR.P would have been issued with a mandatory conversion price of about $21 if that floor level was ever breached.

    A conversion price unadjusted by inflation would have the advantage of simplicity (I hear lots of complaints that preferreds are complicated enough already!) and also easily meet the regulatory desire that conditions of issue reflect the market at time of issue.

    And, after all, the objective is simply to force conversion into equity at some price well above zero; the actual price doesn’t matter so much. I don’t like the idea of using a stale reference price; one reason being is that it would make it harder to issue preferreds during a market decline (since they would be closer to the conversion threshold). During the crisis, preferred share issuance has helped out a lot.

    I would prefer forced conversion to making it discretionary, whether it was the Board or the Regulators who had such discretion. Such a conversion will occur – by design – at a time of stress; the exercise of discretion might be interpreted in a funny way by the markets. We’ve seen a lot of that with sub-debt calls for redemption while out of the money during the crisis, since exercising sound business judgment has been interpreted as a sign of weakness.

  3. patc says:

    There are instruments out there like this already. For instance the Commonwealth Bank of Australia (CBA) has a tier-1 innovative security called PERLS III, essentially a floating step-up with a margin of 1.05%, stepping up to 2.05% in 2016. It trades on the ASX as “PCAPA”. Issued in 2006.

    The interesting feature is that if the bank’s Tier 1 capital ratio drops below 5% an “APRA Event” occurs, and the prefs convert into shares, and the maximum conversion number is 100. These securities have a face value of $200 and the current CBA share price is around the $50 mark. So if the bank is in real trouble, they’ll convert into the face value of equity. If the bank is in extraordinary trouble, they’ll convert into equity but not dilute equity into oblivion.

    Comments:
    – it’s a complex security for retail, the prospectus is 120-odd pages long and full of little conditions. Frankly it’s a complex security for sophisticated investors.
    – the margin’s hopeless, but it was issued pre-GFC. Now trades on reasonable yields
    – caveats aside, it’s not a bad formalism

    What I’d love to see is an instrument that deals with liquidity. There is a hybrid instrument again on the ASX, called IANG – the oddest security imaginable. Essentially it’s a money market fund over which IAG (an insurer) have a call. At any time IAG can exercise an option to pull the money market fund on balance sheet and issue conventional preference shares in IAG for a value equivalent to the original investment.

    I personally dislike IANG because there’s not enough of a penalty for IAG exercising the option, but the underlying principle is sound. If there was a penalty (e.g. IAG exercises option, issues $110 preference shares per $100 money-market funds accessed) then it could be lovely.

  4. […] a comment on the post about HM Treasury’s musings on mandatorially convertible prefs, Assiduous Reader patc provided an introduction to what seems to be the wonderful world of […]

  5. jiHymas says:

    Canada has Innovative Tier 1 Capital with the potential for mandatory conversion into preferred shares (e.g., the recent TD CaTS IV-3 issue), but I am not aware of any mandatory conversions into common.

    I like the “APRA event” provisions of the PCAPA issue, but still think it preferable to make the price of the common a trigger for mandatory conversion, given that Capital Ratios haven’t really performed all that well in this crisis.

    IANG sounds fascinating, but your idea would lead to an immediate loss of $10 (probably in Accumulated Other Comprehensive Income, but it might hit the income statement) at a time when a loss – even if only for bookkeeping purposes – would be very nasty. I suggest that it would be better for the preferreds to pay some kind of spread to the bank bill rate.

  6. […] The British government indicated interest in a debt security that would convert to capital in times of stress, as discussed in the post HM Treasury Responds to Turner Report. […]

  7. […] Contingent capital was first proposed in such a form – as far as I know! – in HM Treasury’s response to the Turner Report. […]

  8. […] trigger is simply the common stock’s trading price. As I stated in my commentary on the HM Treasury response to the Turner Report, this has the advantage of being known in advance; no judgement by the regulatory authorities is […]

  9. […] heartily endorse this idea, which was first proposed by HM Treasury in its response to the Turner report and endorsed by William Dudley of the New York Fed. It looks like this idea is gaining some […]

  10. […] for Contingent Capital that includes the structure I advocate (and have been advocating ever since HM Treasury’s Turner Report response brought the basic idea to my attention) and supports it with rationale that reflects my biases. […]

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