Standard and Poor’s has noted Contingent Capital Is Not A Panacea For Banks, Says Report:
There are certain practical difficulties, however.
The first is whether contingent capital securities will convert into capital early enough to help the bank. For contingent capital securities to prove effective as a buffer for senior bondholders, the conversion triggers need to be set at appropriate levels. However, this is difficult to determine
before a crisis hits.The second is that contingent capital securities may not be sufficiently attractive to investors at a price that is also attractive to the issuing banks. The level of investor demand for contingent capital securities is unclear, given the difficulty that investors may face in pricing the potential conversion risks. Therefore, it is too early to gauge how this market will develop.
…
One big question for the development of the contingent capital market will be how the conversion trigger levels are set. Given that bank capital ratios are typically not strictly comparable, we expect that any specific ratio (such as a 5% Core Tier 1, for example) could mean different things to different issuers. In our capital analysis, we take account of how likely the conversion would be to happen in a time of stress, and this depends on what type of financial stress scenario the trigger ratio would represent. Published capital ratios can be lagging indicators of financial strength, and also can be calculated more conservatively by one bank than another. It may take some time for the contingent capital market to develop norms for trigger levels, and it may be complicated to compare these across banks.For these instruments to be effective in a time of stress, the conversion will also need to happen quickly. This raises several questions:
- •How frequently will the trigger ratio will monitored?
- •Will the status of this ratio always be publicly disclosed?
- •Is there an appropriate process in place to enforce the conversion quickly?
I continue to suggest that the three closing questions are answered readily by ignoring the manipulable and variable capital ratios, and instead making the conversion trigger the breaching of a floor price by the common, with the the conversion price equal to that floor price.
Possibly the most bizarre form of contingent capital I’ve yet seen is the Deutsche Bank Contingent Capital Trust V Trust Preferred Securities, which begin their lives as Upper Tier 2 Sub-debt with a cumulative coupon, but convert to Tier 1 Innovative Capital with a non-cumulative coupon at the whim of the issuer – with no step up, no penalty, no conditions.
Update: More commentary from Tracy Alloway at FTAlphaville.
[…] Her last paragraph is somewhat incoherent with respect to ‘rating agency motivations’. DBRS has published its classification of triggers; Moody’s has announced it will not rate contingent capital with a trigger based on regulatory discretion; quite reasonably, they imply that all else being equal, greater certainty will imply a higher rating on the instruments. S&P’s comments imply that earlier triggers will enhance the rating of senior instruments. […]