Contingent Capital Criticized

The Telegraph recently published a story Mervyn King’s plan for bank capital ‘will backfire’:

Bankers and shareholders, however, fear that the act of converting cocos into equity would be a “red flag” to the market, prompting counterparties to withdraw funds and sparking a liquidity crisis like those at Lehman Brothers and Northern Rock. They say it would act as an “accelerator into distress”.

One senior bank executive said: “The point of conversion would kill the bank. Everyone would pull their liquidity out.” The sentiment was echoed by a leading institutional shareholder, who said: “Institutions don’t like them. If cocos ever converted, that bank would be toast.” Among investors, cocos are colloquially known as “death spiral convertibles”.

I agree that this is the case if there is any discretion at all in the conversion decision, whether this discretion is exercised by the regulators or the issuer. I will also agree that it may very well be the case if some degree of discretion is exercised – which would be the case if regulatory capital triggers are used. If a bank announces in its quarterly results enough losses and provisions to result in ratios being just under or just over the trigger point, there will be an immediate suspicion of jiggery-pokery.

However, I am more dubious about the potential for self-feeding collapse if the trigger I advocate – the price of the common stock – is utilized.

Bankers have also identified a second cause for concern, which they term “negative convexity”. They say coco holders would hedge their position by shorting the bank’s shares as capital ratios fell close to the conversion level.

Paul Berry, from Santander’s global banking and markets’ division, has explained: “As the share price falls, the likelihood increases of conversion. Holders, who do not wish to have any exposure to the share, sell shares to hedge this risk. This selling sends the stock lower, resulting in further stock selling.

“This will send the share price into a terrible self-reinforcing spiral downwards.”

Geez, it’s nice to see the phrase “negative convexity” used in a daily general interest newspaper! Negative convexity is indeed a problem; but one that can be minimized by ensuring that the trigger price is equal to the conversion price. I will certainly agree that the poorly structured Lloyds bank deal, which provides no first-loss protection to the noteholders on conversion, will definitely have that effect.

If structured properly and present in good quantity, contingent capital will simply replace the fire-sales of common shares that were common during the crisis. For instance:
1) Royal Bank sells contingent capital when their stock is trading at $50. In such a situation, I suggest that the conversion and trigger price for Tier 1 Capital (preferred shares and Innovative Tier 1 Capital) be $25.00 (one-half the issue-time price of the common; for Tier 2 Capital the conversion/trigger would be one-quarter of this price)
2) Royal Bank gets into trouble.
3) Share price drops to $25.
4) Royal Bank doesn’t need to sell equity. Instead, the previously issued Tier 1 Capital converts (at $25). They can sell new Tier 1 Capital with a conversion/trigger price of $12.50, instead.

It is, of course, certain that there will be selling pressure on the common when it’s at $30 from the Tier 1 Capital holders (directly and through the options market). However, in the absence of the convertible instruments, there will also be selling pressure based on expectations of new issuance. I suggest that the presence of Contingent Capital structured in this manner will reduce uncertainty, which is the vital thing.

I recently published an opinion piece on Contingent Capital.

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