The Basel Committee on Banking Supervision has released the Global systemically important banks: assessment methodology and the additional loss absorbency requirement, which contains a series of points regarding Contingent Capital.
The idea of using the low-trigger contingent capital so beloved by OSFI (see the discussion of the NVCC Roadshow on October 27) was shot down in short order:
B. Bail-in debt and capital instruments that absorb losses at the point of nonviability (low-trigger contingent capital)
81. Given the going-concern objective of the additional loss absorbency requirement, the Basel Committee is of the view that it is not appropriate for G-SIBs to be able to meet this requirement with instruments that only absorb losses at the point of non-viability (ie the point at which the bank is unable to support itself in the private market).
Quite right. An ounce of prevention is worth a pound of cure!
To understand my remarks on their view of High-Trigger CoCos, readers might wish to read the posts BoE’s Haldane Supports McDonald CoCos. Hedging a McDonald CoCo, A Structural Model of Contingent Bank Capital and the seminal Contingent Capital with a Dual Price Trigger.
High-Trigger Contingent Capital is introduced with:
C. Going-concern contingent capital (high-trigger contingent capital)
82. Going-concern contingent capital is used here to refer to instruments that are designed to convert into common equity whilst the bank remains a going concern (ie in advance of the point of non-viability). Given their going-concern design, such instruments merit more detailed consideration in the context of the additional loss absorbency requirement.
83. An analysis of the pros and cons of high-trigger contingent capital is made difficult by the fact that it is a largely untested instrument that could potentially come in many different forms. The pros and cons set out in this section relate to contingent capital that meets the set of minimum requirements in Annex 3.
However, the discussion is marred by the regulators’ insistence on using accounting measures as a trigger. Annex 3 includes the criteria:
Straw man criteria for contingent capital used to consider pros and cons
1. Fully convert to Common Equity Tier 1 through a permanent write-off or conversion to common shares when the Common Equity Tier 1 of the banking group subject to the additional loss absorbency requirement falls below at least 7% of risk-weighted assets;
Naturally, once you define the trigger using risk-weighted assets or other accounting measures, you fail. Have the regulators learned nothing from the crisis? Every bank that failed – or nearly failed – was doing just fine in their reporting immediately before they got wiped out.
Risk-Weighted Assets are a fine thing in normal times and give a good indication of how much capital will be required once things turn bad – but as soon as there’s a paradigm shift, they stop working. Not to mention the idea that regulators like to manipulate Risk-Weights just as much as bank managers do – by, for instance, risk weighting bank paper according to its sovereign and by considering Greek paper as good as German.
The only trigger mechanism I consider acceptable is the common equity price (your bank doesn’t have publicly traded common equity? That’s fine. But you cannot issue Contingent Capital). For all the problems this comes with, it comes with a sterling recommendation: it will work. If a bank is in trouble, but the conversion has not been triggered – well then, by definition the bank’s common will be priced high enough that they can issue some.
But anyway, we have a flaw in the BCBC definition that renders the rest of the discussion largely meaningless. But what else do we have?
84. High-trigger going-concern contingent capital has a number of similarities to
common equity:(a) Loss absorbency – Both instruments are intended to provide additional loss absorbency on a going-concern basis before the point of non-viability.
(b) Pre-positioned – The issuance of either instrument in good times allows the bank to absorb losses during a downturn, conditional on the conversion mechanism working as expected. This allows the bank to avoid entering capital markets during a downturn and mitigates the debt overhang problem and signalling issues.
(c) Pre-funded – Both instruments increase liquidity upon issuance as the bank sells the securities to private investors. Contingent capital does not increase the bank’s liquidity position at the trigger point because upon conversion there is simply the exchange of capital instruments (the host instrument) for a different one (common equity).
Fair enough.
85. Pros of going-concern contingent capital relative to common equity:
(a) Agency problems – The debt nature of contingent capital may provide the benefits of debt discipline under most conditions and help to avoid the agency problems associated with equity finance.
(b) Shareholder discipline – The threat of the conversion of contingent capital when the bank’s common equity ratio falls below the trigger and the associated dilution of existing common shareholders could potentially provide an incentive for shareholders and bank management to avoid taking excessive risks. This could occur through a number of channels including the bank maintaining a cushion of common equity above the trigger level, a pre-emptive issuance of new equity to avoid conversion, or more prudent management of “tail-risks”. Critically, this advantage over common equity depends on the conversion rate being such that a sufficiently high number of new shares are created upon conversion to make the common shareholders suffer a loss from dilution.
I have no problem with this. However, the last sentence makes it possible to speculate that the UK authorities have recognized the lunatic nature of their decision to accept the Lloyds ECN deal.
(c) Contingent capital holder discipline – Contingent capital holders may have an extra incentive to monitor the risks taken by the issuing bank due to the potential loss of principal associated with the conversion. This advantage over common equity also depends on the conversion rate. However, in this case the conversion rate would need to be such that a sufficiently low number of shares are created upon conversion to make the contingent capital holders suffer a loss from conversion. The conversion rate therefore determines whether the benefits of increased market discipline could be expected to be provided through the shareholders or the contingent capital holders.
I don’t think this makes a lot of sense. Contingent capital holders are going to hold this instrument because they want some degree of first loss protection. On conversion, they’re going to lose the first loss protection at a time when, by definition, the bank is in trouble. Isn’t that enough?
However, I am prepared to listen to arguments that if the conversion trigger common price is X, then the conversion price should be X+Y. In my preferred methodology, Y=0, but like I said, I’ll listen to proposals that Y > 0 is better … if anybody ever makes such an argument.
(d) Market information – Contingent capital may provide information to supervisors about the market’s perception of the health of the firm if the conversion rate is such that contingent capital holders suffer a loss from conversion (ie receive a low number of shares). There may be incremental information here if the instruments are free from any too-big-to-fail (TBTF) perception bias in other market prices. This could allow supervisors to allocate better their scarce resources and respond earlier to make particular institutions more resilient. However, such information may already exist in other market prices like subordinated debt.
Don’t you just love the advertisement for more funding implicit in the phrase “scarce resources”? However, it has been found that sub-debt prices don’t reflect risk. However, I will point out that hedging the potential conversion will affect the price of a McDonald CoCo; it is only regulators who believe that a stop-loss order constitutes a perfect hedge.
(e) Cost effectiveness – Contingent capital may achieve an equivalent prudential outcome to common equity but at a lower cost to the bank. This lower cost could enable banks to issue a higher quantity of capital as contingent capital than as common equity and thus generate more loss absorbing capacity. Furthermore, if banks are able to earn higher returns, all else equal, there is an ability to retain those earnings and generate capital internally. This, of course, depends on other bank and supervisory behaviours relating to capital distribution policies and balance sheet growth. A lower cost requirement could also reduce the incentive for banks to arbitrage regulation either by increasing risk transfer to the shadow banking system or by taking risks that are not visible to regulators.
Lower Financing Costs = Good. I’m fine with this.
86. Cons of going-concern contingent capital relative to common equity:
(a) Trigger failure – The benefits of contingent capital are only obtained if theinstruments trigger as intended (ie prior to the point of non-viability). Given that these are new instruments, there is uncertainty around their operation and whether they would be triggered as designed.
I can’t see that there’s any uncertainty if you use a reasonably high common equity trigger price (I have previously suggested half of the issue-time common price). That’s the whole point. It’s only when you have nonsensical triggers based on accounting measures that you have to worry about this stuff.
(b) Cost effectiveness – While the potential lower cost of contingent capital may offer some advantages, if the lower cost is not explained by tax-deductibility or a broader investor base, it may be evidence that contingent capital is less loss absorbing than common equity.26 That is, the very features that make it debt-like in most states of the world and provide tax-deductibility, eg a maturity date and mandatory coupon payments prior to conversion, may undermine the ability of an instrument to absorb losses as a going concern. For example, contingent capital with a maturity date creates rollover risk, which means that it can only be relied on to absorb losses in the period prior to maturity. Related to this, if the criteria for contingent capital are not sufficiently robust, it may encourage financial engineering as banks seek to issue the most cost effective instruments by adding features that reduce their true loss-absorbing capacity. Furthermore, if the lower cost is entirely due to tax deductibility, it is questionable whether this is appropriate from a broader economic and public policy perspective.
This paragraph illustrates more than anything else the regulators’ total lack of comprehension of markets. CoCo’s will be cheaper than common equity because it has first loss protection, and first loss protection is worth a lot of money – ask any investor! When CIBC lost a billion bucks during the crisis, who took the loss? The common shareholders, right? Did investors in other instruments take any of that loss? No, of course, not. They had first loss protection, and were willing to ‘pay’ for that with the expectation of lower returns.
(c) Complexity – Contingent capital with regulatory triggers are new instruments and there is considerable uncertainty about how price dynamics will evolve or how investors will behave, particularly in the run-up to a stress event. There could be a wide range of potential contingent capital instruments that meet the criteria set out in Annex 3 with various combinations of characteristics that could have different implications for supervisory objectives and market outcomes. Depending on national supervisors’ own policies, therefore, contingent capital could increase the complexity of the capital framework and may make it harder for market participants, supervisors and bank management to understand the capital structure of G-SIBs.
It is this complexity that makes the specifications in Annex 3 so useless. A McDonald CoCo can be hedged with options and we know how options work.
(d) Death spiral – Relative to common equity, contingent capital could introduce downward pressure on equity prices as a firm approaches the conversion point, reflecting the potential for dilution. This dynamic depends on the conversion rate, eg an instrument with a conversion price that is set contemporaneously with the conversion event may provide incentives for speculators to push down the price of the equity and maximise dilution. However, these concerns could potentially be mitigated by specific design features, eg if the conversion price is pre-determined, there is less uncertainty about ultimate creation and allocation of shares, so less incentive to manipulate prices.
Well, sure. How many times can I say: “This objection is met by a McDonald CoCo structure, rather than an idiotic Annex 3 structure,” before my readers’ eyes glaze over?
(e) Adverse signalling – Banks are likely to want to avoid triggering conversion of contingent capital. Such an outcome could increase the risk that there will be an adverse investor reaction if the trigger is hit, which in turn may create financing problems and undermine the markets’ confidence in the bank and other similar banks in times of stress, thus embedding a type of new “event risk” in the market. The potential for this event risk at a trigger level of 7% Common Equity Tier 1 could also undermine the ability of banks to draw down on their capital conservation buffers during periods of stress.
Well, sure, which is just another reason why the 7% Common Equity trigger level of Annex 3 is stupid. I should also point out that as BoE Governor Tucker pointed out, a steady incidence of conversion is a Good Thing:
Moreover, high-trigger CoCos would presumably get converted not infrequently which, in terms of reducing myopia in capital markets, would have the merit of reminding holders and issuers about risks in banking.
(f) Negative shareholder incentives – The prospect of punitive dilution may have some potentially negative effects on shareholder incentives and management behaviour. For example, as the bank approaches the trigger point there may be pressure on management to sharply scale back risk-weighted assets via lending reductions or assets sales, with potential negative effects on financial markets and the real economy. Alternatively, shareholders might be tempted to ‘gamble for resurrection’ in the knowledge that losses incurred after the trigger point would be shared with investors in converted contingent instruments, who will not share in the gains from risk-taking if the trigger point is avoided.
Well, the first case, reducing risk, is precisely the kind of behaviour I thought the regulators wanted. The second sounds a little far-fetched, particularly if (one last time) the trigger event is a decline in the common price.
Anyway, having set up their straw-man argument against High-Trigger CoCos, the regulators made the decision that I am sure their political masters told them to reach:
D. Conclusion on the use of going-concern contingent capital
87. Based on the balance of pros and cons described above, the Basel Committee concluded that G-SIBs be required to meet their additional loss absorbency requirement with Common Equity Tier 1 only.
88. The Group of Governors and Heads of Supervision and the Basel Committee will continue to review contingent capital, and support the use of contingent capital to meet higher national loss absorbency requirements than the global requirement, as high-trigger contingent capital could help absorb losses on a going concern basis.
[…] provisions for covering losses are equivalent to Unfunded Contingent Capital – whereas the BCBS speaks approvingly of pre-funded Contingent Capital and so does OSFI boss Dickson. The fact that the CCP’s notional capital is unfunded is a […]