PrefBlog

Mark Flannery has published a paper with the captioned title dated 2009-10-6, which elaborates and defends his original idea for Contingent Capital that has been previously discussed on PrefBlog (he used to call them Reverse Convertible Debentures):

The financial crisis has clearly indicated that government regulators are reluctant to permit a large financial institution to fail. In order to minimize the transfer of future losses to taxpayers or to solvent banks, we need a system for assuring that large institutions always maintain sufficient capital. For a variety of reasons, supervisors find it difficult to require institutions to sell new shares after they have suffered losses. This paper describes and evaluates a new security, which converts from debt to equity automatically when the issuer’s equity ratio falls too low. “Contingent capital certificates” can greatly reduce the probability that a large financial firm will suffer losses in excess of its common equity, and will provide market discipline by forcing shareholders to internalize more of their assets’ poor outcomes.

Specifically:

• a. A large financial firm must maintain enough common equity that its default is very unlikely. This common equity can satisfy either of two requirements:
  • o Common equity with a market value exceeding 6% of some asset or risk aggregate. For simplicity, I’ll discuss the aggregate as the book value of on-book assets.
  • o Common equity with a market value exceeding 4% of total assets, provided it also has outstanding subordinated (CCC) debt that converts into shares if the firm’s equity market value falls below 4% of total assets. The subordinated debt must be at least 4% of total assets.
• b. The CCC will convert on the day after the issuer’s common shares’ market value falls below 4% of total assets.
• c. Enough CCC will convert to return the issuers’ common equity market value to 5% of its on-book total assets.
• d. The face value of converted debt will purchase a number of common shares implied by the market price of common equity on the day of the conversion.
• e. Converted CCC must be replaced in the capital structure promptly.

There are two problems with this proposal. First, there is a continued dependence upon official balance sheets which, however reflective they are of the truth, are subject to possible manipulation and will not be trusted in times of crisis. Second, the conversion of CCC into equity at contemporaneous market values has a destabilizing effect upon capital markets, brings with it the (admittedly slight) potential for death-spirals and (most importantly for some, anyway) leaves CCC holders immune to the potential for gaps in the market.

Dr. Flannery cedes the first point regarding balance sheets:

Market values are forward-looking and quickly reflect changes in a firm’s condition, including off-book items, which GAAP equity measures might omit. In contrast, GAAP accounting emphasizes historical costs and provides managers with many options about when and how to recognize value changes. These options are manipulated most aggressively when the firm has problems – exactly when rapid re-capitalization is required to ameliorate those problems. A trigger based on GAAP equity value thus guarantees that the trigger will be tripped long after a financial firm enters distress, and perhaps long after it has become insolvent. (Recall how many troubled banks and holding companies during 2008 were “well capitalized” or “adequately capitalized” according to Basel’s book-valued calculations.) A trigger based on GAAP equity value thus guarantees that the trigger will be tripped long after a financial firm enters distress, and perhaps long after it has become insolvent. (Note how many troubled banks and holding companies during 2008 were “well capitalized” or “adequately capitalized” according to Basel’s book-valued calculations.)

I suggest that if the trigger is set according to a pre-determined equity price, then the potential for jiggery-pokery is reduced substantially as, for instance, bank management will have no incentive to manipulate the balance sheet, or to benefit from prior efforts at manipulation. It will be recalled that Citigroup’s problems first made the news due to its off balance sheet SIVs. It will also be recalled that banks have substantial nod-and-wink exposure to defaults experienced in their Money Market Funds that are not recognized until well after the fact.

Additionally, basing the trigger solely on the market price of the common has the great advantage of being separated from accounting and regulatory considerations – the redundancy is important! I suggest that such redundancy with respect to the leverage ratio vs. the BIS ratios is, essentially, what saved the North American banking system.

It is not clear why Dr. Flannery, having thrown out book value for the equity (numerator) part of the trigger, continues to believe in its adequacy for use in the assets (denominator) component.

With respect to the conversion price, Dr. Flannery states:

My proposal in Section 3 would convert CCC face value into shares at a rate implied by the contemporaneous share price. With a contemporaneous-market conversion price, CCC bonds have very low default risk. With a sufficiently high trigger value, the CCC investors will almost surely be fully repaid either in cash or in an equivalent value of shares. Relatively safe CCC bonds whose payoffs are divorced from share price fluctuations should trade at low coupon rates in liquid markets.

With all respect, I consider this to be a bug, not a feature. CCC bonds should have a higher default risk than other bonds – defining default to be a recovery of less than expected value – otherwise there is little incentive for buyers of such bonds to enforce market discipline. I suggest that CCC bondholders should be exposed to gap risk – if the equity trades on day 0 fractionally above the trigger price (however defined) and management makes announcements that evening that cause the stock to gap downwards overnight, I suggest that it is entirely appropriate for unhedged CCC bondholders to take a loss. Exposing equity but not CCC to gap risk will make it harder to recapitalize the bank through new equity issuance.

When discussing the Squam Lake commentary on this issue, Dr. Flannery asserts:

CCC bonds with a market-valued trigger and a fixed conversion price could effectively recapitalize over-leveraged firms. However, the fixed conversion price adds an element of equity risk and uncertainty to the CCC returns. A high conversion price might give shareholders an incentive to induce conversion as a means of selling equity cheaply. A low conversion price would make bondholders eager to bid down share prices (if possible) to trigger conversion. Such strategic considerations are unrelated to the firm’s credit condition and add nothing to the regulatory goal of stabilizing under-capitalized financial firms. Occam’s razor thus supports the separation of equity risk from credit risk in CCC, further abetting transparent solutions for troubled banks.

I do not find this argument convincing. If, as I have suggested, the trigger price is also the conversion price, then the statements A high conversion price might give shareholders an incentive to induce conversion as a means of selling equity cheaply. A low conversion price would make bondholders eager to bid down share prices (if possible) to trigger conversion. becomes not applicable.

Her Majesty’s Treasury has released a discussion document on the role of banks titled Risk, reward and responsibility: the financial sector and society, which discusses contingent capital among other things:

In the recent crisis existing subordinated debt and hybrid capital largely failed in its original objective of bearing losses. Going-concern capital instruments often failed to bear losses because banks felt unable to cancel coupon payments or not call at call-dates (even though it was more expensive to refinance), in part for fear of a negative investor reaction as well as due to the legal complexity of the instruments. Gone-concern capital such as Lower Tier 2 has often failed to bear losses in systemic banks as governments have been forced to step in to prevent insolvency in part to prevent further systemic impacts on debt-holders such as insurance companies. CRD 2, the first in a series of forthcoming packages amending the Capital Requirements Directive, sets out criteria for the eligibility of hybrid capital instruments as original own funds of credit institutions. It also provides a limit structure for the inclusion of hybrid capital instruments in own funds.

Box 3.D reviews academic proposals for Contingent Capital:

Debt-for-Equity Swap – Raviv (2004) [1]
The proposal is for debt that pays its holder a fixed income unless the value of the bank’s capital ratio falls below a predetermined threshold (based on a regulatory measurement). In this event, the debt is automatically converted to the bank’s common equity according to a predetermined conversion ratio (the principal amount may change upon conversion).

Contingent capital certificates – Flannery (2009) [2]

Similar to the above, contingent capital certificates are debt that pays a fixed payment to its holders but converts into common stock when triggered by some measure of crisis. In contrast to the above this would be a market-based measure, with conversion occurring if the issuer’s equity price fell below some pre-specified value. The converted debt would buy shares at the market price of common equity on the day of the conversion rather than at a predetermined price.

Capital Insurance – Kashyap, Rajan and Stein (2008) [3]

Under this proposal, the insurer would receive a premium for agreeing to provide an amount of capital to the bank in case of systemic crisis. The insurer would be required to hold the full insured amount, to be released back to the insurer once the policy matures. The policy would pay out upon the occurrence of a ‘banking systemic event’, for which the trigger would be some measure of aggregate write-offs of major financial institutions over a year-long period. Long-term policies would be hard to price and therefore a number of overlapping short-term policies maturing at different dates are proposed.

Tradable Insurance Credits – Caballero, Kurlat (2009) [4]

The central bank would issue tradable insurance credits, which would allow holders to attach a central bank guarantee to assets on their balance sheet during a systemic crisis. A threshold level or trigger for systemic panic would be determined by the central bank. An attached tradable insurance credit is simply a central bank backed Credit Default Swap (CDS).

1 Bank Stability and Market Discipline: Debt-for-Equity Swap versus Subordinated Notes. Raviv, Alon. 2004.

2 Contingent Tools Can Fill Capital Gaps, Mark Flannery, American Banker; 2009, Vol. 174 Issue 117.

3 Rethinking Capital Regulation Kashyap, Rajan, Stein, paper prepared for Federal Reserve Bank of Kansas City symposium on “Maintaining Stability in a Changing Financial System”, Jackson Hole, Wyoming, August, 2008

4 The “Surprising” Origin and Nature of Financial Crises: A Macroeconomic Policy Proposal, Ricardo J. Caballero and Pablo Kurlat, August 2009

As has been discussed on PrefBlog (as recently as last week), Flannery’s proposal makes most sense to me. The Capital Insurance proposal has been used in Canada, with the RBC CLOCS, but I am not convinced that such elements are reliable in terms of a crisis – to a large degree, this will simply shift the uncertainty and fear of a crisis onto the insurance providers.

Update, 2010-6-13: The Kashyap paper is available on-line.

The UK Financial Services Authority has announced release of a discussion paper, Strengthening Bank Capital Standards 3. Contingent Capital is now official (and stupid):

The CRD amendments impose a new limit structure on hybrid capital. These instruments will now be restricted to three buckets (15%, 35% and 50%) of total tier one capital after deductions. Hybrid capital instruments will be allocated to these buckets based on their characteristics.
…
The 50% bucket is limited to convertible instruments that convert either in emergency situations or at our initiative at any time based on our assessment of the financial and solvency situation of the firm. We also consider that issuers should have the ability to convert at any time, as elaborated by CEBS in CP27.
…
Instruments with a conversion feature in the 50% bucket would be converted into a fixed number of instruments, as determined at the date of issue. This predetermination would be based on the market value of the instruments at the issue date. The mechanism, as reflected in CEBS’s guidance, may reduce this predetermined number if the share price increases, but could not increase it if the share price falls.

In other words, Contingent Capital in the 50% bucket has no first-loss protection at all. I suppose that one might justify these instruments in terms of writing an option straddle (short call, short put) but how on earth will a bank be able to issue these so that they make sense for a wide range of investors?

The lower two buckets make more sense, dependent upon implementation:

Hybrids with going concern loss absorbency features (e.g. write-down or conversion) can be included up to 35% of tier one provided that they do not have an incentive to redeem.

Hybrids that have going concern loss absorbency features (e.g. write-down), but with a moderate incentive to redeem, such as a ‘step-up’ or principal stock settlement, can be included within the 15% bucket. Hybrid instruments issued via SPVs are also limited to this bucket.

However, the first-loss protection under the new regime is severely restricted:

Incentives to redeem: CEBS clarified the interpretation of a moderate incentive to redeem in its recently published guidance. We are proposing the following changes to our Handbook to reflect these clarifications:

• • no more than one step-up will be allowed during the life of a hybrid instrument;
• • the conversion ratio within a principal stock settlement mechanism will be restricted to 150% of the conversion ratio at the time of issue; and
• • instruments that include an incentive to redeem at the time of issue (e.g. a synthetic maturity) will remain within the 15% hybrid bucket allocated for such instruments even if such features remain unused.

They explain:

We consider that conversion should not be unlimited for the other buckets, because this would involve no burden sharing by the hybrid holders. So, a determination at the issue date of a maximum number of shares to be delivered that would be no more than 150% of the market value of the hybrid, based on the share price at the issue date, would be acceptable. This would limit dilution. Shares must be available to be issued, so sufficient extra shares must already have been authorised.

As far as the trigger goes, they’re obsessed with discretion:

For all hybrids, the trigger for the the write-down or conversion mechanism should, at the latest, be where a significant deterioration in the firms’ financial or solvency situation is reasonably foreseeable or on a breach of capital requirements. For the 50% hybrid bucket the trigger would be an emergency situation or the regulator’s discretion.

Q3: Trigger for activation of loss absorbency mechanism
– Do you agree that in order for the mechanism to be effective in supporting the firm’s core capital in times of stress that the trigger needs to be activated at the discretion of the firm?

I think discretion – whether on the part of the firm or of the regulator – is the last thing wanted in times of stress. In such times, investors want as little uncertainty as possible and the exercise of entirely reasonable discretion in a manner not guessed beforehand by the market can have severe consequences, as Deutsche Bank found out, as discussed on December 19, 2008.

The only trigger that makes any kind of sense to me is a decline in the price of the common. Everything else is too uncertain and too susceptible to manipulation.

Interestingly, the FSA estimates the incremental coupon on Innovative Tier 1 Capital:

The new innovative instruments will need to offer a higher return to investors to compensate for the increased risk inherent in the new instrument. It is impossible to quantify the precise increase in cost to firms of servicing such instruments. Consistent with the previous analysis, we have estimated an upper-bound for the differential in coupons between the legacy innovative instruments and the new innovative instruments of 4.7%.

Paul Tucker, Deputy Governor, Financial Stability at the Bank of England, has delivered a speech to the SUERF, CEPS & Belgian Financial Forum Conference: Crisis Management at the Cross‐Road, Brussels containing a rather surprising rationale for investment in Contingent Capital:

Almost no amount of capital is enough if things are bad enough. Which is why contingent capital might potentially be an important element in banks’ recovery plans, as the Governor set out recently in Edinburgh.

This would not be the kind of hybrid capital that mushroomed in the decade or so leading up to the crisis. The familiar types of subordinated debt can absorb losses only if a bank is put into liquidation, and so really has no place in regulatory capital requirements as we cannot rely on liquidation as the only resolution tool. It has been a faultline in the design of the financial system as a whole that banks issued securities that counted as capital for regulatory purposes, and on which they could therefore leverage up, but with institutional investors treating them as very low risk investments backing household pension and annuity savings.

By contrast, contingent capital would be debt that converted into common, loss-absorbing equity if a bank hit turbulence. It is, in effect, a form of catastrophe insurance provided by the private sector.

Why should long-term savings institutions and asset managers be prepared to provide such insurance? One possible reason is that if enough of them were to do so for enough banks, it might well help to protect the value of their investment portfolios more generally. If ever it needed to be demonstrated,the current crisis has surely put it beyond doubt – not only for our generation but for the next one too – that serious distress in the banking system deepens an economic downturn and so impairs pretty well all asset values. By taking a hit in one part of their portfolio by providing equity protection to banks, institutions might well be able to support the value of their investments more widely. And the trigger for conversion from debt into equity could be at a margin of comfort away from true catastrophe; say, a percentage point or so above the minimum regulatory capital ratio.

Of course, this would entail a structural shift over time in investment portfolios. But the system might be able to manage that adjustment. After all, it managed the all together less desirable adjustment to the development of the existing hybrid capital markets. But demand for contingent capital is, inevitably, uncertain at this stage. As are the terms on which it will be provided. We welcome the growing private sector focus on this.

That has to be the craziest rationale I’ve seen yet for investment.

Contingent Capital will succeed only if it designed so that its risk/reward profile makes it sufficently attractive that investors include it in their portfolio in order to make money – some investors, some of the time, for some purposes.

To suggest that it be held in order to make the bond allocation of the portfolio be more bond-like – which is what I think he’s saying – is ludicrous.

Assiduous Readers will by now be sick of hearing this, but I thoroughly dislike the idea of making the trigger dependent upon regulatory capital ratios; this makes the investor – and, to some extent, the bank – hostage to future unknown changes in regulation. It may also make the regulator hostage to the market, if they want to make a change but have to consider the effect on triggering conversion. Making the trigger dependent upon the price of the common – if the common declines by 50% from its price on the contingent capital’s issue date, for instance – will provide a market-based conversion trigger that can be hedged or synthesized on the options market in a familiar and reproducible manner.

… at least until the wind changes:

Bank of America Merrill Lynch (BAC.N) reversed its position for a second time on Wednesday to decide its bond indexes would not include new contingent capital securities, devised for UK bank Lloyds (LLOY.L).
On Tuesday the U.S. bank said it would include these new bonds in its benchmark indexes, but many investors objected.

“The preponderance of feedback that we have received from investors who are measured against our indices indicates that most do not view the new contingent capital securities as part of their investment universe,” Bank of America Merrill Lynch said in a research note.

The Association of British Insurers (ABI) said on Tuesday its members were against including these new securities in bond indexes.
…
BofA Merrill Lynch had originally planned not to include the new bonds in its indexes, but then changed its mind on Tuesday.

“We have decided to evaluate the new securities on their own merits and will revert to our original decision to exclude them from the indexes,” Merrill’s research note said.

The note also said the bank would review all bank Tier 1 debt – the lowest ranking bank bond that has equity-like features – currently in the index to determine if there are, in fact, other securities that should be removed from the index.
…
No decision has been made yet for the iBoxx indexes, a leading benchmark in the investment grade arena, said Markit, which runs the indexes.

Markit’s oversight committee, made up of asset managers, regulators and consultants, is expected to meet next Tuesday to discuss a recommendation on this issue, Markit said.

Barclays Capital has already decided that contigent capital securities that are convertible to equity will not be eligible for broad-based investment-grade Barclays Capital bond indexes such as the Global Aggregate, Sterling Aggregate and US Aggregate indexes.

The new securities would also not be eligible for the bank’s high-yield benchmark indexes, but might be eligible for Barclays Capital Convertible Bond indexes, provided they meet inclusion rules, Barclays said.

I reported last week that UK authorities were promoting inclusion with the presumed purpose of widening the investor pool.

Two amusing things about this article are, firstly: “We have decided to evaluate the new securities on their own merits” which the smiley-boys at Merrill consider to be worthy of note, and secondly, that the stated reasons for exclusion have nothing whatsoever to do with whether these notes are bonds are not.

Can the issuer avoid bankruptcy while being a day late or a dollar short in their payments? No? Then it isn’t a bond.

Update: For all that, the issue is popular:

Lloyds Banking Group said yesterday that it may increase its capital-raising by £1.5 billion to £22.5 billion because of a clamour by investors to take up its offer to swap debt into equity.

Shares in the beleaguered banking group rose 5 per cent to 89¼p on the latest positive signal from the bank.

Investors are flocking to take up Lloyds’ offer to convert their tier 1 and tier 2 debt into new “contingent capital” because it will guarantee them an income of possibly 10 per cent or more in an annual coupon.