Archive for the ‘Contingent Capital’ Category

Royal Bank Issues NVCC-Compliant Sub-Debt

Friday, July 11th, 2014

Royal Bank of Canada has announced:

an inaugural Basel III-compliant offering of $1 billion of subordinated debentures (“the Notes”) through its Canadian Medium Term Note Program.

The Notes bear interest at a fixed rate of 3.04 per cent per annum (paid semi-annually) until July 17, 2019, and at the three-month Banker’s Acceptance Rate plus 1.08 per cent thereafter until their maturity on July 17, 2024 (paid quarterly). The expected closing date is July 17, 2014 and RBC Capital Markets is acting as lead agent on the issue.

The bank may, at its option, with the prior approval of the Office of the Superintendent of Financial Institutions Canada, redeem the Notes on or after July 17, 2019 at par, in whole at any time or in part from time to time, on not less than 30 days and not more than 60 days notice to registered holders.

We routinely undertake funding transactions to maintain strong capital ratios and a cost effective capital structure. Net proceeds from this transaction will be used for general business purposes.

It’s not clear to me how the floating rate of BAs+108bp was calculated. The Canada 10-year is trading at around 2.20%, the five year around 1.55% and three-month BAs a little above 1.20%. None of these values fits very well with the 3.04% initial rate to provide a 108bp increment.

However, the important thing – for some – is the fact that a clear demarcation exists between the five-year pretend-maturity and the ten-year actual maturity. This will make it easier for the sleazy to sell the debt to the stupid.

Not much meat on those bones. The heart of the matter is the conversion feature, as noted by Moody’s:

Moody’s assigned a rating of Baa1 (hyb) to Royal Bank of Canada’s (RBC, Aa3 Negative, C+/a2 Stable) 3.04% CAD1 billion Basel III compliant NVCC subordinated debt. Proceeds from the issuance will be added to the bank’s general funds and utilized for general banking purposes. The NVCC subordinated debt provides loss absorption as it is subject to automatic conversion into common shares, based on a predetermined conversion formula, at the point of non-viability, as defined by the Office of the Superintendent of Financial Institutions Canada (OSFI), subject to regulatory discretion. This incremental loss absorption feature is credit positive for holders of senior securities of RBC, as a layer of loss absorbing securities will reduce the risk of losses incurred higher in the capital hierarchy if the bank gets into financial distress.

This marks the first issuance in Canada of contractual non-viability subordinated debt. The rating is positioned 2 notches below the a2 adjusted baseline credit assessment (adjusted BCA) of RBC, in line with Moody’s standard notching guidance for contractual non-viability subordinated debt. An additional notch is added relative to the notching for “plain vanilla” subordinated debt with normal loss severity (currently 1 notch below adjusted BCA) to capture the potential uncertainty related to the timing of loss absorption.

By way of comparison, Moody’s has the NVCC-compliant Royal Bank preferreds at Baa3:

This marks the first issuance in Canada of contractual non-viability preferred securities. The rating is positioned 4 notches below the a2 adjusted baseline credit assessment (adjusted BCA) of RBC, in line with Moody’s standard notching guidance for contractual non-viability preferred securities. An additional notch is added relative to the notching for legacy Canadian non-cumulative preferred shares (currently 3 notches below adjusted BCA) to capture the potential uncertainty related to the timing of loss absorption.

Standard and Poor’s explains what makes them more creditworthy than preferreds (bolding added):

The ‘A-‘ rating is two notches below the stand-alone credit profile (SACP), incorporating:

  • •A deduction of one notch from the SACP for subordination, reflecting our belief that the Canadian legal and regulatory framework insulates senior debt from defaults on the subordinated debt; and
  • •The deduction of an additional notch to reflect that the subordinated notes feature a mandatory contingent conversion trigger provision. Should a trigger event occur (as defined by The Office of the Superintendent of Financial Institutions’ [OSFI] guideline for Capital Adequacy Requirements, Chapter 2), each subordinated note outstanding will automatically and immediately be converted, without the holder’s consent, into a number of fully paid and freely tradable common shares of the bank, determined in accordance with a conversion formula.

The following constitute trigger events:

  • •OSFI publicly announces it has advised RBC that it believes the bank has ceased, or is about to cease, to be viable and that, after converting the preferred shares and all other contingent instruments RBC has issued, and taking into account any other relevant factors, it is reasonably likely that the bank’s viability will be restored or maintained; or
  • •The federal government or a provincial government in Canada publicly announces that RBC has accepted a capital injection, or equivalent support, from a government or agency, without which the bank would be nonviable, according to OFSI.

Because we expect this instrument’s conversion to occur at or near the point of the banks’ nonviability, we view this mechanism as a nonviability trigger.

We expect to assign “minimal” (as our criteria describe the term) equity content to these subordinated notes because we do not consider notes that have only nonviability features to be able to absorb losses prior to the bank’s point of nonviability.

By way of comparison, S&P has the NVCC-compliant preferreds at BBB+, one notch lower on the global scale than the Sub-Debts A-.

So OSFI gets a lot of discretion in determining conversion – surprise, surprise! Since bond management firms are typically much larger than preferred share management firms (I believe there’s only one of these in Canada!), and since bond investors are typically much bigger than preferred share investors (aka, “retail scum”) I believe that in a crisis there will be frenzied and successful lobbying of OSFI personnel by their future employers to convert preferreds but to ‘just wait a bit’ before forcing sub-debt conversion.

Blair Keefe, David Seville and Thomas Yeo of Tory’s Law Firm recently wrote an article titled The Preferred Share Market Finally Re-Opens For Canadian Banks:

The market is still waiting for the first offering of NVCC subordinated debt. There are a few reasons why the banks have remained hesitant to tap that market. One reason relates to changes in capital ratios mandated by Basel III, which reduce the need for subordinated debt on a bank’s balance sheet. Prior to the introduction of Basel III, subordinated debt could account for almost one-third of the total capital of a bank. With the new minimum total capital requirement of 10.5%2 (including a countercyclical capital buffer of 2.5%) of risk-weighted assets and a 8.5% minimum for tier 1 capital, effectively the most that can be satisfied with subordinated debt is 2% of the bank’s risk-weighted assets. As well, under Basel III, most deductions from capital must be made from common share equity, whereas in the past, certain deductions could be made from total capital. Effective January 1, 2015, the leverage or asset-to-capital ratio in Canada will be based on tier 1 capital as opposed to total capital. This requirement is particularly important for smaller deposit-taking institutions because they tend to be limited by their asset-to-capital multiples. As a result, we expect that subordinated debt will be eliminated from the capital structure of many smaller institutions—and will form a significantly smaller portion of the capital structure of larger institutions than it has historically.

Market uncertainty also remains over how the proposed “bail-in” debt regime will interact with NVCC instruments. In October 2011, the Financial Stability Board issued a paper providing that regulators should have the power to convert (or write off) all or part of the unsecured and uninsured creditor claims of a financial institution under resolution into equity or other ownership instruments. It was proposed that such a conversion would be done in a manner that respects the hierarchy of claims in liquidation. The 2013 Canadian federal government budget includes a proposed plan to implement a “bail-in” regime for systemically important banks3; Canadian banks and the market generally are still waiting for details as to how the federal government intends to implement this regime. The institutional investors that make up the vast majority of the market for subordinated debt are particularly concerned with how the bail-in regime will function and the effect of further dilution after NVCC instruments are converted, resulting in a “wait-and-see” approach to investor interest in NVCC subordinated debt offerings.

The precise conversion formula to be adopted by the banks for NVCC subordinated debt is not yet known. Under OSFI’s requirements, conversion formulas for both NVCC preferred shares and subordinated debt need to be set to ensure respect for the relative hierarchy of claims between the two types of instruments in the event of a triggering event. In other words, since debt ranks ahead of equity in the traditional capital structure, in the event of a triggering event, holders of subordinated debt should receive more common shares on conversion than holders of preferred shares on a dollar-for-dollar basis. The banks have put substantial effort in the development of a formula used in the preferred share offerings which addresses concerns about potential market manipulation and death spirals in situations where conversion appears to be a possibility. As of the date this article was written, all offerings of NVCC preferred shares have used the same formula based on the issue price of the preferred shares, plus declared and unpaid dividends, divided by the volume- weighted average trading price over the 10 trading days before a triggering event, subject to a $5.00 floor price. It is unlikely that other banks will depart from this formula. The preferred share formula would suggest that the conversion formula for subordinated debt will use some multiple of the principal amount of the debt, together with accrued interest, to achieve the hierarchy of claims desired by OSFI. Issuers of NVCC subordinated debt should consider obtaining an advance income tax ruling from the Canada Revenue Agency confirming the deductibility by the bank of the interest payments, although we anticipate no difficulty in banks obtaining that ruling.

So my guess is that not only will the sub-debt benefit by delayed conversion, but the floor on the conversion price to equity will be lower – say, $3-4 instead of the now-standard $5 floor for preferreds. Senior “debt”, presumably, will be lower still.

The next matter of interest is whether this non-debt gets included in the bond indices; given that they’re bank issues, and the banks own TMX, and TMX runs the standard index (this arrangement has been blessed by the regulators, in exchange for regular payments), I’d say it’s a slam-dunk. But I have no information yet.

Update, 2014-7-12: OK, so I found the term sheet on SEDAR. It’s not under Prospectus, it’s under “Marketing Materials”, dated July 9. The conversion is:

The “Contingent Conversion Formula” is (Multiplier x Note Value) ÷ Conversion Price = number of Common Shares into which each Note shall be converted.

The “Multiplier” is 1.5.

The “Note Value” of a Note is the Par Value plus accrued and unpaid interest on such Note.

The “Conversion Price” of each Note is the greater of (i) a floor price of $5, and (ii) the Current Market Price of the Common Shares. The floor price of $5 will be subject to adjustment in the event of (i) the issuance of Common Shares or securities exchangeable for or convertible into Common Shares to all holders of Common Shares as a stock dividend, (ii) the subdivision, redivision or change of the Common Shares into a greater number of Common Shares, or (iii) the reduction, combination or consolidation of the Common Shares into a lesser number of Common Shares. The adjustment shall be computed to the nearest one-tenth of one cent provided that no adjustment of the Conversion Price shall be required unless such adjustment would require an increase or decrease of at least 1% of the Conversion Price then in effect.

“Current Market Price” of the Common Shares means the volume weighted average trading price of the Common Shares on the Toronto Stock Exchange (the “TSX”), if such shares are then listed on the TSX, for the 10 consecutive trading days ending on the trading day preceding the date of the Trigger Event. If the Common Shares are not then listed on the TSX, for the purpose of the foregoing calculation reference shall be made to the principal securities exchange or market on which the Common Shares are then listed or quoted or, if no such trading prices are available, “Current Market Price” shall be the fair value of the Common Shares as reasonably determined by the board of directors of the Bank.

It’s interesting that they’re implementing this with a conversion factor, rather than changing the floor price. Just what the implications of that might be is something that will bear thinking about.

Update, 2014-7-18: DBRS rates at A(low) [Stable].

Market-Based Bank Capital Regulation

Wednesday, March 5th, 2014

Assiduous Reader DR sent me the following query:

Today’s Financial Posts has an article “A better Basel mousetrap to protect taxpayers”, by Finn Poschmann regarding NVCC.

What is your opinion?

A short search brought up the article in question, A Better Basel Mousetrap to Protect Taxpayers, which in turn led me to the proposal by Jeremy Bulow and Paul Klemperer titled Market-Based Bank Capital Regulation:

Today’s regulatory rules, especially the easily-manipulated measures of regulatory capital, have led to costly bank failures. We design a robust regulatory system such that (i) bank losses are credibly borne by the private sector (ii) systemically important institutions cannot collapse suddenly; (iii) bank investment is counter-cyclical; and (iv) regulatory actions depend upon market signals (because the simplicity and clarity of such rules prevents gaming by firms, and forbearance by regulators, as well as because of the efficiency role of prices). One key innovation is “ERNs” (equity recourse notes — superficially similar to, but importantly distinct from, “cocos”) which gradually “bail in” equity when needed. Importantly, although our system uses market information, it does not rely on markets being “right.”

Our solution is based on two rules. First, any systemically important financial institution (SIFI) that cannot be quickly wound down must limit the recourse of non-guaranteed creditors to assets posted as collateral plus equity plus unsecured debt that can itself be converted into equity–so these creditors have some recourse but cannot force the institution into re-organization. Second, any debt guaranteed by the government, such as deposit accounts, must be backed by government-guaranteed securities. This second rule can only realistically be thought of as a very long-run ambition – our interim objective would involve a tight ring-fence of government-guaranteed deposits collateralized by assets that are haircut at rates similar to those applied by lenders (including central banks3 and the commercial banks themselves!) to secured borrowers.

Specifically: first, we would have banks replace all (non-deposit) existing unsecured debt with “equity recourse notes” (ERNs). ERNs are superficially similar to contingent convertible debt (“cocos”) but have important differences. ERNs would be long-term bonds, subject to certain term-structure requirements, with the feature that any interest or principal payments payable on a date when the stock price is lower than a pre-specified price would be paid in stock at that pre-specified price. The pre-specified price would be required to be no less than (say) 25 percent of the share price on the date the bond was issued. For example, if the stock were selling at $100 on the day a bond was issued and then fell below $25 by the time a payment of $1000 was due, the firm would be required to pay the creditor (1000/25) = 40 shares of stock in lieu of the payment. If the stock rebounded in price, future payments could again be in cash.

Crucially, for ERNs, unlike cocos:

  • any payments in shares are at a pre-set share price, not at the current share price or at a discount to it—so ERNs are stabilizing because that price will always be at a premium to the market
  • conversion is triggered by market prices, not regulatory values—removing incentives to manipulate regulatory measures, and making it harder for regulators to relax requirements
  • conversion is payment-at-a-time, not the entire bond at once (because ERNs become equity in the states that matter to taxpayers, they are, for regulatory purposes, like equity from their date of issuance so there is no reason for faster conversion)–further reducing pressures for “regulatory forbearance” and also largely solving a “multiple equilibria” problem raised in the academic literature
  • we would replace all existing unsecured debt with ERNs, not merely a fraction of it—ensuring, as we show below, that ERNs become cheaper to issue when the stock price falls, creating counter-cyclical investment incentives when they are most needed.

OK, so I have difficulties with all this. Their first point is that non-guaranteed creditors “cannot force the institution into re-organization.” Obviously there are many differences of opinion in this, but I take the view that being able to force a company into re-organization – which may include bankruptcy – is one of the hallmarks of a bond. For example, I consider preferred shares to be fixed income – as they have a cap on their total return and they have first-loss protection – but I do not consider them bonds – as they cannot force bankruptcy. The elimination of bankruptcy, although very popular among politicians (who refer to bankruptcy as a form of terrorism) is a very big step; bankruptcy is a very big stick that serves to concentrate the minds of management and directors.

Secondly, they want insured deposits to be offset by government securities. There’s an immediate problem about this in Canada, because insured deposits total $646-billion while government of Canada marketable debt totals $639-billion. You could get around this by saying the CMHC-guaranteed mortgages are OK, but even after years of Spend-Every-Penny pouring fuel on the housing fire, CMHC insurance totals only $559.8-billion (out of a total of $915-billion. At present, Canadian Chartered Banks hold only about $160-billion of government debt. So it would appear that, at the very least, this part of the plan would essentially force the government to continue to insure a ridiculous proportion of Canadian residential mortgages.

And, specifically, they want all (non-deposit) existing unsecured debt with “equity recourse notes”. OK, so how much is that? Looking at recent figures from RBC:

Click for Big

So roughly a quarter of Royal Bank’s liabilities would become ERNs …. and who’s going to buy it? It’s forcibly convertible into equity long before the point of non-viability – that’s the whole point – so for risk management purposes it is equity. If held by another bank, it will attract a whopping capital charge (or if it doesn’t, it should) and it can’t be held by institutional bond portfolios (or if it is, it shouldn’t be). I have real problems with this.

The paper makes several entertaining points about bank regulation:

The regulatory system distorts incentives in several ways. One of the motivations for Citigroup to sell out of Smith, Barney at what was generally believed to be a low price, was that it allowed Citi to book an increase in regulatory capital. Conversely, selling risky “toxic assets” with a regulatory value greater than market is discouraged because doing so raises capital requirements even while reducing risk.[footnote].

[Footnote reads] : Liquidity reduction is another consequence of the current regulatory system, as firms will avoid price-discovery by avoiding buying as well as selling over-marked assets. For example, Goldman Sachs stood ready to sell assets at marks that AIG protested were too low, but AIG did not take up these offers. See Goldman Sachs (2009). For an example of traders not buying even though they claimed the price was too low, see the FCIC transcript of a July 30, 2007 telephone call between AIG executives. “We can’t mark any of our positions, and obviously that’s what saves us having this enormous mark to market. If we start buying the physical bonds back … then any accountant is going to turn around and say, well, John, you know you traded at 90, you must be able to mark your bonds then.” Duarte (2012) discusses the recent trend of European banks to meet their requirements to raise regulatory capital by repurchasing their own junk bonds, arguably increasing the exposure of government insurers.

However, don’t get me wrong on this: the basic idea – of conversion to a pre-set value of stock once the market breaches that pre-set value – is one that I’ve been advocating for a long time. They are similar in spirit to McDonald CoCos, which were first discussed on PrefBlog under the heading Contingent Capital with a Dual Price Trigger (regrettably, the authors did not discuss McDonald’s proposal in their paper). ERNs are ‘high-trigger’ instruments, and therefore will help serve to avert a crisis, rather than merely mitigate one, as is the case with OSFI’s NVCC rules; I have long advocated high triggers.

My basic problem is simply that the authors:

  • Require too many ERNs as a proportion of capital, and
  • Seek to Ban the Bond

However, it may easily be argued that these objections are mere matters of detail.

New RBC / NA / CWB reset prefs

Monday, February 3rd, 2014

I have been asked, in an eMail with the captioned title:

Not sure this is going to the right place. Can’t find anyone else to send these comments to.

I owned a number of bank “rate reset” prefs. In the past year, many have been redeemed, and a few have been reset for another 5 years.

There are 3 new issues that recently came out (RY / NA / CWB) with changes to factor in the new Basel capital requirements. My understanding is that basically, if real bad things happen to the bank, the shares can be converted to commons without the holders consent.

In my mind, this is a major negative change to an investor’s position compared to the previous reset prefs. But the pricing of these new issues (either the rate or reset premium) does not seem to give any value to the additional risk. In addition, there does not seem to be any discussion or commentary of the additional exposure anywhere. Is it possible that the people selling these new issues might have a bit of a conflict position (the brokerage houses are all owned by the banks).

Do you have any thoughts on this? If you agree, how does one convince the market that the pricing needs to be adjusted?

I would appreciate any comments you might have – maybe I’m missing something in my thinking. Thank you.

The new issues referred to are:

The desire for change is fueled by political resentment that European banks were bailed out while Tier 1 Capital note-holders were not wiped out and in some cases were unscathed (see my article Prepping for Crises; particularly the footnoted draft version. Or you could just google “burden sharing”).

As I have stressed in the past the big problem is that the Superintendent of Financial Institutions has a huge amount of discretion:

Principle # 3: The contractual terms of all Additional Tier 1 and Tier 2 capital instruments must, at a minimum Footnote 41, include the following trigger events:

  • a.
    the Superintendent of Financial Institutions (the “Superintendent”) publicly announces that the institution has been advised, in writing, that the Superintendent is of the opinion that the institution has ceased, or is about to cease, to be viable and that, after the conversion of all contingent instruments and taking into account any other factors or circumstances that are considered relevant or appropriate, it is reasonably likely that the viability of the institution will be restored or maintained; or

  • b. a federal or provincial government in Canada publicly announces that the institution has accepted or agreed to accept a capital injection, or equivalent support, from the federal government or any provincial government or political subdivision or agent or agency thereof without which the institution would have been determined by the Superintendent to be non-viable Footnote 42.

The term “equivalent support” in the above second trigger constitutes support for a non-viable institution that enhances the institution’s risk-based capital ratios or is funding that is provided on terms other than normal terms and conditions. For greater certainty, and without limitation, equivalent support does not include:

  • i. Emergency Liquidity Assistance provided by the Bank of Canada at or above the Bank Rate;
  • ii. open bank liquidity assistance provided by CDIC at or above its cost of funds; and
  • iii. support, including conditional, limited guarantees, provided by CDIC to facilitate a transaction, including an acquisition or amalgamation.

In addition, shares of an acquiring institution paid as non-cash consideration to CDIC in connection with a purchase of a bridge institution would not constitute equivalent support triggering the NVCC instruments of the acquirer as the acquirer would be a viable financial institution.

The first trigger is the tricky one, although there are also problems with number 2.

This uncertainty has led DBRS to rate these issues a notch lower than other bank issues (in line with S&P’s earlier decision), but there doesn’t appear to be any market recognition of this analysis.

This is precisely what the regulator wants – they have long been in favour of a low trigger for contingent conversion, in opposition to much of the rest of the world. As discussed on October 27, 2011 (the internal link is broken as part of OSFI’s policy to discourage public discussion of their pronouncements), OSFI dismissed high-triggers; while there were lots of rationalizations in their NVCC roadshow, the real reason was articulated by Ms. Dickson in a speech:

The conversion trigger would be activated relatively late in the deterioration of a bank’s health, when the supervisor has determined that the bank is no longer viable as currently structured. This should result in the contingent instrument being priced as debt. Being priced as debt is critical, as it makes it far more affordable for banks, and therefore has the benefit of minimizing the impact on the costs of consumer and business loans.

So to hell with high-trigger CoCos and their potential to avert a crisis! In normal times, it will be cheaper for the banks to issue low-trigger CoCos and thereby be able to pay their directors more, particularly the ones who are ex-regulators.

So that’s the background. With respect to the reader’s question:

If you agree, how does one convince the market that the pricing needs to be adjusted?

Well, you can’t, really. I get a lot more requests to recommend bank issues, good solid Canajun banks, none of this insurance or utility garbage, on the grounds of “safety”, than I get requests to comment on risk factors particularly applicable to bank issues.

All you can do is make your own assessment of risk and your own assessment of reward, feed all your analysis into the sausage-making machine, hope you’ve made fewer analytical errors than other market participants and that the world doesn’t change to such a degree that analysis was useless anyway. Which isn’t, perhaps, the most detailed advice I have ever given, but it’s the best I can do.

Contingent Capital: The Case for COERCs

Saturday, April 6th, 2013

A question in the comments to my old post A Structural Model of Contingent Bank Capital led me to look up what Prof. George Pennacchi has been doing lately; together with Theo Vermaelen and Christian C. P. Wolff he has written a paper titled Contingent Capital: The Case for COERCs:

In this paper we propose a new security, the Call Option Enhanced Reverse Convertible (COERC). The security is a form of contingent capital, i.e. a bond that converts to equity when the market value of equity or capital falls below a certain trigger. The conversion price is set significantly below the trigger price and, at the same time, equity holders have the option to buy back the shares from the bondholders at the conversion price. Compared to other forms of contingent capital proposed in the literature, the COERC is less risky in a world where bank assets can experience sudden, large declines in value. Moreover, the structure eliminates concerns of an equity price “death spiral” as a result of manipulation or panic. A bank that issues COERCs also has a smaller incentive to choose investments that are subject to large losses. Furthermore, COERCs reduce the problem of “debt overhang,” the disincentive to replenish shareholders’ equity following a decline.

The basic justification for the COERCs is:

In contrast to the Credit Suisse coco bond [with accounting and regulatory triggers], the trigger is based on market value based leverage ratios, which are forward looking, rather than backward looking, measures of financial distress. It also means that at the time of the triggering event the stock price is known, unlike in the case of coco bonds with accounting based capital ratio triggers. As the trigger is driven by the market and not by regulators, regulatory risk is avoided. The conversion price is set at a large discount from the market price at the time of conversion, which means that conversion would generate massive shareholder dilution. However, in order to prevent this dilution, shareholders have an option to buy back the shares from the bondholders at the conversion price. In practice, what will happen is that when the trigger is reached, the company will announce a rights issue with an issue price equal to the conversion price and use the proceeds to repay the debt. As a result, the debt will be (almost) risk-free. In our simulations, we show that it is possible to design a COERC in such a way that the fair credit spread is 20 basis points above the risk-free rate. So although the shareholders are coerced to repay the debt, the benefit from this coercion is reflected in the low cost of debt as well as the elimination of all direct and indirect costs of financial distress. Although at the time of the trigger, the company will announce an equity issue, there is no negative signal associated with the issuance as the issue is the automatic result of reaching a pre-defined trigger.

Market based triggers are generally criticised because they create instability: bond holders have an incentive to short the stock and trigger conversion. Moreover, the fear of dilution may encourage shareholders to sell their shares so that the company ends up in a self-fulfilling death spiral. However, because in a COERC shareholders have pre-emptive rights in buying the shares from the bondholders, they can undo any conversion that is result of manipulation or unjustified panic. Moreover, because bondholders will generally be repaid, they have no incentive to hedge their investment by shorting the stock when the leverage ratio approaches the trigger, unlike the case of coco bonds where bondholders will become shareholders after the triggering event. The design of the contract also discourages manipulation by other bondholders. Bolton and Samama (2010) argue that other bond-holders may want to short the stock to trigger conversion, in order to improve their seniority. However, because the COERCs will be repaid in these circumstances such activity will not improve other bondholder’s seniority.

Further justification is given as:

Our objective is to propose an alternative, an instrument that a value maximizing manager would like to issue, without being forced by regulators. Companies are coerced to issue equity and repay debt by fear of dilution, not by the decision of a regulator. Imposing regulation against the interest of the bank’s shareholders will encourage regulatory arbitrage and may also reduce economic growth.6 If bankers, on the other hand, can be convinced that issuing contingent capital increases shareholder value, then any regulatory “encouragement” to issue these securities will be welcomed. Our proposal is therefore more consistent with a free market solution to the general problem that debt overhang discourages firms from recapitalizing when they are in financial distress. Hence the COERC should be of interest to any corporation where costs of financial distress are potentially important.

It seems like a very good idea. One factor not considered in the paper is the impact on equity investors.

Say you have an equity holding in a bank that has a stock price (and the fair value of the stock price) slightly in excess of the trigger price for its COERCs. At that point, buyers of the stock (and continuing holders!) must account for the probability that the conversion will be triggered and their will be a rights issue. Therefore, in order to avoid dilution, they must not only pay the fair market value for the stock, but they must also have cash on hand (or credit lines) available that will allow them to subscribe to the rights offering; the necessity of having this excess cash will make the common less attractive at its fair market value. This may serve to accelerate declines in the bank’s stock price.

It is also by no means assured that shareholders will be able to sell the rights anything close to their fair value.

A Goldman Sachs research report titled Contingent capital Possibilities, problems and opportunities is also of interest. Canadians panic-stricken by the recent musings in the federal budget (see discussion on April 1, April 2 and April 5) will be fascinated by:

Bail-in is a potential resolution tool designed to protect taxpayer funds by converting unsecured debt into equity at the point of insolvency. Most bail-in proposals would give regulators discretion to decide whether and when to convert the debt, as well as how much.

There is an active discussion under way as to whether bail-in should be a tool broadly applicable to all forms of unsecured credit (including senior debt) or whether it should be a specific security with an embedded write-down feature.

Naturally, this discussion is not being held in Canada; we’re too stupid to be allowed to participate in intelligent discussions.

As might be expected, GS is in favour of market-based solutions and consequent ‘high-trigger’ contingent capital:

Going-concern contingent capital differs substantially from the gone-concern kind. It is designed to operate well before resolution mechanisms come into play, and thus to contain financial distress at an early stage. The recapitalization occurs at a time when there is still significant enterprise value, and is “triggered” through a more objective process with far less scope for regulatory discretion. For investors to view objective triggers as credible, however, better and more-standardized bank disclosures will be needed on a regular basis. Because this type of contingent capital triggers early, when losses are still limited, it can be issued in smaller tranches. This, in turn, allows for greater flexibility in
structuring its terms.

When the early recapitalization occurs, control of the firm can shift from existing shareholders to the contingent capital holders, and a change in management may occur. The threat of the loss of control helps to strengthen market discipline by spurring the firm to de-risk and de-leverage as problems begin to emerge. As such, going-concern contingent capital can be an effective risk-mitigating tool.

GS further emphasizes the need to appeal to fixed income investors:

Contingent capital will only be viable as a large market if it is treated as debt

Whether “going” or “gone,” contingent capital will only be viable as a large market if it is treated as debt. This is not just a question of technical issues like ratings, inclusion in indices, fixed income fund mandates and tax-deductibility, though these issues are important. More fundamentally, contingent capital must be debt in order to appeal to traditional fixed income investors, the one market large enough to absorb at least $925 billion in potential issuance over the next decade.

Surprisingly, GS is in favour of capital-based triggers despite the problems:

A capital-based trigger would force mandatory conversion if and when Tier 1 (core) capital fell below a threshold specified either by regulators (in advance) or in the contractual terms of the contingent bonds. We think this would likely be the most effective trigger, because it is transparent and objective. Investors would be able to assess and model the likelihood of conversion if banks’ disclosure and transparency are enhanced. Critically, a capital-based trigger removes the uncertainty around regulatory discretion and the vulnerability to market manipulation that the other options entail.

Capital-based triggers are also vulnerable to financial reporting that fails to accurately reflect the underlying health of the firm. Lehman Brothers, for example, reported a Tier 1 capital ratio of 11% in the period before its demise – well above the regulatory minimum and a level most would have considered healthy. The same was true for Bear Stearns and Washington Mutual before they were acquired under distress. We think this issue must be resolved for investors to embrace capital-based triggers.

Fortunately there are several ways to make capital ratios more robust, whether by “stressing” them through regulator-led stress tests or by enforcing more rigorous and standardized disclosure requirements that would allow investors to better assess the health of the bank. Such standardized disclosures could relieve regulators of the burden of conducting regular stress tests, and would significantly enhance transparency. The value of stress testing and greater disclosures is one lesson from the financial crisis. The US Treasury’s 2009 stress test illustrates this point vividly. While not perfect, it offered greater
transparency and comparability of bank balance sheets than investors were able to derive from public filings. With this reassurance, investors were willing to step forward and commit capital. The European stress test proves the point as well: it did not significantly improve transparency and thus failed to reassure investors or attract capital.

That is the crux of the matter and I do not believe that the Gordian Knot can be cut in the real world. The US Treasury made their stress test strict and credible because it knew in advance that its banks would pass. The Europeans made their stress test ridiculous and incredible because they knew in advance that their banks would fail.

I liked their succinct dismissal of regulatory triggers:

While flexibility can be helpful, particularly given that no two crises are alike, recent experience shows that some regulators may be hesitant to publicly pronounce that a financial firm is unhealthy, especially during the early stages of distress. There is, after all, always the hope that the firm’s problems will be short-lived, or that an alternative solution to the triggering of contingent capital can be found. Thus a regulator may be unlikely to pull the trigger – affecting not only the firm and all of its stakeholders, but also likely raising alarm about the health of other financial firms – unless it is certain of a high degree of distress. By then, losses may have already risen to untenable levels, which is why this type of trigger is associated with gone-concern contingent capital.

GS emphasizes the importance of the indices:

The inclusion of contingent capital securities in credit indices will also be an important factor, perhaps even more important than achieving a rating. This is because the inclusion itself would attract investors, who otherwise might risk underperforming benchmarks by being underweight a significant component of the index. Credit indices currently do not include mandatorily convertible equity securities, although they can include instruments that allow for loss absorption through a write-down feature. This again contributes to the appeal of the write-down feature (rather than the simple conversion to equity) to most fixed income investors. If contingent capital securities were included in credit indices, this addition would be likely to drive a substantially deeper contingent capital market.

Here in Canada, of course, the usual benchmark is prepared by the TMX, which the regulators allowed to become bank-owned on condition that it improved the employment prospects for regulators. It’s a thoroughly disgraceful system which will blow up in all our faces some days and then everybody will pretend to be surprised.

GS is dismissive of regulatory triggers and NVCC:

A discretionary, “point of non-viability” trigger would likely be attractive to many regulators as it helps them to preserve maximum flexibility in the event of a financial crisis. This can be useful given that no two crises are exactly alike. It could also allow regulators to consider multiple factors – including the state of the overall financial system – when making the decision to pull the trigger. Discretion also gives regulators the opportunity to exercise regulatory forbearance away from the public spotlight.

Yet we believe this preference for discretion and flexibility makes it difficult for regulators to meet one of their most important – yet mostly unspoken – goals, which is to develop a viable contingent capital market. Regulators have certainly solicited feedback from investors, but some seem to believe that simply making contingent capital mandatory for issuers means that investors will buy them. However, from conversations with many investors, we believe that regulators may need to move toward a more objective trigger; if not, the price of these instruments may be prohibitive.

There is another set of participants in a potential contingent capital market: taxpayers. Regulators represent taxpayers’ interests by promoting systemic stability and requiring robust loss-absorption capabilities at individual banks. But the interests of regulators and taxpayers may not always be fully aligned. If taxpayers’ principal goal is to avoid socializing private-sector losses, and to prevent the dislocation of a systemic crisis even in its early stages, then they should want a stringent version of contingent capital – one that converts to equity at a highly dilutive rate, based on an early and objective trigger. The discretion and flexibility inherent in regulatory-triggered gone-concern contingent capital may have less appeal to taxpayers. From their standpoint, gone-concern contingent capital might well have allowed a major financial firm to fail, causing job losses and other disruptions across the financial system. Taxpayers may find the potential risk-reducing incentives created by going-concern contingent capital to be a more robust answer to the problem of too big to fail.

Goldman’s musings on investor preference can be taken as an argument in favour of COERCs:

Traditional fixed-income investors will likely want contingent capital to have a very low probability of triggering, which leads them to prefer an objective, capital-based and disclosure-enhanced trigger. Many investors have indicated their concerns about the challenges of modeling a discretionary trigger: it is very difficult to model the probability of default, the potential loss given default or even the appropriate price to pay for a security that converts under a discretionary and opaque process. Greater transparency is a prerequisite for a capital-based trigger to be seen as credible by investors, because they will need to have greater confidence that banks’ balance sheets reflect reality. We also believe that investors would be more likely to embrace a capital-based trigger if the terms were quite stringent, thereby lowering the probability of conversion.

Credit Suisse to Issue High-Trigger CoCos

Wednesday, July 18th, 2012

Under pressure from the Swiss bank regulator Credit Suisse is issuing High-Trigger CoCos:

Credit Suisse today announced a number of measures to accelerate the strengthening of its capital position in light of the current regulatory and market environment. An immediate set of actions will be implemented to increase the capital by CHF 8.7 billion. Additional capital actions and earnings related impacts are to increase the capital by a further CHF 6.6 billion by year-end 2012.

The measures will result in an expected end-2012 look-through Swiss Core Capital Ratio of 9.4%, compared to the 2018 requirement of 10%. Look-through Swiss Core Capital includes look-through Basel III Common Equity Tier 1 (CET1) and existing participation securities (“Claudius notes”) that qualify as part of the Swiss equity requirement in excess of the 8.5% Basel III G-SIB Common Equity Tier 1 (CET1) ratio.

The measures will result in an expected look-through Swiss Total Capital Ratio of 10.8% at end 2012. This broadly compares to the figure of 5.9% calculated by the Swiss National Bank (SNB) at the end of 1Q12 and published in its 2012 Financial Stability Report. Look-through Swiss Total Capital includes look-through Basel III CET1 and the participation securities (“Claudius notes”). Additionally it includes the Group’s Buffer Capital Notes (“CoCos with high trigger”).

There are no details available on the projected notes, but they have some Tier 2 Buffer Capital Notes outstanding.

For example, there is a USD 2-billion issue of 7.875 per cent. Tier 2 Buffer Capital Notes due 2041:

Interest on the BCNs will accrue from and including 24 February 2011 (the ‘‘Issue Date’’) to (but excluding) 24 August 2016 (the ‘‘First Optional Redemption Date’’) at an initial rate of 7.875 per cent. per annum, and thereafter at a rate, to be reset every five years thereafter, based on the Mid Market Swap Rate (as defined herein) plus 5.22 per cent.

If a Contingency Event or a Viability Event (each as defined herein) occurs, the BCNs shall, subject to the satisfaction of certain conditions, mandatorily convert into Ordinary Shares (as defined herein) which shall be delivered to the Settlement Shares Depository (as defined herein) on behalf of the Holders, as more particularly described in ‘‘Terms and Conditions of the BCNs—Conversion’’. In the event of a Contingency Event Conversion (as defined herein), such Ordinary Shares may, at the election of CSG, be offered for sale in a Settlement Shares Offer as described herein.

Contingency Event means that CSG has given notice to the Holders that CSG’s Core Tier 1 Ratio (prior to the Basel III Regulations Date) or the Common Equity Tier 1 Ratio (on or after the Basel III Regulations Date) is below 7 per cent. as at the date of the financial statements contained in a Quarterly Financial Report and that a Contingency Event Conversion will take place.

Viability Event means that either: (a) the Regulator has notified CSG that it has determined that Conversion of the BCNs, together with the conversion or write off of holders’ claims in respect of any other Buffer Capital Instruments, Tier 1 Instruments and Tier 2 Instruments that, pursuant to their terms or by operation of laws are capable of being converted into equity or written off at that time, is, because customary measures to improve CSG’s capital adequacy are at the time inadequate or unfeasible, an essential requirement to prevent CSG from becoming insolvent, bankrupt or unable to pay a material part of its debts as they fall due, or from ceasing to carry on its business; or (b) customary measures to improve CSG’s capital adequacy being at the time inadequate or unfeasible, CSG has received an irrevocable commitment of extraordinary support from the Public Sector (beyond customary transactions and arrangements in the ordinary course) that has, or imminently will have, the effect of improving CSG’s capital adequacy and, without which, in the determination of the Regulator, CSG would have become insolvent, bankrupt, unable to pay a material part of its debts as they fall due or unable to carry on its business.

The BCNs will be converted into a number of Ordinary Shares determined by dividing the principal amount of each BCN by the Conversion Price in effect on the relevant Conversion Date. ‘‘Conversion Price’’ means (i) at any time when the Ordinary Shares are admitted to trading on a Recognised Stock Exchange, in respect of any Conversion Date, the greatest of (a) the Reference Market Price of an Ordinary Share on the fifth Zurich Business Day prior to the date of the relevant Contingency Event Notice or, as the case may be, the Viability Event Notice translated into United States dollars at the Exchange Rate, (b) the Floor Price on the fifth Zurich Business Day prior to the date of the Contingency Event Notice or, as the case may be, the Viability Event Notice; and (c) the nominal value of each Ordinary Share on the Share Creation Date (being, at the Issue Date, CHF 0.04) translated into United States dollars at the Adjusted Exchange Rate, or (ii) without prejudice to ‘‘Takeover Event and De-listing’’ below, at any time when the Ordinary Shares are not admitted to trading on a Recognised Stock Exchange by reason of a Non-Qualifying Takeover Event or otherwise, the greater of (b) and (c) above.

Very good. There’s a high trigger and conversion at market price. The part I dislike is that the conversion trigger is a regulatory ratio – we found during the crisis that regulatory ratios aren’t worth much in the course of a panic. Still – much better than anything we’re ever likely to see in Canada!

BCBS Discusses Contingent Capital

Friday, November 4th, 2011

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.

DBRS To Rate NVCC Preferreds

Wednesday, August 17th, 2011

Following the finalization of the OSFI NVCC Advisory and basically simultaneously with the Review-Negative slapped on NVCC-eligible extant preferreds, DBRS has announced that it:

has concluded today that it expects it can rate Canadian subordinated debt with a non-viability contingent capital clause (sub debt NVCC) and Canadian preferred shares with a non-viability contingent capital clause (pref NVCC) following the review of the Office of the Superintendent of Financial Institutions Canada (OSFI) Advisory on Non-Viability Contingent Capital, issued on August 16, 2011 (NVCC Advisory).

In this document, all references to non-viability contingent capital (NVCC) instruments are based on our expectations that non-viability (as determined by OSFI) is the only contingent event, that the contingent event triggers permanent conversion to common equity and that over time, as NVCC becomes the major instrument with respect to subordinated debt and preferred shares, any trigger event for sub debt NVCC holders would cause these holders to become meaningful owners of the bank in question. These considerations are also consistent with our ability to rate the NVCC instruments. According to DBRS criteria, the triggers are well defined and permit an assessment of the risks.

Both the sub debt NVCC and pref NVCC ratings will have wider notching, based on the global standard notching for preferred shares, because of additional risk associated with tripping the trigger. The expected losses resulting from tripping the trigger would have an impact on the relative rating of sub debt NVCC and pref NVCC. As guidance, sub debt NVCC will likely be rated no higher than the standard rating for preferred shares and the pref NVCC will likely be rated one notch below the standard rating for preferred shares.

For clarity, global standard notching for preferred shares means the starting point for notching preferred share ratings is the intrinsic assessment (IA) rating rather than the final senior debt rating, and the degree of notching from the IA rating to the preferred share rating widens to reflect our perception of the increased risk in these capital instruments. The base notching policy is three notches for AA, four notches for “A” and five notches for BBB and lower IA ratings. Note that when DBRS initiated the criteria on June 29, 2009, most banks in Canada had their preferred share ratings downgraded to only one notch above the global standard notching for preferred shares

DBRS has determined that the likelihood of tripping the trigger event (i.e., non-viability as determined by OSFI) would be very hard or remote. DBRS’s decision was based on the assessment of the criteria to be considered in triggering conversion of NVCC instruments that was spelled out in the NVCC advisory by OSFI. Lower-rated banks suggest an increased probability of conversion as a result of tripping the trigger given the greater need for a bank to generate regulatory capital. This would result in higher notching from the intrinsic assessment, as set out in the DBRS methodology Rating Bank Preferred Shares and Equivalent Hybrids. As such, both the sub debt NVCC and pref NVCC ratings would be tied to the preferred share rating of the bank.

The expected losses as a result of the conversion would affect the rating for sub debt NVCC relative to pref NVCC. It is the economic entitlement each receives post-trigger that is the significant factor in the relative ratings as opposed to the host security’s pre-trigger features. This economic entitlement can be assessed only after terms are provided in a contractual agreement between the issuing bank and the purchaser.

OSFI Finalizes NVCC Advisory

Wednesday, August 17th, 2011

OSFI has released a final Advisory on NVCC, with some changes from the draft advisory which was discussed on PrefBlog. The draft advisory has been removed from OSFI’s website in accordance with their policy to ensure that the rationale behind their policies and their development is not understood by investors. Naturally, no comment letters have been published, nor have any documents been referenced that might provide any vestiege of support for their arbitrary and capricious rule-making.

The final advisory begins with a non-sequiter that would not be tolerated in Grade 4:

All regulatory capital must be able to absorb losses in a failed financial institution. During the recent crisis, however, this premise was challenged as certain non-common Tier 1 and Tier 2 capital instruments did not absorb losses for a number of foreign financial institutions that would have failed in the absence of government support.

Principle 3 from the draft advisory, giving the Superintendent the right to trigger conversion if she feels like it, with no appeal, has been retained. Banks are urged to hire lots of former OSFI employees.

There is now a requirement that there be a floor on the conversion price – this did not exist before:

Principle # 4: The conversion terms of new NVCC instruments must reference the market value of common equity on or before the date of the trigger event. The conversion method must also include a limit or cap on the number of shares issued upon a trigger event.

On the one hand, this will prevent so-call “death spirals”. On the other hand, it may make NVCC instruments harder to issue during times of crisis. The necessity of such an unprincipled principle is necessary due to OSFI’s insistence on “low-trigger” NVCC, at a time when the rest of the world has determined that “high-trigger” NVCC is the way to go (see, for example, statements by officials of S&P, more from S&P, Switzerland, the UK, respected academics, and other respected academics, and an equivocal view from IMF staff).

Principal #8, which throws contract law into the same garbage bin as bankruptcy law, has been retained:

Principle # 8: The terms of the NVCC instrument should include provisions to address NVCC investors that are prohibited, pursuant to the legislation governing the DTI, from acquiring common shares in the DTI upon a trigger event. Such mechanisms should allow such capital providers to comply with legal prohibitions while continuing to receive the economic results of common share ownership and should allow such persons to transfer their entitlements to a person that is permitted to own shares in the DTI and allow such transferee to thereafter receive direct share ownership.

Section 2 seeks to ensure permanent employment and many future job opportunities for OSFI employees:

Section 2: Information Requirements to Confirm Quality of NVCC Instruments

While not mandatory, DTIs are strongly encouraged to seek confirmations of capital quality from OSFI’s Capital Division prior to issuing NVCC instruments11. In conjunction with such requests, the DTI is expected to provide the following information….

Capital Surcharges for Globally Important Investment Banks

Monday, June 27th, 2011

The Bank for International Settlements has announced:

the Group of Governors and Heads of Supervision (GHOS), the oversight body of the Basel Committee on Banking Supervision (BCBS), agreed on a consultative document setting out measures for global systemically important banks (G-SIBs). These measures include the methodology for assessing systemic importance, the additional required capital and the arrangements by which they will be phased in. These measures will strengthen the resilience of G-SIBs and create strong incentives for them to reduce their systemic importance over time.

The GHOS is submitting this consultative document to the Financial Stability Board (FSB), which is coordinating the overall set of measures to reduce the moral hazard posed by global systemically important financial institutions. This package of measures will be issued for consultation around the end of July 2011.

The assessment methodology for G-SIBs is based on an indicator-based approach and comprises five broad categories: size, interconnectedness, lack of substitutability, global (cross-jurisdictional) activity and complexity.

The additional loss absorbency requirements are to be met with a progressive Common Equity Tier 1 (CET1) capital requirement ranging from 1% to 2.5%, depending on a bank’s systemic importance. To provide a disincentive for banks facing the highest charge to increase materially their global systemic importance in the future, an additional 1% surcharge would be applied in such circumstances.

The higher loss absorbency requirements will be introduced in parallel with the Basel III capital conservation and countercyclical buffers, ie between 1 January 2016 and year end 2018 becoming fully effective on 1 January 2019.

The GHOS and BCBS will continue to review contingent capital, and support the use of contingent capital to meet higher national loss absorbency requirements than the global minimum, as high-trigger contingent capital could help absorb losses on a going concern basis.

I have mixed views on this. I reported last August that the push towards surcharges was gaining ground and have been advocating surcharges based on size since (at least!) March 2009.

However, I am unfavourably disposed towards the narrow focus of the plan, which affects only “global systemically important banks” as defined by the regulators and then uses an as-yet untested formula “based on an indicator-based approach and comprises five broad categories: size, interconnectedness, lack of substitutability, global (cross-jurisdictional) activity and complexity” to assess the surcharge imposed. There’s a lot of room for error there, and a lot of room for lobbying. There’s also a lot of cliff effect: what will be the effect on the markets when a bank’s G-SIB status is changed? What if it changes during the height of a crisis? What if a well capitalized medium sized bank is interested in purchasing a failing medium sized bank during a crisis? We saw that during the crisis, a lot of the American banks bulked up – will they be willing to bid next time? And finally, of course, the subjective nature of the G-SIB status determination opens up the door for a lot of lobbying and corruption.

I would be much happier with a system that was formula-based and applied to all banks on a progressive basis.

I was very pleased to see that the committees “support the use of contingent capital to meet higher national loss absorbency requirements than the global minimum, as high-trigger contingent capital could help absorb losses on a going concern basis”. The critical part of that phrase is high-trigger contingent capital, which is really one in the eye for those morons at OSFI, who have decided that the lowest possible trigger is the best. However, the “low-trigger” policy was enacted during the reign of the Assistant Croupier; now that he has departed for a greener pastures with a company he used to regulate (see June 14), the new incumbent may have different ideas.

BoE's Haldane Supports McDonald CoCos

Monday, March 28th, 2011

I use the term “McDonald CoCo” to describe a hybrid security that is initially debt-like coverts into equity when the issuer’s common equity price declines below a preset floor. The conversion is performed at the equity trigger price.

I will note immodestly that, were there any justice in the world, they would be called Hymas CoCos, since I published first, but there ain’t no justice and McDonald has the union card.

Anyway, Andrew G Haldane, Executive Director of the Bank of England, has published remarks based on a speech given at the American Economic Association, Denver, Colorado, 9 January 2011:

For large and complex banks, the number of risk categories has exploded. To illustrate, consider the position of a large, representative bank using an advanced internal set of models to calibrate capital. Its number of risk buckets has increased from around seven under Basel I to, on a conservative estimate, over 200,000 under Basel II. To determine the regulatory capital ratio of this bank, the number of calculations has risen from single figures to over 200 million. The quant and the computer have displaced the clerk and the envelope.

At one level, this is technical progress; it is the appliance of science to risk management. But there are costs. Given such complexity, it has become increasingly difficult for regulators and market participants to vouch for the accuracy of reported capital ratios. They are no longer easily verifiable or transparent. They are as much an article of faith as fact, as much art as science. This weakens both Pillars II and III. For what the market cannot observe, it is unlikely to be able to exercise discipline over. And what the regulator cannot verify, it is unlikely to be able to exercise supervision over. Banks themselves have recently begun to voice just such concerns.

… and complexity is Bad:

This evidence only provides a glimpse at the potential model error problem viewed from three different angles. Yet it suggests that model error-based confidence intervals around reported capital ratios might run to several percentage points. For a bank, that is the difference between life and death. The shift to advanced models for calibrating economic capital has not arrested this trend. More likely, it has intensified it. The quest for precision may have come at the expense of robustness.

Hayek titled his 1974 Nobel address “The Pretence of Knowledge”. In it, he highlighted the pitfalls of seeking precisely measurable answers to questions about the dynamics of complex systems. Subsequent research on complex systems has confirmed Hayek’s hunch. Policy predicated on over-precision risks catastrophic error. Complexity in risk models may have perpetuated Hayek’s pretence in the minds of risk managers and regulators.

Like, for instance, in the run-up to the height of the crisis:

To see that, consider the experience of a panel of 33 large international banks during the crisis. This panel conveniently partitions itself into banks subject to government intervention in the form of capital or guarantees (“crisis banks”)
and those free from such intervention (“no crisis banks”).

Chart 5 plots the reported Tier 1 capital ratio of these two sets of banks in the run-up to the Lehman Brothers crisis in September 2008. Two observations are striking. First, the reported capital ratios of the two sets of banks are largely indistinguishable. If anything, the crisis banks looked slightly stronger pre-crisis on regulatory solvency measures. Second, regulatory capital ratios offer, on average, little if any advance warning of impending problems. These conclusions are essentially unchanged using the Basel III definitions of capital.

Click for Big

Got any better ideas?

What could be done to strengthen the framework? As a thought experiment, consider dropping risk models and instead relying on the market. Market-based metrics of bank solvency could be based around the market rather than book value of capital. The market prices of banks are known to offer useful supplementary information to that collected by supervisors when assessing bank health.8 And there is also evidence they can offer reliable advance warnings of bank distress

To bring these thoughts to life, consider three possible alternative bank solvency ratios based on market rather than accounting measures of capital:

  • Market-based capital ratio: the ratio of a bank’s market capitalisation to its total assets.
  • Market-based leverage ratio: the ratio of a bank’s market capitalisation to its total debt.
  • Tobin’s Q: the ratio of the market value of a bank’s equity to its book value.

The first two are essentially market-based variants of regulatory capital measures, the third a well-known corporate valuation metric. How do they fare against the first principles of complex, adaptive systems?

Click for big

Having set the stage, he starts talking about CoCos:

Alongside equity, banks would be required to issue a set of contingent convertible instruments – so-called “CoCos”. These instruments have attracted quite a bit of attention recently among academics, policymakers and bankers, though there remains uncertainty about their design. In particular, consider CoCos with the following possible design

  • Triggers are based on market-based measures of solvency, as in Charts 6–8.
  • These triggers are graduated, stretching up banks’ capital structure.
  • On triggering, these claims convert from debt into equity.

Although novel in some respects, CoCos with these characteristics would be simple to understand. They would be easy to monitor in real time by regulators and investors. And they would alter potentially quite radically incentives, and thus market dynamics, ahead of banking stress becoming too acute.

He points out:

CoCos buttress market discipline and help lift the authorities from the horns of the timeconsistency dilemma. They augment regulatory discretion at the point of distress with contractual rules well ahead of distress. Capital replenishment is contractual and automatic; it is written and priced ex-ante and delivered without temptation ex-post. Because intervention would be prompt, transparent and rule-based, the scope for regulatory discretion would be constrained. For that reason, the time-consistency problem ought to be reduced, perhaps materially. A contractual belt is added to the resolution braces.

These are the most important things. As investors, we want as much certainty as possible. Contractual conversion with a preset trigger and conversion factor removes the layer of regulatory uncertainty that bedevils most other approaches.

He highlights one concern that has been of interest to the Fed, and which seems to be the thing that industry professionals focus on when I discuss this with them:

If such a structure is for the best in most states of the world, why does it not already exist? At least two legitimate concerns have been raised. First, might market-based triggers invite speculative attack by short-sellers? The concern is that CoCo holders may be able to shortsell a bank’s equity to force conversion, then using the proceeds of a CoCo conversion to cover their short position.

There are several practical ways in which the contract design of CoCos could lean against these speculative incentives. Perhaps the simplest would be to base the conversion trigger on a weighted average of equity prices over some prior interval – say, 30 days. That would require short-sellers to fund their short positions for a longer period, at a commensurately greater cost. It would also create uncertainty about whether conversion would indeed occur, given the risk of prices bouncing back and the short-seller suffering a loss. Both would act as a speculative disincentive.

A second potential firewall against speculative attack could come from imposing restrictions on the ability of short-sellers to cover their positions with the proceeds of conversion.

I like the first solution and am particularly gratified that he chose essentially the same VWAP measurement period that I chose as a basis for discussion.

I don’t like the second firewall. Stock is stock is stock. Everybody knows you can’t cheat an honest man, right? Well, you can’t manipulate a healthy stock, either. Not on the scale of a 30-day VWAP, you can’t.

A related concern is that CoCos alter the seniority structure of banks’ capital, as holders of CoCos potentially suffer a loss ahead of equity-holders. But provided the price at which CoCos convert to equity is close to the market price, conversion does not transfer value between existing equity-holders and CoCo investors. And provided conversion is into equity it need not imply investor loss. If a market move really is unjustified, prices will correct over time towards fundamentals. The holder of a converted CoCo will then garner the upside.

I don’t understand this bit. As long as the trigger/conversion price is set well below the market price at CoCo issue time (I suggested that “half” was a good figure), then CoCos will retain significant first-loss protection.