Category: Contingent Capital

Contingent Capital

OSFI Announcement on Non-Qualifying Capital Instruments

OSFI has announced:

Media are invited to participate in a briefing via teleconference with the Office of the Superintendent of Financial Institutions (OSFI) on two Advisories relating to BASEL III: Treatment of non-qualifying capital instruments under Basel III and Non-Viability Contingent Capital.

Mark White, Assistant Superintendent, Regulation Sector, will provide a brief overview and will be available to answer questions.

Media who wish to participate must confirm their attendance with Léonie Roux, Communications and Consultations.

Please note that all details are subject to change. All times are local.

DATE: Friday February 4, 2011
TIME: 4:00 PM
PLACE: 613-960-7518 (Ottawa)
1-888-265-0903
Participant pass code: 725300

Update, 4:21pm: Good old OSFI, hopelessly incompetent and secretive as always!

I notified Ms. Roux of my intent to participate and was answered with:

Good afternoon,
Please note that today’s conference call is for media only.

A separate conference call is being set up for analyts and investors that may wish to participate.

The conference call will take place on Monday morning at 11:30AM, an advisory will be issued shortly.

I responded:

I represent media via my blog at http://www.prefblog.com

No response. So I called in at about 4:01pm and got some fragments of seemingly random open-mike buzz.

OSFI has deleted the original advisory and replaced it with one that does not include a telephone number or pass code.

OSFI: The dumbest shits on the planet.

Contingent Capital

OSFI Seeking to Manipulate Bond Indices and Retail Investors?

Barry Critchley of the Financial Post has written a piece titled Banks prepare for CoCos that contains the interesting assertion:

“We would expect that the banks would make use of the contingent market for the incremental 3.5% of their capital because holding the balance in common equity could potentially adversely affect profitability,” said Altaf Nanji, an analyst with RBC Capital Markets.

But lots of things have to be clarified before that issuance starts.

– The securities have to be rated. And that’s not a slam dunk given that the securities are convertible if certain trigger points are reached. So far, Fitch is the only ratings agency that has rated any of the securities, though Standard & Poor’s has issued a request for comment on them.

– The determination has to be made whether the securities should be in a bond index. Certainly OSFI wants them in the index and has make its plan very clear.

Shades of Hades, or at least the UK! Assiduous Readers will remember the tergiversations that were the topic of the post Merrill Keeps Lloyds ECNs out of UK Bond Indices that started when UK authorities made a similar attempt to debase the bond indices.

There’s only one teensy little problem with putting CoCos into bond indices: they’re not freaking bonds! If you don’t have the ability to bankrupt your debtor for being a day late or a dollar short, you’re not a bond-holder.

Canadian retail investors should be concerned, since bond ETFs are the most reasonable way for a bond investor to get exposure to bonds and there is already a high degree of aldulteration in bond ETFs, as I pointed out in my article Bond ETFs. On the positive side, there is the chance that a sharp divergence of opinion on the matter may lead to a wider variety of bond indices being marketted. REAL bond indices, I mean, not garbage like the DEX HYBrid index, discussed on September 30, 2010.

Update, 2011-2-7: A Reader has advised me (in rather polemical language!) that he considers my views on the DEX HYBrid Index to be significantly influenced by a conflict of interest, to wit: in late 2006, following the purchase by the TSX of the bond indices from Scotia Capital, it occurred to me that there was the potential for doing some kind of business with the Exchange based on my HIMIPref™ software, analytics, and indices (at that time, TXPR did not exist). I contacted them, they expressed curiosity and I made a presentation to them.

Sadly, nothing came of this attempt and my correspondent alleges that I have been left with a conflict of interest that renders it impossible for me to present my views on the DEX HYBrid Index as being independent.

I don’t see it. If I harboured such a violent grudge over every unsuccessful sales pitch I’ve made over the years, I wouldn’t have time for much else! However, given the nature of the allegations and the language used, I deem it proper to err on the side of disclosure. So make your own minds up regarding my motivation for disrespecting the DEX HYBrid Bond Index!

My correspondent has been invited to post a comment on the blog stating his views, or to provide me with a rebuttal that will be given equal time; to date, this invitation has been declined.

Contingent Capital

BIS Finalizes Tier 1 Loss Absorbancy Rules

The Bank for International Settlements has announced:

minimum requirements to ensure that all classes of capital instruments fully absorb losses at the point of non-viability before taxpayers are exposed to loss.

This is yet another example of bureaucrats ursurping the role of the courts:

The terms and conditions of all non-common Tier 1 and Tier 2 instruments issued by an internationally active bank must have a provision that requires such instruments, at the option of the relevant authority, to either be written off or converted into common equity upon the occurrence of the trigger event … Any compensation paid to the instrument holders as a result of the write-off must be paid immediately in the form of common stock (or its equivalent in the case of non-joint stock companies).

4. The trigger event is the earlier of: (1) a decision that a write-off, without which the firm would become non-viable, is necessary, as determined by the relevant authority; and (2) the decision to make a public sector injection of capital, or equivalent support, without which the firm would have become non-viable, as determined by the relevant authority.

5. The issuance of any new shares as a result of the trigger event must occur prior to any public sector injection of capital so that the capital provided by the public sector is not diluted.

In a rational world, the issuing banks will include another trigger for conversion that occurs well before the point of non-viability can credibly be discussed by regulators, as I have urged in the past.

A trigger based on the price of the common stock would greatly reduce uncertainty in evaluating these instruments; allow hedging in the options market; provide a smoother transition of Tier 1 Capital to common equity; and, most importantly, provide far better protection of overall financial stability. It will be interesting to see if that happens – but frankly, I’m betting against it.

Update, 2011-1-14: There has been some speculation that the phase-out of the existing Tier 1 Capital rules will mean that extant PerpetualDiscounts will be redeemed (at par!). This is based on the section of the release titled “Transitional Arrangements”:

Instruments issued on or after 1 January 2013 must meet the criteria set out above to be included in regulatory capital. Instruments issued prior to 1 January 2013 that do not meet the criteria set out above, but that meet all of the entry criteria for Additional Tier 1 or Tier 2 capital set out in Basel III: A global regulatory framework for more resilient banks and banking systems, will be considered as an “instrument that no longer qualifies as Additional Tier 1 or Tier 2” and will be phased out from 1 January 2013 according to paragraph 94(g).

The linked document was discussed in the PrefBlog post Basel III. The relevant paragraph, 94(g), states in part:

Capital instruments that no longer qualify as non-common equity Tier 1 capital or Tier 2 capital will be phased out beginning 1 January 2013. Fixing the base at the nominal amount of such instruments outstanding on 1 January 2013, their recognition will be capped at 90% from 1 January 2013, with the cap reducing by 10 percentage points in each subsequent year. This cap will be applied to Additional Tier 1 and Tier 2 separately and refers to the total amount of instruments outstanding that no longer meet the relevant entry criteria. To the extent an instrument is redeemed, or its recognition in capital is amortised, after 1 January 2013, the nominal amount serving as the base is not reduced.

So the thinking is that extant PerpetualDiscounts will no longer qualify as Tier 1 capital and be considered by the banks to be too expensive to keep on the books.

The most recent OSFI speech was by Mark White and, as noted on January 12, didin’t really have much to say. With respect to new Tier 1 rules, he stated:

Existing non-common tier 1 and tier 2 instruments which do not meet the new requirements will, on an aggregate basis, be subject to an annual, steadily increasing phase-out from 2013 to 2023. To avoid the bail-out by taxpayers of capital in a failed bank, it is also expected that all non-common capital will ultimately be required to be written-off, or to convert to common shares, if a non-viable bank will receive an infusion of government capital.

On December 16, 2010 OSFI responded to the release of the Basel III text to signal that work is continuing on the transition for non-qualifying capital instruments – and that further guidance will be issued as implementation progresses. We realize that many are anxiously awaiting guidance on how non-qualifying capital will be phased out in Canada. However, it could do a disservice if OSFI provides premature guidance before the minimum international requirements are set. Suffice it to say that OSFI currently expects, at a minimum, to follow the minimum transition requirements with respect to phasing-out disqualified capital. Our goals will be to maximize the regulatory capital in the system and, where practicable, to give effect to the legitimate expectations of the issuers and investors.

OSFI’s December 16 release was discussed briefly on the market update of that day.

Once the Basel III rules text governing NVCC requirements has been finalized by the BCBS, OSFI intends to issue guidance clarifying the phase-out of all non-qualifying instruments by DTIs, including OSFI’s expectations with respect to rights of redemption under regulatory event [footnote] clauses.

Footnote: In general, a regulatory event may be defined as receipt by the bank of a notice or advice by the Superintendent, or the determination by the bank, after consultation with the Superintendent, that an instrument no longer qualifies as eligible regulatory capital under the capital guidelines issued by OSFI. The definition of regulatory event is governed by the terms of the capital instrument and interested persons should refer to the relevant issuance documents.

So what do I think? Mainly I think it’s too early to tell.

First off, the preferred shares may be grandfathered, as previously speculated. OSFI has shown no hesitation in grandfathering instruments in the past – they did this with Operating Retractible issues. One argument in favour of this idea is that it’s relatively easy to come up with a coercive exchange offer: CIT did this, as discussed on October 2, 2009, as did Citigroup (see also the specific terms).

Another reason not to get too excited is the length of time involved. If the banks (and insurers) are forced to redeem their prefs over a ten year period, they’re not going to redeem the lowest coupon ones first! If you look at something priced at, say, $22, and consider you might have to wait until 2023 to get your money … that’s thirteen years, an increment of $0.23 p.a. Call it a 1% yield increment. Very nice – but you’re locked in for all that time and there’s a fair amount of uncertainty.

Contingent Capital

Nagel, Tory's Opine on Preferred Shares, Contingent Capital

Financial Webring Forum brings to my attention a Globe & Mail article titled What happens to rate reset prefs in Basel III?:

John Nagel at Desjardins Securities has been watching the issue closely, trying to get clarity from the Office of the Superintendent of Financial Institutions. He has a vested interest in the outcome because the Desjardins team invented the structure.

At the moment nothing has been decided, but Mr. Nagel said the last he heard, a contingent capital clause was being considered for all new rate reset issues. As a reminder, contingent capital simply means a security type that will convert to common equity when things get rocky.

As far as he knows, outstanding rate reset issues will be grandfathered under Basel III and will count as Tier 1 capital and equity. Going forward, though, Mr. Nagel thinks prospectuses for these issues could have a section, possibly called the Automatic Exchange Event, that describes how preferred shares are exchanged into common equity.

However, this type of “trigger event” would only happen if OSFI declares the financial institution “non-viable” and Mr. Nagel suspects it’s unlikely that will happen in Canada.

“If a bank or an institution was in trouble, long before it would be declared non-viable they would halt trading and OSFI would say ‘Fine, you’re merging with BMO or RBC,” he said. If a merger occurred, the distressed institution’s preferred shares would then become obligations of the acquirer.

No moral hazard here, no way, not in Canada!

The critical “point of non-viability” at which Mr. Nagel believes conversion will be triggered is in accord with Dickson’s speech in May, most recently referenced in PrefBlog in the post A Structural Model of Contingent Bank Capital. The recent BIS proposals insist on some conversion point, setting the point of non-viability as the floor limit, as discussed in BIS Proposes CoCos: Regulatory Trigger, Infinite Dilution.

As I have discussed, many a time and oft, I think that’s a crazy place to have the conversion trigger. It may help somewhat in paying for a crisis, but it will do nothing to prevent a crisis. S&P agrees.

In order to prevent a crisis, the conversion trigger has to be set much further from the point of bankruptcy; the McDonald CoCos are an academic treatment of a model I have advocated for some time: there is automatic conversion if the common price falls below a pre-set trigger price; the conversion is from par value of the preferreds into common at that pre-set price. I suggest that a sensible place to start thinking about setting the trigger price is one-half the common equity price at the time of issue of the preferreds.

Tory’s published a piece by Blair W Keefe in May, titled Canada Pushes Embedded Contingent Capital:

A number of concerns arise with the use of embedded contingent capital.

First, it is likely that the conversion itself could cause a “run” on the troubled bank: effectively, the conversion means that the bank is on the eve of insolvency and the conversion does not create any additional capital; it merely improves the quality of the capital. As a practical matter, it will likely be essential for the government to immediately provide funding to the bank; however, with the former holders of subordinated debt and preferred shares being converted into holders of common shares, the government could replenish the subordinated debt rather than being required to replenish the Tier 1 capital, which occurred in the financial crisis. Therefore, it should be less likely that the government would suffer a financial loss.

This echoes my point about prevention vs. cure.

Third, the cost of capital could increase significantly for banks, particularly if the new capital instruments are viewed as equity – given their conversions in times of financial difficulty to common share equity – rather than debt instruments. OSFI is sensitive to this concern and is the reason why OSFI is advocating a trigger that occurs on the eve of insolvency (rather than earlier in the process) when the holders of subordinated debt and preferred shares would anticipate incurring losses in any event.

In other words, OSFI thinks you can get something for nothing. Ain’t gonna happen. Either we’ll raise the cost of capital for the banks, or we’ll do this pretend-regulation thing for free and then find out it doesn’t work. One or the other.

Seventh, if the embedded contingent capital proposals are adopted, how will those requirements need to be reflected in the Basel III capital proposals? Similarly, what treatment will rating agencies give to contingent capital? If the triggering event is considered remote, rating agencies may not give “equity” credit treatment for the instruments.

Finally, with any change of this nature, market participants worry about the unexpected consequences: Will hedge funds or other market participants be able to “game” the system? Will the conversion features create more instability for a bank experiencing some financial difficulty? Could the conversion create a death spiral of dilution? and so on.

Ms. Dickson’s beloved “Market Price Conversion” formula will almost definitely create a death spiral. While fixed-price conversion may create multiple equilibria (which the Fed worries about), I see that as being the lesser of a host of evils. Gaming can be reduced if the conversion trigger is based on a long enough period of time: my original and current suggestion is VWAP measured over 20 consecutive trading days. It would be very expensive to game that to any significant extent, and not very profitable. On the other had, if the conversion trigger is a single share trading below the conversion price … yes, that presents more of a problem.

Contingent Capital

Contingent Capital Update

A Reuters columnist suggested Big banks winners from new contingent capital move:

Plans to make hybrid bond investors share the pain when banks run into trouble could polarise the financial sector into big firms that can afford to pay up for capital and smaller players that cannot.

But these plans from the Basel Committee on Banking Supervision could reinforce a pattern emerging in the aftermath of the crisis — a two-tier banking market with international banks that investors favour over smaller banks seen as riskier.

“It could polarise the market further in terms of issuer access and could shut out some smaller institutions and give larger firms a competitive advantage,” said one debt capital markets banker at a major international banking group.

I don’t think that this is necessarily the case. Small banks in the US have never been able to issue their own non-equity regulatory capital – it has all been repackaged into CDOs. This was one of the sideswipes of the Panic of 2007 – the CDO market froze up and these smaller banks were unable to issue.

Investors have mixed views on contingent capital. They would have problems with more issues along the lines of bonds sold by British bank Lloyds, which are designed to convert to equity in the early stages of a bank running into difficulties.

“We don’t think there is a large market for them, certainly among institutional bond investors,” said Roger Doig, credit analyst at Schroders. Analysts say that such issues are difficult for credit rating agencies to evaluate and many institutional credit investors are not mandated to hold equity.

Well, we will see. It’s not fair focussing on the poorly structure Lloyds ECN issue as that gave no first-loss protection to holders.

The McDonald CoCos are not only much better structured and better investments, but they will also work better in averting a crisis, rather than helping to clean up.

Stan Maes and William Schoutens provide Contingent Capital: An In-Depth Discussion:

Somewhat paradoxically, funded contingent capital or CoCos may actually increase the systemic risks they are intended to reduce. For example, whereas some banking regulators recorded CoCos as capital, some insurance regulators treated them as debt. Hence, significant amounts of CoCos were held by insurers, creating a risk of contagion from the banking sector to the insurance sector. Also a problem of moral hazard arises. Taking excessive risks (by for example buying additional risky assets) could lead to a triggering of the note and hence the wiping out of a lot of outstanding debt. Banks with contingent debt could therefore be tempted to seek additional risk near the trigger point (taking risk on the back of the CoCo holders and maybe taxpayers as well).

Finally, Hart and Zingales (2010) argue that contingent capital introduces inefficiency as conversion eliminates default, which forces inefficient businesses to restructure and incompetent managers to be replaced.

Allowing CoCos to be held as assets by other financial institutions and risk-weighted as debt is just stupid. I won’t waste time discussing stupidity.

Given the above, it may make a lot of sense to define triggers in terms of market based terms. Note however that a simple market based trigger may not be desirable as short sellers may be tempted to push down the stock price in order to profit from the resulting dilution of the bank’s stock following the conversion triggered by the stock price drop. Such a self-generated decline in shares prices is referred to as a “death spiral”. The above problem can be mitigated by making the trigger dependent on a rolling average stock price (say the average closing price of the stock over the preceding 20 business days, as Duffie (2010) and Goodhart (2010) propose). In fact, Flannery (2009) demonstrates that the incentive for speculative attack is lessened or even eliminated altogether by setting a sufficiently high contractual conversion price, such that the conversion becomes anti-dilutive (raising the price of the share rather than lowering it).

A market based trigger has the additional advantage that it limits the ability of management to engage in balance sheet manipulation. Also, it prevents forbearance on behalf of the regulators, as it eliminates regulatory discretion in deciding when the trigger should be invoked. Some analysts refer to the double trigger as the double disaster (regulatory discretion as well as politics).

My own preference is for the Volume Weighted Average Price over a relatively lengthy period (20 trading days?) to be the trigger.

If the conversion ratio is based on the stock price at the time of the triggering point, the amount of capital to be brought in can be very substantial and will make thecounterparty a major, if not the largest, shareholder. Original shareholders will be diluted. On the one hand, there is a clear potential dilution effect which could affect the bank’s equity price itself. On the other hand, CoCos may as well introduce a floor on the equity price in these situations.

When the conversion ratio is determined at the time of conversion and not at the time of issuance, the conversion is likely to be relatively generous to the holder of the contingent capital instrument. When the debt holders can expect to get out at close to par value, it would reduce the cost of the contingent capital instrument, making it a significantly cheaper form of capital than equity (of course its low coupon would reduce investors’ appetite).

The authors close with:

We close by raising concerns about the pricing of the instruments by highlighting the similarities between CoCos and equity barrier options and credit default swaps. These barrier-like features and the fact that CoCos are fat-tail event claims, in combination with calibration and model risks, imply that these contingent instruments are very hard to value under a particular model. Since CoCos are expected not to be highly liquid instruments (and until real market prices are widely available), the extreme complexity of mark to modeling CoCos will be a big disadvantage that may hamper their success.

Contingent Capital

Carney: Central Planning = Good

PrefBlog’s Department of Thesis Title Suggestions has another offering for aspiring MAs and MBAs: is the period of market ascendence over? I suggest that it is arguable that the fall of the Soviet Union in 1990 brought with it a period of free-market ascendency: behind every political and regulatory decision was the knowledge that central planning doesn’t work.

However, the Panic of 2007 has brought with it the knowledge that free markets don’t work either, and 1990 is ancient history, of no relevance to today’s perceptive and hard-nosed bureaucrats. So the pendulum is swinging and the pendulum never swings half way.

In his role as a leading proponent of central planning, Bank of Canada Governor Mark Carney gave a speech today titled The Economic Consequences of the Reforms:

Consider the jaded attitudes of the bank CEO who recounted: ―My daughter called me from school one day, and said, ‗Dad, what‘s a financial crisis?‘ And, without trying to be funny, I said, ‗This type of thing happens every five to seven years.‘‖

Footnote: J. Dimon, Chairman and CEO, JP Morgan Chase & Company, in testimony to the U.S. Financial Crisis Inquiry Commission, 13 January 2010

Possibly the most intelligent remark in the whole speech, but it was set up as straw man.

Should we be content with a dreary cycle of upheaval?

Such resignation would be costly. Even after heroic efforts to limit its impact on the real economy, the global financial crisis left a legacy of foregone output, lost jobs, and enormous fiscal deficits. As is typically the case, much of the cost has been borne by countries, businesses, and individuals who did not directly contribute to the fiasco.

This is true to a certain extent. Society is comprised of networks of relationships, some productive, others being a waste of time (do you believe that institutional bond salesmen are prized by employers because of their keen insight into the market and their uncanny ability to discern budding trends in the market? Ha-ha! They have a book of clients who will call them when the client wants to trade, that’s all). Humans form these networks with little more intelligence than an ant-hill; we only survive because recessions come along every now and then to sweep away at least a portion of the unproductive networks, leaving its participants to get new jobs, move, change their lifestyle and basically try again to form links to other networks that may, one hopes, be productive.

A financial crisis is larger than a normal recession, as Carmen M. Reinhart & Kenneth S. Rogoff have written. This has two effects – first, the number of inefficient networks that are swept away simultaneously is larger, and secondly a number of effiicient networks gets caught up in the frenzy and are swept away as well (they’re dependent upon the availability of credit. Trade finance took a beating during the crisis, for instance).

So yeah, financial crises are bad. But the most expensive North American bail-out has been GM (and is continuing to be GM, since they are being restored to health with the aid of electric car subsidies in addition to their usual welfare cheques) and GM was most certainly not an efficient network. The financial crisis was the trigger, not the cause.

Thus, we cannot blame all the pain on faceless bankers; much of it would have occurred anyway.

Carney claims:

By using securitization to diversify the funding sources and reduce credit risks, banks created new exposures. The severing of the relationship between originator and risk holder lowered underwriting and monitoring standards.

There is some doubt about this. The FRBB notes:

The evolving landscape of mortgage lending is also relevant to an ongoing debate in the literature about the direction of causality between reduced underwriting standards and higher house prices. Did lax lending standards shift out the demand curve for new homes and raise house prices, or did higher house prices reduce the chance of future loan losses, thereby encouraging lenders to relax their standards? Economists will debate this issue for some time.

It appears that this inconvenient debate will occur behind closed doors, as far as Carney is concerned.

Carney goes on to state:

In addition, the transfer of risk itself was frequently incomplete, with banks retaining large quantities of supposedly risk-free leveraged super senior tranches of structured products.

This is a clear failure of regulation, but we won’t won’t hear any discussion of this point, either.

These exposures were compounded by the rapid expansion of banks into over-the-counter derivative products. In essence, banks wrote a series of large out-of-the-money options in markets such as those for credit default swaps. As credit standards deteriorated, the tail risks embedded in these strategies became fatter. With pricing and risk management lagging reality, there was a widespread misallocation of capital.

footnote: See A. Haldane, ―The Contribution of the Financial Sector—Miracle or Mirage?‖ Speech delivered at the Future of Finance Conference, London, 14 July 2010.

An interesting viewpoint, since writing a CDS is the same thing as buying a bond, but without the funding risk. I’ll have to check out that reference sometime.

The shortcomings of regulation were similarly exposed. The shadow banking system was not supported, regulated, or monitored in the same fashion as the conventional banking system, despite the fact they were of equal size on the eve of the crisis.

There were also major flaws in the regulation and supervision of banks themselves. Basel II fed procyclicalities, underestimated risks, and permitted excess leverage. Gallingly, on the day before each went under, every bank that failed (or was saved by the state) reported capital that exceeded the Basel II standard by a wide margin.

So part of the problem was that not enough of the system was badly regulated?

In particular, keeping markets continuously open requires policies and infrastructure that reinforce the private generation of liquidity in normal times and facilitate central bank support in times of crisis. The cornerstone is clearing and settlement processes with risk-reducing elements, particularly central clearing counterparties or ―CCPs‖ for repos and OTC derivatives. Properly risk-proofed CCPs act as firewalls against the propagation of default shocks across major market participants. Through centralised clearing, authorities can also require the use of through-the-cycle margins, which would reduce liquidity spirals and their contribution to boom-bust cycles.(footnote)

The second G-20 imperative is to create a system that can withstand the failure of any single financial institution. From Bear Stearns to Hypo Real Estate to Lehman Brothers, markets failed that test.

Footnote: Market resiliency can also be improved through better and more-readily available information. This reduces information asymmetry, facilitates the valuation process and, hence, supports market efficiency and stability. In this regard, priorities are an expansion of the use of trade repositories for OTC derivatives markets and substantial enhancements to continuous disclosure standards for securitization.

This part is breathtaking. In the first paragraph, Carney extolls the virtues of setting up centralized single points of failure; in the second, he decries the system of having single points of failure. I have not seen this contradiction addressed in a scholarly and robust manner; the attitude seems to be that single points of failure are not important as long as they don’t fail; and they won’t fail because they’re new and will be supervised.

It is, however, the footnote that is egregious in either its ignorance or its intellectual dishonesty – one of the two. It has been shown time and time again that increased public information reduces dealer capital allocation, making the market more shallow and brittle (eg, see PrefBlog posts regarding TRACE. Additionally, see the work on what happened when the TSX started making level 2 quotes available back in 1993 or whenever it was. I feel quite certain that, somewhere, there is some investigation on what Bloomberg terminals did to the Eurobond market in the late eighties, but I’ve never seen any.)

Today, after a series of extraordinary, but necessary, measures to keep the system functioning, we are awash in moral hazard. If left unchecked, this will distort private behaviour and inflate public costs.

So, as part of the campaign to eliminate moral hazard, we’re going to have central clearinghouses? So it won’t matter if Bank of America does a $50-billion dollar deal with the Bank of Downtown Beanville, as long as it’s centrally cleared? And this will reduce moral hazard?

There’s another internal contradiction here, but I don’t think it will be discussed any time soon.

Another promising avenue is to embed contingent capital features into debt and preferred shares issued by financial institutions. Contingent capital is a security that converts to capital when a financial institution is in serious trouble, thereby replenishing capital without the use of taxpayer funds. Contingent conversions could be embedded in all future new issues of senior unsecured debt and subordinated securities to create a broader bail-in approach. Its presence would also discipline management, since common shareholders would be incented to act prudently to avoid having their stakes diluted by conversion. Overall, the Bank of Canada believes that contingent capital can reduce moral hazard and increase the efficiency of bank capital structures. We correspondingly welcome the Basel Committee‘s recent public consultation paper on this topic.

Carney’s proposed inclusion of senior debt as a form of contingent capital has been discussed in the post Carney: Ban the bond!. As has been often discussed on PrefBlog, this is simply a mechanism whereby bureaucrats can be given the power of bankruptcy courts, with none of those inconvenient creditors’ rights and committees to worry about. Just like the GM bail-out!

He then reprises the BoC paper on the effects of increased bank capitalization on mortgage rates, which has been discussed in the post BIS Assesses Effects of Increasing Bank Capitalization among others.

First, banks are assumed to fully pass on the costs of higher capital and liquidity requirements to borrowers rather than reducing their current returns on shareholders‘ equity or operating expenses, such as compensation, to adjust to the new rules.

Consider the alternative. If banks were to reduce personnel expenses by only 10 per cent (equal to a 5 per cent reduction in operating expenses), they could lower spreads by an amount that would completely offset the impact of a 2-percentage-point increase in capital requirements.

Second, higher capital and liquidity requirements are assumed to have a permanent effect on lending spreads, and hence on the level of economic output. No allowance is made for the possibility that households and firms may find cheaper alternative sources of financing.

The second point is critical. It seems quite definite that this will happen – if bank mortgages go up 25-50bp in the absence of other changes, then mortgage brokers will do a booming business. But he wants to regulate shadow-banks, too. And it will mean that shadow banks (or unregulated shadow-shadow-banks) will skim the cream off the market, leaving the banks with lower credit quality.

There has been nowhere near enough work done on the knock-on effect of these changes.

However, there are a variety of other potential benefits from higher capital and liquidity standards and the broader range of G-20 reforms.
First, the variability of economic cycles should be reduced by a host of macroprudential measures. Analysis by the Bank of Canada and the Basel group suggests a modest dampening in output volatility can be achieved from the Basel III proposals, as higher capital and liquidity allow banks to smooth the supply of credit over the cycle. For instance, a 2-percentage-point rise in capital ratios lowers the standard deviation of output by about 3 per cent.

So it would seem that we’re going to have another Great Moderation, except that this time irrational exuberance will not occur and we’ll live in the Land of Milk and Honey forever. Well, it’s a nice dream.

Greater competition commonly leads to more innovative and diverse strategies, which would further promote resiliency of the system. Greater competition and safer banks may also contribute to lower expected return on equity (ROE) for financial institutions. This, in turn, could help offset the costs and increase the net benefits discussed earlier.

These gains from competition could be considerable. The financial services sector earns a 50 per cent higher return on equity than the economy-wide average. If greater competition leads to a one-percentage-point decline in the ROE (through a decline in spreads), the estimated cost from a one-percentage point increase in capital would be completely offset.

Do all you bank equity investors hear this properly? What will the desired 1% decline in ROE do to your portfolio?

This was, quite frankly, a very scary speech.

Contingent Capital

BIS Proposes CoCos: Regulatory Trigger, Infinite Dilution

The Bank for International Settlement has released a Proposal to ensure the loss absorbency of regulatory capital at the point of non-viability – consultative document:

the proposal is specifically structured to allow each jurisdiction (and banks) the freedom to implement it in a way that will not conflict with national law or any other constraints. For example, a conversion rate is not specified, nor is the choice between implementation through a write-off or conversion. Any attempt to define the specific implementation of the proposal more rigidly at an international level, than the current minimum set out in this document, risks creating conflicts with national law and may be unnecessarily prescriptive.

The Basel Committee welcomes comments on all aspects of the proposal set out in this consultative document. Comments should be submitted by 1 October 2010 by email to: baselcommittee@bis.org.

However, if we define gone-concern also to include situations in which the public sector provides support to distressed banks that would otherwise have failed, the financial crisis has revealed that many regulatory capital instruments do not always absorb losses in gone-concern situations.

That’s a nice little definition of “gone concern”, giving bureaucrats the authority to ursurp the prerogatives of the legal system. One thousand years of bankruptcy law … pffffft!

The proposal will be examined clause by clause:

All non-common Tier 1 instruments and Tier 2 instruments at internationally active banks must have a clause in their terms and conditions that requires them to be written-off on the occurrence of the trigger event.

Reasonable enough.

Any compensation paid to the instrument holders as a result of the write-off must be paid immediately in the form of common stock (or its equivalent in the case of non-joint stock companies).

This means that write-down structure’s like Rabobank’s would not, of themselves, qualify for inclusion. There would need to be another clause in the terms reflecting the possibility of the BIS proposal being triggered while the other trigger is waiting.

The issuing bank must maintain at all times all prior authorisation necessary to immediately issue the relevant number of shares specified in the instrument’s terms and conditions should the trigger event occur.

Well, sure.

The trigger event is the earlier of: (1) the decision to make a public sector injection of capital, or equivalent support, without which the firm would have become non-viable, as determined by the relevant authority; and (2) a decision that a write-off, without which the firm would become non-viable, is necessary, as determined by the relevant authority.

This is the dangerous part, as it gives unlimited authority to the regulators to wipe out a bank’s capital investors, with no accountability or recourse whatsoever.

The issuance of any new shares as a result of the trigger event must occur prior to any public sector injection of capital so that the capital provided by the public sector is not diluted.

This means that infinite dilution of the common received on conversion is possible.

The relevant jurisdiction in determining the trigger event is the jurisdiction in which the capital is being given recognition for regulatory purposes. Therefore, where an issuing bank is part of a wider banking group and if the issuing bank wishes the instrument to be included in the consolidated group’s capital in addition to its solo capital, the terms and conditions must specify an additional trigger event. This trigger event is the earlier of: (1) the decision to make a public sector injection of capital, or equivalent support, in the jurisdiction of the consolidated supervisor, without which the firm receiving the support would have become non-viable, as determined by the relevant authority in that jurisdiction; and (2) a decision that a write-off, without which the firm would become non-viable, is necessary, as determined by the relevant authority in the home jurisdiction.

Reasonable enough, but this could cause a lot of fun with rogue regulators and cross-default provisions.

Any common stock paid as compensation to the holders of the instrument can either be common stock of the issuing bank or the parent company of the consolidated group.

The major problem – besides the evasion of bankruptcy law – with this document is that there is no distinction drawn between Tier 1 and Tier 2 capital for conversion purposes. Tier 1 capital is supposed to provide going-concern loss absorption, but the only thing triggering conversion is the Armageddon scenario. I don’t think that sub-debt holders will be particularly pleased about that.

However, the terms of this proposal are so abusive, so antithetical to the interests of investors, that I suspect most instruments will be issued with a pre-emptive trigger, so that conversion will be triggered prior to the regulators (well … reasonable regulators, anyway) exercising their unlimited and unaccountable power.

Bloomberg notes:

The Association for Financial Markets in Europe, an industry group representing banks, said last week that failing financial companies should reduce the risk to taxpayers by using contingent capital and by converting debt into equity to fund their own rescue.

In what it termed a “bail-in,” AFME said bank bond holders should see their securities convert into common shares in the event an institution’s capital ratios fall below a pre-set level, the group said in a discussion paper on Aug. 12.

Update: The AFME discussion paper, The Systemic Safety Net: Pulling failing firms back from the edge is very vague and relies on assertions, rather then evidence and argument, to make its point. It might also be dismissed as intellectually dishonest, in that it takes no account of any other proposals or academic work.

Of some interest is their view on the market-based triggers I endorse:

A trigger based on market metrics or a determination of impending systemic risk (made by a regulator) would not be effective. In addition to creating marketability issues, a trigger based on share price or market capitalisation is subject to manipulation and will almost certainly foreclose a proactive capital raise because it may fail to move the firm a safe enough distance from the trigger, which in turn will generate further negative price spirals. A trigger based on a determination of systemic risk is also unattractive, partly because it could not be used in cases of idiosyncratic risk. Waiting until firm‐specific risk has spiralled into systemic risk is destabilising.

Their preference is for a trigger based on capital ratios:

A trigger based on a core capital ratio set above the minimum core tier 1 capital requirements under the re‐invigorated Basel III capital standards would meet these criteria. Firms should have the discretion to set the trigger in accordance with their own objectives to achieve the optimal balance between prudential and economic considerations. Factors the issuer might consider in setting the trigger are:

a. To receive treatment as going concern capital the trigger should activate before any breach of the firm’s minimum regulatory capital requirements, or any other circumstances giving rise to regulatory intervention.

b. The probability of breach needs to be low enough to attract a credit rating as debt and, as such, near to subordinated debt for purposes of pricing.

I have grave difficulties with their view that market prices will be manipulated, but capital levels won’t. Additionally, as an investor, I have grave reservations about tying my investment to a capital ratio definition that will almost certainly be changed in the life of the instrument.

Contingent Capital

BIS Outlines Basel III

The Bank for International Settlements has announced:

the oversight body of the Basel Committee on Banking Supervision, met on 26 July 2010 to review the Basel Committee’s capital and liquidity reform package. Governors and Heads of Supervision are deeply committed to increase the quality, quantity, and international consistency of capital, to strengthen liquidity standards, to discourage excessive leverage and risk taking, and reduce procyclicality. Governors and Heads of Supervision reached broad agreement on the overall design of the capital and liquidity reform package. In particular, this includes the definition of capital, the treatment of counterparty credit risk, the leverage ratio, and the global liquidity standard. The Committee will finalise the regulatory buffers before the end of this year. The Governors and Heads of Supervision agreed to finalise the calibration and phase-in arrangements at their meeting in September.

The Basel Committee will issue publicly its economic impact assessment in August. It will issue the details of the capital and liquidity reforms later this year, together with a summary of the results of the Quantitative Impact Study.

The Annex provides vague details, vaguely:

Instead of a full deduction, the following items may each receive limited recognition when calculating the common equity component of Tier 1, with recognition capped at 10% of the bank’s common equity component:

  • Significant investments in the common shares of unconsolidated financial institutions (banks, insurance and other financial entities). “Significant” means more than 10% of the issued share capital;
  • Mortgage servicing rights (MSRs); and
  • Deferred tax assets (DTAs) that arise from timing differences.

A bank must deduct the amount by which the aggregate of the three items above exceeds 15% of its common equity component of Tier 1 (calculated prior to the deduction of these items but after the deduction of all other deductions from the common equity component of Tier 1). The items included in the 15% aggregate limit are subject to full disclosure.

There’s at least some recognition of the riski of single point failure:

Banks’ mark-to-market and collateral exposures to a central counterparty (CCP) should be subject to a modest risk weight, for example in the 1-3% range, so that banks remain cognisant that CCP exposures are not risk free.

1-3%? Not nearly high enough.

The Committee agreed on the following design and calibration for the leverage ratio, which would serve as the basis for testing during the parallel run period:

  • For off-balance-sheet (OBS) items, use uniform credit conversion factors (CCFs), with a 10% CCF for unconditionally cancellable OBS commitments (subject to further review to ensure that the 10% CCF is appropriately conservative based on historical experience).
  • For all derivatives (including credit derivatives), apply Basel II netting plus a simple measure of potential future exposure based on the standardised factors of the current exposure method. This ensures that all derivatives are converted in a consistent manner to a “loan equivalent” amount.
  • The leverage ratio will be calculated as an average over the quarter.

Taken together, this approach would result in a strong treatment for OBS items. It would also strengthen the treatment of derivatives relative to the purely accounting based measure (and provide a simple way of addressing differences between IFRS and GAAP).

When it comes to the calibration, the Committee is proposing to test a minimum Tier 1 leverage ratio of 3% during the parallel run period.

A leverage of 33x on Tier 1? It’s hard to make comparisons … the definition of exposures appear to be similar to Canada’s, but Canada uses total capital with a leverage pseudo-cap of 20x – this can be increased at the discretion of OSFI, without disclosure by either OSFI or the bank as to why the increase is considered prudent and desirable.

I suspect that Canadian banks, in general, will have about the same relationship to the new leverage cap as they have to the extant leverage cap, but will have to wait until those with access to more data have crunched the numbers.

US comparisons are even harder, as their leverage is capped at 20x Tangible Common Equity, but uses only on-balance-sheet adjustments.

The vaguest part of the Annex is:

In addition to the reforms to the trading book, securitisation, counterparty credit risk and exposures to other financials, the Group of Governors and Heads of Supervision agreed to include the following elements in its reform package to help address systemic risk:

  • The Basel Committee has developed a proposal based on a requirement that the contractual terms of capital instruments will allow them at the option of the regulatory authority to be written-off or converted to common shares in the event that a bank is unable to support itself in the private market in the absence of such conversions. At its July meeting, the Committee agreed to issue for consultation such a “gone concern” proposal that requires capital to convert at the point of non-viability.
  • It also reviewed an issues paper on the use of contingent capital for meeting a portion of the capital buffers. The Committee will review a fleshed-out proposal for the treatment of “going concern” contingent capital at its December 2010 meeting with a progress report in September 2010.
  • Undertake further development of the “guided discretion” approach as one possible mechanism for integrating the capital surcharge into the Financial Stability Board’s initiative for addressing systemically important financial institutions. Contingent capital could also play a role in meeting any systemic surcharge requirements.

The only form of contingent capital that will actually serve to prevent severe problems from becoming crises is “going concern” CC – which is regulator-speak for Tier 1 capital. The “conversion at the point of non-viability” “at the option of the regulatory authority” is merely an attempt by the regulators to short-circuit the bankruptcy process and should be considered a debasement of creditor rights.

There are a number of adjustments to the proposals for the Liquidity Coverage Ratio and the Net Stable Funding Ratio on which I have no opinion – sorry folks, I just plain haven’t studied them much!

Bloomberg comments:

France and Germany have led efforts to weaken rules proposed by the committee in December, concerned that their banks and economies won’t be able to bear the burden of tougher capital requirements until a recovery takes hold, according to bankers, regulators and lobbyists involved in the talks. The U.S., Switzerland and the U.K. have resisted those efforts.

Update, 2010-07-27: The Wall Street Journal fingers Germany as the dissenter:

Germany refused—at least for now—to sign on to parts of an agreement on the latest round of an evolving international accord on bank-capital standards being negotiated by the Basel Committee on Banking Supervision, according to officials close to the talks.

But a footnote to the news release said: “One country still has concerns and has reserved its position until the decisions on calibration and phase-in arrangements are finalized in September.” That one country wasn’t identified in the release by the Basel Committee.

Contingent Capital

Contingent Capital: Canada a Laughing-stock?

The Globe & Mail reports:

Finance Minister Jim Flaherty is edging away from his alternative to a global bank tax, acknowledging in an interview that it’s “debatable” whether enough countries can be won over to make Canada’s contingent capital plan work on a global scale.

It’s still too early to write off the idea, which would require banks to sell debt that would convert to equity at times of stress. Mr. Flaherty stressed that he remains a fan of the concept, which he sees as a form of self-insurance that would make financial institutions less likely to rely on taxpayers to bail them out in future.

But the proposal has run into a wall of doubt in financial markets, where investors are skeptical that enough buyers could be found to make the securities affordable for banks to issue.

“I like the contingent capital idea, but I understand some of the concerns that have been expressed about it. It needs more work, more discussion.”

As far as Canada is concerned, it might be a good idea to try some work, some discussion; any work, any discussion.

As I have complained in the past, Canada’s efforts to provide a coherent plan have been limited to an off-the-cuff remark from the Central Bank (promoting an insane extension to the idea that has the intent of eliminating creditors’ rights) together with an intellectually dishonest speech and childish essay by the head of bank regulation. There is no evidence of any money being spent whatsoever on research, discussion, or thought.

Canada may not just have blown its own credibility with these antics, but, such are the vagaries of politics, have made the entire idea more difficult to achieve.

What did we ever do to deserve a clown like Spend-Every-Penny as Finance Minister?

Contingent Capital

Carney: Ban the Bond!

Mark Carney, Governor of the Bank of Canada, gave a speech to the International Organization of Securities Commissions (IOSCO) meeting, Montreal, 10 June 2010. I was stunned by suggestion regarding contingent capital:

One promising avenue is to embed contingent capital features into debt and preferred shares issued by financial institutions. Contingent capital is a security that converts to capital when a financial institution is in serious trouble, thereby replenishing the capital of the institution without the use of taxpayer funds. Contingent conversions could be embedded in all future new issues of senior unsecured debt and subordinated securities to create a broader bail-in approach. Its presence would also serve as a useful disciplinary device on management since common shareholders would be incented to act prudently and avoid having their stake in the institution diluted away by the prospect of conversion.

New issues of senior unsecured debt???

Such an unprecendented proposal should be made only in the context of some very lengthy arguments in favour of the advisability of such an incredible change.

Contingent Capital may be a good thing, but it is not a bond! If I own a bond and you’re late paying me, I can put you in bankruptcy. If this is not true – as with CC – then it wasn’t a bond.

And Carney wants all senior unsecured debt to be contingent? To get an idea of the scope of this revolutionary idea, have a look at Table 54a of RY’s 2009 Annual Report: it shows that senior unsecured bonds outstanding amounted to $69.8-billion dollars. This compares to $39.6-billion in shareholders’ equity (including preferred shares).

In making such a suggestion without publishing a scrap of research into Canadian contingent capital; without making any qualifications; and without, in fact, doing much else at all, Mr. Carney has shown himself to be unfit to continue as Governor of the Bank of Canada.

Update: I have sent the following eMail to the BoC:

I refer to Mark Carney’s remarks to the IOSCO conference, published on your website at http://www.bankofcanada.ca/en/speeches/2010/sp100610.html

Mr. Carney spoke approvingly of the potential for “all future new issues of senior unsecured debt” to become contingent capital.

I am not aware that anybody, anywhere, has made such a proposal. Has the Bank of Canada published any research whatsoever on the probable effects of such a revolutionary change in capital markets? Is the Bank of Canada aware of any such research?