PrefBlog

Mr Paul Tucker, Deputy Governor of the Bank of England, made a speech at the Clare Distinguished Lecture in Economics, Cambridge, 18 February 2011 titled Discussion of Lord Turner’s lecture, “Reforming finance – are we being radical enough?”:

But none of what I have said makes a case for placing all of our eggs in the resolution basket. Switching metaphors, we need belt and braces. Which is why the G20 agreed that the so-called Global Systemically Important Financial Institutions (G-SIFIs) should carry greater loss absorbing capacity (or GLAC) than implied by Basel III.

First best would be equity. Indeed, Adair has argued this evening that ideally Basel 3 would have set a higher equity requirement. But that did not happen. In practice, we are going to have to be open-minded, but also principled, about quasi-equity instruments contributing to GLAC for SIFIs (sorry about the acronyms!). Currently, the leading candidate is so-called Contingent Capital bonds (CoCos), which convert from debt into equity in certain states of the world. It seems to me that to serve the purpose of GLAC for large and complex firms, such instruments would need to convert when a firm was still fundamentally sound, which is to say that they should have high capital triggers. For a large and complex firm, a low capital trigger would be dangerous, as funders and counterparties would be likely to flee before reaching the point at which the firm would be recapitalised through the CoCos’ conversion.

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.

Lord Turner’s speech discusses a particular hobby-horse of mine:

It is therefore crucial that our answers to the SIFI problem cover also the more difficult but more likely scenario of multiple bank systemic stress. And in such conditions, bail-inable bonds will only enable us to avoid the dilemma of Autumn 2008, if the following vital conditions are met:

• • If regulators could be confident that those bonds are held outside the banking system; and
• • in addition, confident that the bonds are held by investors who have so arranged their assets and liabilities that they could face the imposed losses without that in turn inducing systemic effects.

And it may be very difficult to be confident that those conditions we met.

There are two ways to gain that confidence – the first relies on empirical observation, the second on an assumption of fully informed investor rationality. Neither route may be entirely robust.

• • The first way to seek such confidence, would be for regulators to understand, or to regulate, which investors hold bank medium-term debt. Our information on this today is imperfect. We believe a significant proportion is initially held by other banks, and a larger proportion still by a broadly defined group of ‘fund managers’. (Slide 7). But ownership after secondary market trading could be significantly different. And some of these ‘fund managers’ may be in turn financed by banks (e.g. hedge funds by prime brokers), or linked to the banking system by complex repo and derivative relationship so that losses suffered by one bank, could indirectly impose losses or confidence shocks on others. And our ability to track these complex inter-connections, and as a result to predict the knock-on consequences of initial losses in conditions of systemic fragility is imperfect today and likely to remain so. We need to improve our understanding of the complex interconnections of our financial system: but it is unclear that understanding will ever be good enough for us confidently to impose large losses simultaneously on the senior debt of multiple large banks (or indeed multiple small banks), in conditions of macro-systemic stress.
• • The other route to confidence, would be based on faith in market and investor rationality, assuming axiomatically that investors who buy bail-inable bonds will only do so on the basis of rational assessments of their ability to absorb risks in all possible future states of the world, including those of macroeconomic stress. As Section 3 will discuss, this axiomatic assumption was at the core of the pre-crisis conventional wisdom, the reason why public authorities thought they could sleep easy in the face of an explosive growth in financial scale, complexity and interconnectedness. But it relies on an assumption of fully informed rationality, which may be simply untrue, and indeed impossible. For as Andrei Shleifer et al (2010) have argued in an extremely perceptive recent paper, it may be inherent to human nature that in the good times investors systematically fail to take rational account of the tail of low probability adverse events.

A bail-inable bond will have a highly skewed probability distribution of pay-outs. (Slide 8 ) Over a long period of time, only the zero-loss segment of the distribution will be observed. A low probability of significant loss continues to exist, but Gennaioli, Shleifer and Vishay argue that that low probability will be wholly discounted through a behavioural process which they label ‘local thinking’ – the reality, deeply rooted in human nature, that not all contingencies are represented in decision makers’ thought processes. After a period of good times, investors will assume that senior bank debt is effectively risk-free: as indeed they did, in the years before the crisis (Slide 9). Regulators cannot therefore rely on free-market discipline to ensure that the debt is only held by investors who can suffer loss without that causing knock-on systemic disruption.

If therefore we can neither perfectly and continuously monitor or regulate who owns bail-inable debt, nor rely on free-market discipline to ensure that it is always appropriately held, contractually bail-inable debt and technical resolvability will be valuable but still imperfect solutions to the ‘too big to fail’ problem. We can only be sure that losses can be smoothly absorbed if we are sure that the investors who provide funds do not suffer from ‘local thinking’ but remain perpetually aware of the full distribution of possible results. Subordinated debt which can convert to equity well before potential failure (‘early trigger CoCos’) may approach what is required since the price will presumably vary with probabilistic expectations of future conversion. But only with pure equity can we be fully confident that the dangers of ‘local thinking’ will not creep in over time, and that investors, facing day-by-day price movements up and down will remain continually aware that they hold a potentially loss absorbing instrument. The implication of Shleifer’s ‘local thinking’ theory is that if investors are to remain continuously aware of the full frequency distribution of objectively possible results the observed frequency distribution of returns needs to include negatives and well as positives. This is achieved by equity returns but not by low risk debt.

OSFI, in its infinite wisdom, is going in entirely the opposite direction: the lowest possible conversion triggers for CoCos, and seeking to include CoCos in the regular bond indices so that investors will be fooled into buying them.

Credit Suisse is issuing contingent capital:

The bank agreed to sell $3.5 billion of contingent convertibles with a coupon of 9.5 percent, and 2.5 billion francs with a coupon of 9 percent, it said. The sale will happen no earlier than October 2013, which is the first call date on $3.5 billion of 11 percent and 2.5 billion francs of 10 percent Tier 1 capital notes the bank sold in 2008.

The notes will convert into shares if the bank’s Basel III common equity Tier 1 ratio falls below 7 percent. The conversion price will be the higher of the floor price of $20 or 20 francs per share or the daily weighted average sale price of ordinary shares over the trading period preceding the notice of conversion, the bank said.

The transaction is subject to the implementation of Swiss regulations and the approval of shareholders, the bank said. The Swiss committee proposed that the country’s two biggest banks should hold common equity equal to at least 10 percent of their assets, weighted according to risks. In addition, the companies may hold up to 3 percent in so-called high-trigger CoCos that would convert into shares if the bank’s common equity ratio falls below 7 percent, plus 6 percent in CoCos that would convert at a 5 percent trigger.

Credit Suisse said the 6 billion-franc sale would satisfy about 50 percent of the high-trigger requirement. The bank said it would like to see the market for contingent convertible bonds expand to a wider group of buyers and is pursuing an additional offering of such notes to potential investors outside the U.S. and certain other countries.

On the positive side, conversion occurs well before the the point of non-viability. On the negative – the trigger is based on Capital Ratios, which I have strongly criticized in the past and continue to criticize.

The Financial Times comments:

Switzerland’s other big bank, UBS, takes a diametrically opposed view to Credit Suisse, on cocos, arguing that they will be excessively expensive because no one knows how to price them properly. UBS prefers the “haircut bond” as an instrument.

But investors believe that other UK banks, such as HSBC, could be drawn to cocos. “That would really seal cocos’ reputation,” said one London-based investor. “But in the meantime, we expect the Nordics, particularly Sweden, to be big issuers. We also think this will take off in the US.” In spite of a lack of enthusiasm from US regulators, the likes of Morgan Stanley and Goldman Sachs are privately intrigued by cocos.

Senior bankers at BNP and Société Générale have similarly signalled a willingness to consider coco issuance to finance buffers. Analysts at Barclays Capital said the market for European cocos alone could be close to €700bn ($945bn) by 2018.

Many traditional fixed-income investors are barred from owning instruments such as cocos that can convert into equity.

Update, 2011-2-23: The deal was a huge success:

Investors rushed to take up the benchmark issue by Credit Suisse of a new financial instrument hailed by regulators as a key tool for rebuilding the capital strength of banks, placing orders of $22bn – 11 times the $2bn on offer.

The deluge of orders represented a big vote of confidence in the nascent market for contingent capital bonds, dubbed cocos.
…
Asset managers took about two-thirds of Credit Suisse’s cocos, while private banks took a third on behalf of their clients. A total of 550 different investors – an unusually large number – put in orders for the bonds. The strong demand from asset managers was particularly important since they will form the backbone of any sustainable market for the products.

Credit Suisse’s deal was helped by the fact the bank anchored its coco deal by simultaneously announcing a agreement to swap $6.2bn of its existing hybrid debt for cocos – covering in one go about half the total cocos the bank needs to issue.

OSFI has released a Draft Advisory titled Non-Viability Contingent Capital (NVCC):

OSFI has determined that, effective January 1, 2013 (the Cut-off Date), all non-common Tier 1 and Tier 2 capital instruments issued by DTIs must comply with the following principles to satisfy the NVCC requirement:

Principle # 1: Non-common Tier 1 and Tier 2 capital instruments must have, in their contractual terms and conditions, a clause requiring a full and permanent conversion [Footnote 4] into common shares of the DTI upon a trigger event.[Footnote 5] As such, original capital providers must not have any residual claims that are senior to common equity following a trigger event.

Footnote 4: The BCBS rules permit national discretion in respect of requiring contingent capital instruments to be written off or converted to common stock upon a trigger event. OSFI has determined that conversion is more consistent with traditional insolvency consequences and reorganization norms and better respects the legitimate expectations of all stakeholders.

Footnote 5 The non-common capital of a DTI that does not meet the NVCC requirement but otherwise satisfies the Basel III requirements may be, as permitted by applicable law, amended to meet the NVCC requirement.

Some extant contingent capital has a “write-up” clause, whereby amounts written down can be recovered if the company squeaks through its troubles.

The minimum condition reveals that OSFI is more interested in political posturing than averting a crisis. If they wanted to avert a crisis, they would insist that conversion took place long before the point of non-viability, when the common still had value.

Principle # 3: All capital instruments must, at a minimum, include the following trigger events:

• a. the Superintendent of Financial Institutions (the “Superintendent”) advises the DTI, in writing, that she is of the opinion that the DTI has ceased, or is about to cease, to be viable and that, after the conversion of all contingent capital instruments and taking into account any other factors or circumstances that she considers relevant or appropriate, it is reasonably likely that the viability of the DTI will be restored or maintained; or
• b. a federal or provincial government in Canada publicly announces that the DTI has accepted or agreed to accept a capital injection, or equivalent support [Footnote 6], from the federal government or any provincial government or political subdivision or agent or agency thereof without which the DTI would have been determined by the Superintendent to be non-viable [Footnote 7]

  Footnote 6: OSFI, after consulting with its FISC partner agencies, will provide guidance to DTIs upon request whether a particular form of government support being offered to such DTI is considered equivalent to a capital injection. For example, the Bank of Canada’s Emergency Liquidity Assistance (ELA) does not constitute equivalent support as it is targeted at solvent institutions experiencing temporary liquidity problems.

  Footnote 7: Any capital injection or equivalent support from the federal government or any provincial government or political subdivision or agent or agency thereof would need to comply with applicable legislation, including any prohibitions related to the issue of shares to governments.

So the Superintendent, an employee of the federal Ministry of Finance, has absolute power – there is no appeal. There is nothing to prevent the Superintendent from saying tomorrow that the Royal Bank is non-viable, the Government is buying a hundred-billion shares for a dollar, fuck you suckers, goodbye. Five hundred years of bankruptcy law out the window.

Principle # 8: The issuing DTI must provide a trust arrangement or other mechanism to hold shares issued upon the conversion for non-common capital providers that are not permitted to own common shares of the DTI due to legal prohibitions. Such mechanisms should allow such capital providers to comply with such legal prohibition 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.

Since we’re ignoring bankruptcy law, why not ignore every other law and contract while we’re at it?

Section 3: Issuance of Capital Instruments prior to the Cut-off Date
…
3. DTIs are encouraged to consider amending the terms of existing non-common instruments that do not comply with the NVCC requirement to thereby achieve compliance, or to otherwise take actions, including exchange offers, which would mitigate the effects of such non-compliance.

It’s possible that some issuers might try this, but it’s awfully hard to imagine the kind of coercion that would be required to get something like this to pass for a PerpetualDiscount, given the reasonable expectation of redemption at par within ten-odd years.

Section 4: Criteria to be considered in Triggering Conversion of NVCC

In triggering the conversion of NVCC, the Superintendent will exercise his or her discretion to maintain a financial institution as a going-concern where it would otherwise become non-viable. In doing so, the Superintendent will consider the below list of criteria and any other relevant OSFI guidance [Footnote 16]. These criteria may be mutually exclusive and should not be viewed as an exhaustive list.[Footnote 17]

The exercise of discretion by the Superintendent will be informed by OSFI’s interaction with the Financial Institutions Supervisory Committee (FISC)[Footnote 18] (and any other relevant agencies the Superintendent determines should be consulted in the circumstances). In particular, the Superintendent will consult with the FISC member agencies and the Minister of Finance prior to making a non-viability determination.

Footnote 16: See, in particular, OSFI’s Guide to Intervention for Federally-Regulated Deposit-Taking Institutions.

Footnote 17: The Superintendent retains the flexibility and discretion to deal with unforeseen events or circumstances on a case-by-case basis.

Footnote 18: Under the OSFI Act, FISC comprises OSFI, the Canada Deposit Insurance Corporation, the Bank of Canada, the Department of Finance, and the Financial Consumer Agency of Canada. Under the chairmanship of the Superintendent of Financial Institutions, these federal agencies meet regularly to exchange information relevant to the supervision of regulated financial institutions. This forum also provides for the coordination of strategies when dealing with troubled institutions.

Full discretion, no judiciary, no appeal. Goodbye Canada, hello Soviet Union.

Update, 2011-2-7: DBRS says:

OSFI has also issued a draft advisory on non-viable contingent capital. Again, the draft advisory was consistent with the BCBS’s release on minimum requirements to ensure loss absorbency at the point of non-viability (January 13, 2011). The NVCC Draft Advisory sets out the governing principles, information requirements and criteria to be considered in triggering a conversion of non-viable contingent capital. DBRS will state its views on non-viable contingent capital when OSFI publishes a final release of the advisory, expected in 2011.

Notwithstanding the NVCC Draft Advisory, DBRS’s global bank rating methodology continues to deem the five largest Canadian banks (Bank of Montreal, Bank of Nova Scotia, Canadian Imperial Bank of Commerce, Royal Bank of Canada, and The Toronto-Dominion Bank) systemically important in Canada, which positively impacts DBRS’s senior and subordinated debt ratings of these banks.

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.

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.

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.

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.

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).
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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.

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.
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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.
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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.