PrefBlog

Hybrid instruments (usually referred to on PrefBlog as “Innovative Tier 1 Capital” due to the Canadian connection; on a global basis, the term “hybrid” includes “non-innovative” hybrids and also such terms as “additional own funds” and “ancillary own funds”) achieved recognition in the BIS Sydney Press Release of October 27, 1998, “Instruments Eligible for Inclusion in Tier 1 Capital”:

The Basle Committee on Banking Supervision has taken note that over the past years some banks have issued a range of innovative capital instruments, such as instruments with step-ups, with the aim of generating Tier 1 regulatory capital that is both cost-efficient and can be denominated, if necessary, in non-local currency. The Committee has carefully observed these developments and at its meeting on 21st October 1998 decided to limit acceptance of these instruments for inclusion in Tier 1 capital. Such instruments will be subject to stringent conditions and limited to a maximum of 15% of Tier 1 capital.
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In order to protect the integrity of Tier 1 capital, the Committee has determined that minority interests in equity accounts of consolidated subsidiaries that take the form of SPVs should only be included in Tier 1 capital if the underlying instrument meets the following requirements which must, at a minimum, be fulfilled by all instruments included in Tier 1:

• issued and fully paid;
• non-cumulative;
• able to absorb losses within the bank on a going-concern basis;
• junior to depositors, general creditors, and subordinated debt of the bank;
• permanent;
• neither be secured nor covered by a guarantee of the issuer or related entity or other arrangement that legally or economically enhances the seniority of the claim vis-à-vis bank creditors;
• and callable at the initiative of the issuer only after a minimum of five years with supervisory approval and under the condition that it will be replaced with capital of same or better quality unless the supervisor determines that the bank has capital that is more than adequate to its risks.

As careful readers of the back pages of the financial press may remember, we are now experiencing a Credit Crunch, that got rolling in a big way in August 2007, seems to have peaked in March 2008 with the near-death experience of Bear Stearns and … still continues. With this in mind, the Committee of European Banking Supervisors has – after drafting a proposal and obtaining comments from the players, published a Proposal for a common EU definition of Tier 1 hybrids, advice which was solicited from them by the European Commission:

29. The main features of the instrument (including whether it is grandfathered), the proportion of Tier 1 capital it accounts for must be periodically and publicly disclosed by the issuer. The main features of the instrument must be easily understood.

30. Moreover, the three economic characteristics must all be fulfilled at the same time – loss absorbency, permanence and ability of the issuer to cancel payments.
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34. The instrument helps to prevent insolvency if the following conditions are met :
• the instrument is permanent;
• the issuer has the flexibility to cancel coupon/dividend payment;
• the instrument would not be taken into account for the purposes of determining whether the institution is insolvent; and
• the holder of the instrument cannot be in a position to petition for insolvency.
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46. Issuers must be able to waive payments on a non-cumulative basis and for an unlimited period of time whenever necessary.

47. If the institution is in breach of its minimum capital requirements (or another level defined by the supervisor) then it must waive payments.

48. In addition, no provision in the terms of the hybrid instrument may prevent the supervisors from requiring institutions to waive payments at their discretion based on the financial situation of the institution.

49. Dividend pushers are acceptable but must be waived when either of the supervisory events mentioned above occurs between the date the coupon is pushed and the date it is to be paid. Under those circumstances, payment of the coupons will be forfeited and no longer be due and payable by the issuer.

50. The instrument is not cumulative in kind or in cash: any coupon or distribution not paid by the issuer is forfeited and is no longer due and payable by the issuer.

51. The issuer must have full access to waived payments.

52. Alternative Coupon Satisfaction Mechanisms are permitted only in cases where the issuer has full discretion over the payment of the coupons or dividends at all times, and only if the ACSM achieves the same result as a cancellation of coupon (i.e. there is no decrease in capital). To meet this condition, the deferred coupons must be contributed without delay to the capital of the issuer in exchange for newly issued shares having an aggregate fair value equal to the amount of the coupon/dividend. The obligation of the institution is limited to the issue of the shares. Hence, the issuer must have already authorised and unissued shares. The shares may be, afterwards, sold in the market but the institution must not be committed to find investors for these shares. If the sales proceeds are less than the coupon, the issuer must not be obliged to issue further new shares to cover the loss incurred by the hybrid holders.

53. Distributions can only be paid out of distributable items; where distributions are pre-set they may not be reset based on the credit standing of the issuer.
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58.
Under both options, the limit for innovative hybrid instruments would be at all times 15% of total Tier 1 capital after specific Tier 1 deductions (but without taking into account deductions from original and additional own funds). The 15% would be included in the assessment of the limits above.

Further, paragraph 64 of the CEBS paper reports that 89% of Europe’s Innovative Instruments are non-cumulative; while:

65. The small percentage of cumulative instruments with payment in cash includes grandfathered issues of silent partnerships in Germany and a few non-innovative and innovative grandfathered instruments in Ireland and Denmark. The small percentage of cumulative instruments with payment in kind includes mostly innovative and non-innovative instruments in the United Kingdom.

66. Direct issues of perpetual non-cumulative preference shares never incorporate cumulative features, be it in cash or in kind.

67. Coupon payments in kind, often called Alternative Coupon Satisfaction Mechanisms (ACSM) 7, mean that the issuer can satisfy the coupon payment in the form of shares (as opposed to cash).

68. Instruments with this feature only account for a small part of the total but are, for tax reasons, significant in some jurisdictions, notably in the United Kingdom, Belgium and the Netherlands. A few grandfathered issues have been reported in Ireland and Austria.

A “dividend pusher” is defined in paragraph 83.

CEBS does consider the question of ACSM:

91. Therefore ACSM is only acceptable if it achieves the same result as a cancellation of the coupon (i.e. there is no decrease in capital) and when the issuer has full discretion over the payment of the coupons or dividends at all times. To meet this condition, the deferred coupons must be satisfied without delay using newly issued shares that have an aggregate fair value equal to the amount for the coupon/dividend. The obligation of the institution is limited to the issue of shares. The issuer must already have authorised and unissued shares. The shares may be, afterwards, sold in the market but the institution must not be committed to find investors for these shares. If the sales proceeds are less than the coupon, the issuer must not be obliged to issue further new shares to cover the loss incurred by the hybrid holder.

It would appear that the recent OSFI draft advisory on Tier 1 capital is – grudgingly – in accordance with the results of CEBS discussion, with respect to cumulativity.

It should be noted that “in accordance” does not mean the same thing as “good”. It is my understanding that the OSFI advisory is intended to allow the issuance of Innovative Tier 1 Qualifying capital despite the “Hallowe’en Massacre” Income trust legislation that changed all the rules.

Chris Van Loan of Blakes wrote a paper “The October 31, 2006 Income Trust Proposals and Innovative Tier 1 Instruments” (not available online). In the introduction, he makes the point:

a trust … would use the proceeds from issuing [Innovative Tier 1 instruments] to either purchase loans and debt obligations from the relevant financial institution (an “Asset-Based Structure”) or to make a loan to such financial institution (a “Loan-Based Structure”).

For example, the most recent Innovative Tier 1 Instrument was RBC TruCS – Series 2008-1:

The gross proceeds to the Trust from the Offering of $500,000,000 will be used to fund the acquisition by the Trust of Trust Assets from the Bank.
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The Trust’s objective is to acquire and hold the Trust Assets that will generate net income for distribution to holders of Trust Securities. The Trust Assets consist primarily of: (i) Mortgage Co-Ownership Interests (as defined herein) in one or more pools of Residential Mortgages (as defined herein) originated by the Bank or its affiliates; or (ii) Mortgage-Backed Securities (as defined herein).

… whereas, in the case of RBC TruCS — Series 2013:

The gross proceeds from the Offering of approximately $900,000,000 will be used by the Trust to acquire the Bank Deposit Note from the Bank.

The Loan Based Structure – exemplified by the 2013 TruCS – had a variety of legal kerfuffles described by Mr. Van Loan, but “just as the world seemed safe again for Loan-Based Structures, the SIFT Proposals would seem to have thrown yet another roadblock in the way of these innovative Tier 1 instruments”. Under the Hallowe’en Massacre rules:

A trust that is a SIFT [Specified Investment Flow-Throughs] will not be permitted to deduct certain otherwise deductible amounts distributed to unitholders which distributions will be subject to a special rate of tax meant to approximate the federal-provincial corporate income tax rate.

OK, so is the trust (issuing the TruCS) a SIFT? One of the conditions is that it holds one or more “non-portfolio properties” … and a deposit note from the bank that created and controls the trust is considered to be a “non-portfolio property”. Accordingly:

the SPV would be required to pay the special tax on such non-portfolio earnings and holders of the Capital Trust Securities receiving distributions from the SPV out of such earnings would be taxed as if they had received dividends from taxable Canadian corporations

Not a problem for taxable holders. Big problem for non-taxable holders, such as pension funds. End of Loan-Based Innovative Tier 1 Capital. Thank you, Mr. Flaherty.

Mr. Van Loan notes that representations have been made to the Ministry of Finance to fix up the law, but the actions of OFSI indicate – to me – that these representations have been unsuccessful.

But we know – from Royal Bank’s issuance of “RBC TruCS – Series 2008-1” – that the banks can and will issue Asset Backed Innovative Tier 1 Capital. I will confess that I don’t know whether such issuance will count against their limit on covered bonds. It might; it might not. But at any rate, the OSFI advisory seems to specifically target the issuance of Loan-backed Innovative Tier 1 Capital.

Now we get to the question that has been puzzling indefatigable Assiduous Readers all along – why should I care? Well … let’s have a look at Bank Capital for 2Q08 and drill down to RY Capitalization: 2Q08. Look at that. 15% of their capital is in the form of Innovative Tier 1 Instruments.

Let us assume that RY gets into trouble. Some might consider this to be far-fetched … but as fixed-income investors, this is the basic thing we worry about. How safe is our capital? How likely are the dividends to continue without pause? We don’t mind day-to-day market fluctuations so much, and as preferred share investors we’re willing to take more risk than exists with, say, sub-debt or deposit notes … but we want to know what our risks are. This is considered prudent.

So RY gets into trouble at a time when … as may eventually be the case given the nature of the OSFI advisory … the maximum 15% of its Tier 1 Capital is comprised of Tier 1 instruments with a cumulative coupon. Dividends on both common and preferreds during this period are lost and gone, but we’ll just have to hope the bank works out its difficulties and dividends start up again soon.

15% of tier 1 capital has a cumulative coupon, paid in kind (ACSM) with preferred shares. Let’s say the penalty rate on this capital is 6.66%, just to make the numbers easier. Therefore, every year during this period, preferred shares are accumulating at a rate of 1% of Tier 1 capital. RY has 23.3-billion of Tier 1 capital at the moment (in times of stress, presumably, it would have declined due to write-offs), so we can call that $230-million-worth of preferred shares accumulating during the stress period. An entire new issue. Additionally, we consider the fact that preferreds make up only 10% of RY’s Tier 1 capital: so one-tenth of the entire outstanding preferred share float will be accumulating every year.

This is a lot of dilution, and it’s potential dilution that did not exist prior to the new OSFI advisory. And, just to make sure that preferred shareholders get their faces thoroughly kicked in, it’s a pretty good bet that the happy recipients of the cumulated preferred shares will dump them immediately upon receipt – killing a market that should be in the early stages of tremulous recovery at that point.

This is not just a selfish concern about the value of extant investments in the preferred market. In the current Credit Crunch, we’ve seen a lot of issuance of preferreds, convertible and otherwise, by banks that have been badly hurt. The dilutive effect of the cumulated coupons will make it harder for a wounded bank to take that route and crawl out of its hole – so it’s a prudential concern.

So, to review:

• Banks can currently issue Asset Backed Innovative Tier 1 Capital
• The Hallowe’en Massacre eliminated their ability to issue Loan Backed Innovative Tier 1 Capital (LBIT1C)
• The OSFI Advisory restores their ability to issue LBIT1C
• The OSFI Advisory, with respect to cumulativity, is just barely within international standards
• The OSFI Advisory has made the world a slightly scarier place for preferred share investors
• The OSFI Advisory makes it somewhat easier for banks to obtain Tier 1 capital in good times, at the expense of making it harder to obtain such capital in bad times
• There has been no public discussion of the OSFI Advisory

It is thoroughly outrageous that OSFI feels empowered to make such far-reaching – and unnecessary – changes to bank capitalization rules without discussion.

OSFI does not meet international standards for transparency.