PrefBlog

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

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

Box 3.D reviews academic proposals for Contingent Capital:

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

Contingent capital certificates – Flannery (2009) [2]

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

They explain:

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

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

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

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

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

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

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

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