PrefBlog

Retail investors in the UK have been barred from buying Contingent Capital instruments:

The U.K.’s Financial Conduct Authority will ban firms from selling contingent convertible bonds to individual investors, saying they’re too complex and risky for the mass retail market.

From Oct. 1, the FCA will limit sales of CoCos to institutional, professional investors and high-net-worth individuals for 12 months, the London-based regulator said in a statement today. The FCA will publish a consultation paper on a set of permanent set of rules for CoCos in September.

“In a low interest rate environment, many investors might be tempted by CoCos offering high headline returns,” Christopher Woolard, the FCA’s director of policy, risk and research, said in a statement today. “However, they are complex and can be highly risky.”
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“Every time a bank gets into trouble and you have retail investors in subordinated debt or CoCos, it gets difficult and embarrassing for the regulators,” said Mark Taber, who helped organize a group of individual holders of Co-Operative Bank Plc bonds when the British lender was restructured following a capital shortfall. “They don’t want to have that problem every time that happens. They want to be able to deal with banks.”

Their press release states:

Temporary product intervention rules are made without prior consultation and thus will not undergo the usual process for testing draft rules and receiving feedback from the public before they are made. While every effort has been made to ensure these temporary rules have the effect described in this communication, we remain aware of the possibility of unintended consequences.

In a linked document the European Securities and Markets Authority acknowledges (emphasis added):

Investors should fully understand and consider the risks of CoCos and correctly factor those risks into their valuation. To correctly value the instruments one needs to evaluate the probability of activating the trigger, the extent and probability of any losses upon trigger conversion (not only from write-downs but also from unfavourably timed conversion to equity) and (for AT1 CoCos) the likelihood of cancellation of coupons. These risks may be highly challenging to model. Though certain risk factors are transparent, e.g., trigger level, coupon frequency, leverage, credit spread of the issuer, and rating of instrument, if any, other factors are discretionary or difficult to estimate, e.g. individual regulatory requirements relating to the capital buffer, the issuers’ future capital position, issuers’ behaviour in relation to coupon payments on AT1 CoCos, and any risks of contagion. A comprehensive appreciation of the value of the instrument also needs to consider the underlying loss absorption mechanism and whether the CoCo is a perpetual note with discretionary coupons (AT1 CoCos) or has a stated maturity and fixed coupons (T2 CoCos). Importantly, as one descends down the capital structure to sub-investment grade where the majority of CoCos sit, the level of precision in estimating value when compared to more highly rated instruments, deteriorates. ESMA believes that this analysis can only take place within the skill and resource set of knowledgeble institutional investors.

The FCA action comes at a time when investor appetite is very high:

Denmark may be forced to amend its policy on how much hybrid debt banks can use to meet capital requirements after European regulators recommended limits.

The European Banking Authority in London is proposing that contingent convertible debt make up no more than 44 percent of the additional capital that national regulators tell the banks they oversee to hold. The so-called Pillar 2 capital is used to address risks not covered by minimum European Union requirements.
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Nykredit said in May it expected its 600 million-euro ($805 million) Tier 2 CoCo to be eligible for use as both Pillar 1 and Pillar 2 capital. The lender said at the time it “may be tempted to sell more” following investor demand. The bond, which has a coupon of 4 percent, yielded 3.63 percent today in Copenhagen trading, little changed from yesterday.

Danske sold a 750 million-euro Additional Tier 1 note in March with the intention that the security could be used to meet Pillar 2 requirements, Claus Jensen, the bank’s chief investor relations officer, said by phone. The 5.75 percent note yielded 5.32 percent today, versus 5.33 percent yesterday.

In a Financial Times, piece, Alberto Gallo, head of macro-credit research at RBS, writes:

The worry is that some buyers may not understand the differences and risks of coco structures. Around a fifth of buyers are private clients, and this proportion could rise as the market goes mainstream: the first bond index for cocos was recently initiated by Bank of America Merrill Lynch.
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In its last Financial Stability Report, the Bank of England mentioned the investor base for cocos had broadened, but warned that “investors were placing insufficient weight on the likelihood of a conversion being triggered”.

An analysis of existing coco bonds published by RBS shows prices only compensate for the coupon deferral risk, not for potential losses from conversion. Finally, Tobias Berg of Bonn University and Christoph Kaserer of Munich Technical University recently suggested cocos could push banks to take more risk, given their asymmetric risk-return profile with losses skewed towards investors.

No one really knows what would happen if a bank were to suspend its coupon payments, or worse, had to convert its cocos. Several investors fear this could compound volatility or even disrupt the whole market: some already predict 10 percentage point price drops the first time a bank hits a trigger on its cocos.
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Regulators must act now to avoid waking up to these problems when it is too late. The first thing to do is flag clearly that cocos are not regular bonds, before investors unaware of the risks start buying. The case of Bankia’s bail-in in Spain highlighted the social pain of pushing losses on to bonds held by retail investors. Cocos can expose holders to cliff-like losses: they are not for orphans or widows.

Second, regulators need to create standards and reduce complexity across jurisdictions, clarifying how triggers and conversion mechanisms really work in a crisis. In doing so, they should favour instruments where the risks and rewards are aligned with shareholders, like cocos that convert into and dilute equity in case of losses, and discourage writedown cocos, where bondholders crystallise losses but get no upside.

All this is happening as Barclays starts marketing a CoCo index:

“CoCo issuance has steadily grown in recent years and we anticipate further expansion of this market as financial institutions issue these bonds to help achieve required regulatory capital ratios,” said Brian Upbin, Head of Benchmark Index Research at Barclays. “Though CoCos are not eligible for broad-based bond indices such as the Global Aggregate, there are debt investors who hold these securities as out-of-index investments and need a benchmark of asset class risk and returns.”

The Barclays Global Contingent Capital Index includes hybrid capital securities with explicit equity conversion or writedown loss absorption mechanisms that are based on an issuer’s regulatory capital ratio or other explicit solvency-based triggers. Subindices by currency, country, credit quality, and capital security type are available as part of this family. Bespoke credit and high-yield indices that include traditional hybrid capital as well as contingent capital securities are also now available with this expanded security coverage. The inception date of this index is May 1, 2014, and the index universe contains 65 CoCo issues with a market value of $98bn as of May 31, 2014.

Barclays also indicates:

“Though CoCos are not eligible for broad-based bond indices such as the global aggregate, there are debt investors who hold these securities as out-of-index investments and need a benchmark of asset class risk and returns,” he [Brian Upbin, head of benchmark index research at Barclays] said.
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Barclays plans to exclude securities with conversion features based solely on the discretion of local regulators, those that have an additional equity conversion option based on regulatory or solvency criteria, inflation-linked bonds and floating-rate issues, private placements and retail bonds, and illiquid securities with no available internal or third-party pricing source.

Update, 2014-8-14: It has just occurred to me that this is somewhat akin to Canadian ABCP – where vendors (completely voluntarily and not with a regulatory gun to their heads at all, definitely not) compensated retail investors who lost money. At least the FCA has the decency to ban things before they go wrong … even though it means won’t get a Canadian-style slush fund out of it.

The Ministry of Finance has announced:

a public consultation on a key element of the Government’s comprehensive risk management framework for Canada’s domestic systemically important banks.
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The proposed regime focuses on a specific range of liabilities and excludes deposits. In addition, insured deposits will continue to be guaranteed by the Canada Deposit Insurance Corporation.

Comments on the attached draft consultation paper can be submitted to the Department of Finance at ConsultationsFSS-SSF@fin.gc.ca or to the address below. The closing date for comments is September 12.

I think the first thing to observe from this announcement is that this is a deliberate slap in the face to OSFI and an indicator, yet again, of the politicization of the bank regulatory framework.

The consultation paper claims as its objective:

The Taxpayer Protection and Bank Recapitalization regime for Canada’s D-SIBs would allow for the expedient conversion of certain bank liabilities into regulatory capital when a D-SIB fails (i.e., at the point when the institution becomes non-viable). It would thus enable a resolution strategy that protects taxpayers by ensuring that losses are borne by shareholders and creditors of the failed bank while preserving the same legal entity and contracts of the bank (i.e., keeping it open or “continuing”) and, in turn, maintaining the critical services the bank provides to its customers.

… and hints at a favourable view towards a holdco/opco bank structure:

The bail-in (or equivalent) powers introduced or planned in other jurisdictions reflect the way that major banks in those jurisdictions are structured. For example, the U.S. and U.K. have large banking groups that are organized with a non-operating holding company at the top of the group, and operating bank subsidiaries underneath. In contrast, Canadian banks are organized with an operating bank as the top-tier parent company. The Government welcomes views on the potential merits of a holding company model (similar to that of other major jurisdictions) in the context of reforms to strengthen Canada’s bank resolution framework.

It is not clear whether this would or could involve a decrease in the protectionism that has given rise to the Big 6 oligopoly.

… and summarizes:

The purpose of this consultation paper is to set out the major features of a proposed Taxpayer Protection and Bank Recapitalization regime for Canada. The overarching policy objective that drives the design of the regime is to preserve financial stability while protecting taxpayers. This objective is supported by the Taxpayer Protection and Bank Recapitalization regime by:

• ◾Reducing the likelihood of a D-SIB failure by enhancing market discipline, limiting moral hazard and constraining incentives for excessive risk-taking by ensuring that bank creditors and capital providers bear losses in the event of a D-SIB becoming non-viable;
• ◾Ensuring that, in the event that a D-SIB experiences severe losses leading to non-viability, it can be quickly restored to viability with no or minimal taxpayer exposure to loss through a resolution strategy which enables conversion of certain liabilities into additional equity capital; and,
• ◾Supporting D-SIBs’ ability to provide critical services to the financial system and economy during normal times and in the event that a D-SIB experiences severe losses.

First, they want statutory conversion power:

The Government proposes that the cornerstone of the Taxpayer Protection and Bank Recapitalization regime be a statutory power allowing for the permanent conversion—in whole or in part—of specified eligible liabilities into common shares of a bank (see Scope of Applicationbelow) designated as a D-SIB by OSFI,[6] following certain preconditions (see Sequencing and Preconditionsbelow). The power would also allow for (but not require) the permanent cancellation, in whole or in part, of pre-existing shares of the bank. [Footnote]

[Footnote reads]: For greater certainty, this power would only be applied to common shares of the bank which were outstanding prior to the point of non-viability

Two pre-conditions would exist before this statutory conversion:

First, there must be a determination by the Superintendent of Financial Institutions that the bank has ceased, or is about to cease, to be viable. Second, there must be a full conversion of the bank’s NVCC instruments.[8]

Note that these are necessary, but not sufficient, preconditions for the exercise of the conversion power. Authorities would retain the discretion to not exercise the conversion power even if the preconditions had been met. For example, authorities may decide not to exercise the power if conversion of NVCC instruments were deemed to be sufficient to adequately recapitalize the bank.

This would apply to new senior debt; existing senior debt will be grandfathered.

In order to allow for a smooth transition for affected market participants and to maximize legal clarity and enforceability of the Taxpayer Protection and Bank Recapitalization regime, the Government proposes that the conversion power only apply to D-SIB liabilities that are issued, originated or renegotiated after an implementation date determined by the Government. The regime would not be applied retroactively to liabilities outstanding as of the implementation date.

The Government proposes that “long-term senior debt”—senior unsecured debt[9] that is tradable and transferable with an original term to maturity of over 400 days—be subject to conversion through the exercise of the statutory conversion power.[10] Authorities would also have the ability to cancel, in whole or in part, the pre-existing common shares of the bank in the context of exercising the conversion power. This scope of application would minimize the practical and legal impediments to exercising a conversion in a timely fashion. It would also minimize any potential adverse impacts on banks’ access to liquidity under stress and support financial stability more broadly.

They would choose the proportion of senior debt converted, and there would be no ‘cram-down’ on more junior instruments other than common shares:

The Government proposes that authorities have the flexibility to determine, at the time of resolution, the portion of eligible liabilities that is to be converted into common shares in accordance with the conversion power. All long-term senior debt holders would be converted on a pro rata basis—that is, each of these creditors would have the same portion (up to 100 per cent) of the par value of their claims converted to common shares.

Authorities’ determination of the total amount of eligible liabilities to be converted would be based on ensuring that the D-SIB emerges from a conversion well-capitalized, with a buffer of capital above the target capital requirements set by OSFI.

Conversion of eligible liabilities would respect the hierarchy of claims in liquidation on a relative, not absolute, basis. For example, for every dollar of their claim that is converted, long-term senior debt holders would receive economic entitlements (in the form of common shares) that are more favourable than those provided to former NVCC subordinated debt investors, but NVCC subordinated debt investors would not be subject to 100 per cent losses in the context of exercising the conversion power.

Conversion terms would be similar in form to NVCC conversion:

Building on this approach, and to provide greater certainty and transparency to investors and creditors that may be subject to the statutory conversion power, the Government proposes to link the conversion terms it would apply with respect to eligible liabilities to those of outstanding NVCC instruments. Specifically, the number of common shares that would be provided for each dollar of par value of a claim that is converted would be tied to the conversion formulas of any outstanding NVCC instruments.

This approach would be communicated to all market participants in advance, and would be applied as follows: long-term senior debt holders would receive, for each dollar of par value converted, an amount of common shares determined as a fixed multiple, X,of the most favourable conversion formula[12] among the bank’s NVCC subordinated debt instruments (or, if none exists, the bank’s NVCC preferred shares[13]).[14]

As with the overall approach, the fixed conversion multiplier, X, would be set in advance by public authorities through regulation or guidance (and would thus be public information).[Footnote]

[Footnote reads:] For example, a potential range for the conversion multiplier would be 1.1 to 2.0.

As discussed in the post Royal Bank Issues NVCC-Compliant Sub-Debt, the conversion multiplier is essentially affects the floor conversion price of the common (which may be assumed to be very low in a non-viability situation); $5 for preferred shares, For sub-debt, the formula is:

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

The “Multiplier” is 1.5.

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

The “Conversion Price” of each Note is the greater of (i) a floor price of $5, and (ii) the Current Market Price of the Common Shares.

If they want to keep the senior debt senior to the sub-debt, the conversion multiplier may have to be more than 1.5! However, they’re also giving themselves the ability to cancel existing common, so it doesn’t really matter what the multiplier is.

In a startling nod to the rule of law, there is actually an intention to allow access to the courts to complain!

The Government proposes that shareholders and creditors subject to conversion be entitled to be made no worse off than they would have been if the bank had been resolved through liquidation. The Government further proposes that the process for determining and, if necessary, providing compensation to shareholders and creditors that have been subject to conversion build on existing processes set out in subsections 39.23 to 39.37 of the Canada Deposit Insurance Corporation Act.

The Canada Deposit Insurance Corporation Act contains the usual bafflegab, but essentially allows dissenting bond-holders to take their case for additional compensation to court.

There will be a minimum amount of convertible instruments:

The Government therefore proposes that D-SIBs be subject to a Higher Loss Absorbency (HLA) requirement to be met flexibly through the sum of regulatory capital (i.e., common equity and NVCC instruments) and long-term senior debt (see Scope of Applicationabove) that is directly issued by the parent bank.
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The Government proposes that the HLA requirement be set at a specific value (as opposed to a range). The Government further proposes that this value be between 17 and 23 per cent of risk-weighted assets (RWA). For example, a HLA requirement at the low end of this range (17 per cent of RWA) would ensure that banks could absorb losses of 5.5 per cent of RWA and emerge from a conversion with common equity of 11.5 per cent of RWA (Basel III minimum Total Capital Ratio of 10.5 per cent plus a buffer of 1 per cent).

They state an intention to fiddle with deposit insurance:

The Government is committed to ensuring that Canada’s deposit insurance framework adequately protects the savings of Canadian consumers. In this regard, deposits will be excluded from the Taxpayer Protection and Bank Recapitalization regime. As announced in Economic Action Plan 2014, the Government plans to undertake a broad review of Canada’s deposit insurance framework by examining the appropriate level, nature, and pricing of protection provided to deposits and depositors.

This is very mysterious, but I assume that uninsured deposits – and deposit notes! – will be senior to senior debt. I just hope to bloody hell they resolve the BA vs. BDN mystery.

Finally, they list the specific questions they want to pretend to address:

Questions for Consultation

1.Is the proposed scope of securities and liabilities that would be subject to the conversion power appropriate? Why / why not?

2.Is the proposed minimum term to maturity at issuance of 400 days appropriate for the purpose of differentiating between short-term and long-term liabilities?

3.Does the proposed regime strike the correct balance between flexibility for authorities and clarity and transparency for market participants?

4.Is the proposal for a fixed conversion multiplier appropriate? Why / why not? What considerations should be taken into account when setting the value of a fixed conversion multiplier as proposed?

5.Is the proposed form of the Higher Loss Absorbency requirement appropriate? What considerations should be taken into account when setting this requirement?

6.Should authorities have the flexibility to provide compensation to written-down creditors in the form of preferred shares in the bank (i.e., instead of common shares)? Why / why not?

7.What would be an appropriate transition period for implementation of the Taxpayer Protection and Bank Recapitalization regime?

8.Are the proposed objectives for the review of existing resolution powers and incorporation of the conversion power into Canada’s bank resolution framework appropriate? What additional considerations should be taken into account to maximize the effectiveness of the conversion power as part of the overall resolution framework?

9.Could a holding company model provide advantages in the application of the bridge bank powers (i.e., akin to the U.S. approach) or conversion powers (i.e., akin to the U.K. approach)?

As usual, there are two fundamental objections to the proposed scheme: firstly, these are all low-trigger conversions, which might be good enough to resolve a crisis, but do not even attempt to avert a crisis; secondly, it gives powers formerly held by a bankruptcy court to a handful of highly politicized, unscrutinized bureaucrats in the CDIC.

I see the whole thing as a lot of flim-flam; a fig-leaf over the ravaging of the rule of law. In any future horrific scenario, there will be so much uncertainty regarding the fate of capital instruments that a bank in dire straits simply will not be able to issue anything.