DBRS Addresses Contingent Capital

DBRS has announced a policy on contingent capital.

DBRS has today clarified its approach to rating a subset of hybrids and other debt capital instruments whose features include principal write-downs or conversions to lower positioned instruments, if certain trigger events occur. See DBRS Methodology, “Rating Bank Subordinated Debt and Hybrid Capital Instruments with Contingent Risks” April 2010.

“Principal write-downs” were used in the recent Rabobank issue. “Conversions to lower positioned instruments” (which, presumably, includes the possible conversion of Innovative Tier 1 Capital to preferred shares, which has been around for ages), is the mainstream proposal and was used in the ground-breaking Lloyds deal (which was poorly structured due to the high conversion price).

The DBRS Methodology: Rating Bank Subordinated Debt and Hybrid Capital Instruments with Contingent Risks notes:

This view that most hybrids are closer to debt than equity was evident in the global fi nancial crisis. Despite all their ‘bells and whistles’, most of these bank capital instruments could not be converted into equity to help struggling banks absorb losses and bolster their capital while they were still operating. The main benefi t for bank equity capital came when banks made exchange offers for hybrids, either at less than par or for equity instruments. The limited contribution to equity capital is consistent with DBRS’s perspective on the function of these instruments for banks. In analyzing the contribution of bank capital instruments to a bank’s capitalization, DBRS does not generally give any signifi cant equity credit for hybrid instruments, although we recognize their full value in meeting regulatory requirements.

They classify triggering events as:

In assessing the additional risk of these contingent features, an important factor is the ease of tripping the triggers that cause the adverse event to occur. The easier the triggers are to trip, the greater the additional risk for the hybrid holder. DBRS organizes the ease of tripping triggers into four broad categories:
• Level 4 “Very Hard”, e.g., Bank is insolvent or has been seized
• Level 3 “Hard”, e.g., Bank has exhausted most of its capital, but is not technically insolvent
• Level 2 “Easier”, e.g., Bank no longer meeting minimum regulatory requirements
• Level 1 “Easiest”, e.g., Capital ratio falls below a level set above minimum requirements
For those instruments where the trigger event requires the bank to be insolvent or seized by the authorities, DBRS views the risk as similar to debt instruments.

Julie Dickson’s op-ed advocated – eseentially – a Level 4 trigger – but, of course, she is trying to get something for nothing: equity capital priced like debt. The solution I advocate, a conversion into stock if the stock trades below a certain level, is a Level 1 solution; more expensive for the banks, but on the other hand, actually has a hope of accomplishing something. YOU CAN’T GET SOMETHING FOR NOTHING FOREVER! Hasn’t the last few years convinced anybody of that?

The fi rst step is evaluating the elevated risk posed by the specifi c features of each instrument. For some instruments, the combinations are relatively straightforward. An instrument with triggers that are hard to trip and resulting positions that are above preferreds is viewed as having elevated risk. For instruments with triggers that are easier to trip and resulting positions that are comparable to preferreds, the risk is viewed as being very elevated. Under DBRS’s approach certain instruments with contingent features can pose exceptional risk, if their triggers are the easiest to trip and the resulting position for holders is closer to common equity. One factor in rating these instruments below preferred shares could be that tripping the triggers could occur without preference shares being impacted or leave them in a preferential position relative to the converted instruments. Outside these straightforward combinations, there are a number of combinations that involve judgment in making the assessment of risk (See Exhibit 1). or those instruments where the write-downs or conversions to lower positioned instruments can be reversed, if the bank survives, the risk to investors remains largely the same as it would be in the absence of the feature. That is, investors face losses only if the bank is declared insolvent.

There seems to be acceptance of the idea that it will be possible for subordinated debt to leapfrog prefs and become equity; and I don’t understand this idea at all. Once you allow leapfrogging, investing becomes a lottery. Let all elements of capital have a mandatory conversion into equity at some point, says I; and make it clear that leapfrogging is not likely.

In my proposal, where prefs would trigger/convert at 50% of the common price at time of issue and sub-debt would trigger/convert at 25%, leapfrogging is sort of possible. You could issue a pref, wait a few years (decades?) until the common price doubles, then issue sub-debt. But that’s fine, that’s allowed. All the regulators should be worried about is the risk at the time of sale to the public.

DBRS also published a not-very-interesting Methodology
Rating Bank Subordinated Debt and Hybrid Instruments with Discretionary Payments
. They used it when downgrading Dexia’s sub-debt today, amongst other actions.

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