Today’s Globe & Mail had a story titled Bankers cast doubt on tax alternative:
Some Canadian bankers are skeptical about the feasibility of Ottawa’s proposal for a new type of security that would enable banks to “self-insure” against failure, a key part of the country’s fight against plans for a global bank tax.
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A key stumbling block, bankers say, is that the contingent capital securities would come with so much risk that investors will demand a high interest rate to buy them. That will make selling the securities unattractive to banks and could even lead to the securities being more costly to banks than a bank tax, some analysts say.
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The biggest issue with the idea, some bankers say, is the potential conversion from debt to common stock. The last thing a debt investor wants is to end up owning equity in a troubled company, bankers said. That’s because in the event of a bankruptcy or liquidation, common shares rank behind debt. As a result, investors demand much higher returns from equity-like securities, making them more costly for the selling bank.Also, many big investors such as some pension funds are not allowed to buy debt that converts into equity. That shrinks the potential market, again increasing the cost for banks.
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The Canadian Bankers Association, the umbrella industry group, has highlighted the issue of finding buyers. “Careful consideration must also be given to the cost and marketability of such an instrument, particularly in a smaller market like Canada, which has a concentrated investor base,” the group said.Selling ECC securities could raise a bank’s cost of capital by as much as one to two percentage points, reducing earnings by 4 per cent to 7 per cent, analyst John Reucassel of BMO Nesbitt Burns said in a note to clients. Mr. Reucassel said banks may also have to pay more to issue preferred shares, which are a big source of capital. That’s because preferred shares would rank below the new ECC notes in the capital structure of the bank, he said.
Other fears include the possibility that hedge funds or other investors could game the system, and that the conversion features could actually create more instability for a bank that’s in trouble and lead to a death spiral of dilution, Mr. Keefe said.
I don’t understand John Reucassel’s comment about preferred shares: CC is intended to replace sub-debt, which is currently senior to preferreds. If it converts, it will be equity and junior to preferreds – which is the reason why I feel that, should CC become important, a similar conversion will be applied to prefs.
The comment many big investors such as some pension funds are not allowed to buy debt that converts into equity. is a problem, but not insurmountable. Changing an investment mandate is not exactly the world’s most difficult task; having never had much interest in convertibles I don’t know whether any legislative changes would be necessary; but if so … change ’em.
As for selling it … just put the bank’s name in big letters at the top of the paper and shuffle it over to the salesmen. Canada’s docile investment community will buy whatever they’re told to buy. Hey – it worked for Tier 1 capital! Stick it in the index, too – that’s worked before as well.
And as for being more expensive for the issuers … well, yeah. That’s the whole point. Extant structures do not provide protection in a crisis. Contingent Capital will provide protection in a crisis.Therefore, a rational person might expect the paper to be more expensive. I suspect that CC will eventually come to pass when the regulators say “OK – you’ve got to have 6% Core Tier 1 capital, which is defined as equity + CC. At least two-thirds of that must be equity. For the rest, go choose.” As long as the CC is cheaper than equity, the banks will issue it, given that choice.
The Canadian Bankers Association states:
Embedded contingent capital is one of the alternatives to a global bank tax that is being proposed. With embedded contingent capital, banks would issue securities that would convert to common equity in the event that the bank faced serious financial difficulties.
The contingent capital proposals being contemplated are very complex and there are still many details to be ironed out. The CBA welcomes the opportunity to work with regulators in the development of this proposal.
The banks agree with the idea that the conversion of these securities should only be triggered when a financial institution is in very serious trouble. Careful consideration must also be given to the cost and marketability of such an instrument, particularly in a smaller market like Canada, which has a concentrated investor base.
It is fascinating to learn that The banks agree with the idea that the conversion of these securities should only be triggered when a financial institution is in very serious trouble. This will do nothing to contain a crisis.
It’s rather sad, though, that they couldn’t find it within themselves to acknowledge that several issues have been done in Europe.
And finally, Paul Volcker dismisses the whole idea:
“It sounds attractive, and it sounds attractive to me, but for some reason it never gets much traction,” Mr. Volcker, the physically towering former Federal Reserve chairman who is one of President Barack Obama’s key advisers on financial regulation, said of the Canadian proposal to have banks hold embedded contingent capital.
“If someone wanted to experiment with it, I would say, ‘God bless them.’’’
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While in favour of contingent capital, Mr. Volcker stopped short of saying that he believed it would work. He said the concept has been around for 30 years, yet has never taken off.Mr. Volcker said sophisticated investors tell him the market for such a security would be severely “constricted,” presenting challenges to any bank hoping to sell contingent capital at a favourable price. There’s also a legitimate question whether enough contingent capital could be sold to make a difference if a bank were seriously strained. If a bank is so strained that its only avenue to raise funds is to convert its own debt, then it’s probably too late, Mr. Volcker said.
“It might make the funeral look a little different, but it’s going to be a funeral anyway,” Mr. Volcker said.
At the very least, this forced the usually sycophantic Canadian press to print the idea that CC is not a brand new idea developed by those hard-nosed geniuses at OSFI!