BIS Proposes CoCos: Regulatory Trigger, Infinite Dilution

The Bank for International Settlement has released a Proposal to ensure the loss absorbency of regulatory capital at the point of non-viability – consultative document:

the proposal is specifically structured to allow each jurisdiction (and banks) the freedom to implement it in a way that will not conflict with national law or any other constraints. For example, a conversion rate is not specified, nor is the choice between implementation through a write-off or conversion. Any attempt to define the specific implementation of the proposal more rigidly at an international level, than the current minimum set out in this document, risks creating conflicts with national law and may be unnecessarily prescriptive.

The Basel Committee welcomes comments on all aspects of the proposal set out in this consultative document. Comments should be submitted by 1 October 2010 by email to:

However, if we define gone-concern also to include situations in which the public sector provides support to distressed banks that would otherwise have failed, the financial crisis has revealed that many regulatory capital instruments do not always absorb losses in gone-concern situations.

That’s a nice little definition of “gone concern”, giving bureaucrats the authority to ursurp the prerogatives of the legal system. One thousand years of bankruptcy law … pffffft!

The proposal will be examined clause by clause:

All non-common Tier 1 instruments and Tier 2 instruments at internationally active banks must have a clause in their terms and conditions that requires them to be written-off on the occurrence of the trigger event.

Reasonable enough.

Any compensation paid to the instrument holders as a result of the write-off must be paid immediately in the form of common stock (or its equivalent in the case of non-joint stock companies).

This means that write-down structure’s like Rabobank’s would not, of themselves, qualify for inclusion. There would need to be another clause in the terms reflecting the possibility of the BIS proposal being triggered while the other trigger is waiting.

The issuing bank must maintain at all times all prior authorisation necessary to immediately issue the relevant number of shares specified in the instrument’s terms and conditions should the trigger event occur.

Well, sure.

The trigger event is the earlier of: (1) the decision to make a public sector injection of capital, or equivalent support, without which the firm would have become non-viable, as determined by the relevant authority; and (2) a decision that a write-off, without which the firm would become non-viable, is necessary, as determined by the relevant authority.

This is the dangerous part, as it gives unlimited authority to the regulators to wipe out a bank’s capital investors, with no accountability or recourse whatsoever.

The issuance of any new shares as a result of the trigger event must occur prior to any public sector injection of capital so that the capital provided by the public sector is not diluted.

This means that infinite dilution of the common received on conversion is possible.

The relevant jurisdiction in determining the trigger event is the jurisdiction in which the capital is being given recognition for regulatory purposes. Therefore, where an issuing bank is part of a wider banking group and if the issuing bank wishes the instrument to be included in the consolidated group’s capital in addition to its solo capital, the terms and conditions must specify an additional trigger event. This trigger event is the earlier of: (1) the decision to make a public sector injection of capital, or equivalent support, in the jurisdiction of the consolidated supervisor, without which the firm receiving the support would have become non-viable, as determined by the relevant authority in that jurisdiction; and (2) a decision that a write-off, without which the firm would become non-viable, is necessary, as determined by the relevant authority in the home jurisdiction.

Reasonable enough, but this could cause a lot of fun with rogue regulators and cross-default provisions.

Any common stock paid as compensation to the holders of the instrument can either be common stock of the issuing bank or the parent company of the consolidated group.

The major problem – besides the evasion of bankruptcy law – with this document is that there is no distinction drawn between Tier 1 and Tier 2 capital for conversion purposes. Tier 1 capital is supposed to provide going-concern loss absorption, but the only thing triggering conversion is the Armageddon scenario. I don’t think that sub-debt holders will be particularly pleased about that.

However, the terms of this proposal are so abusive, so antithetical to the interests of investors, that I suspect most instruments will be issued with a pre-emptive trigger, so that conversion will be triggered prior to the regulators (well … reasonable regulators, anyway) exercising their unlimited and unaccountable power.

Bloomberg notes:

The Association for Financial Markets in Europe, an industry group representing banks, said last week that failing financial companies should reduce the risk to taxpayers by using contingent capital and by converting debt into equity to fund their own rescue.

In what it termed a “bail-in,” AFME said bank bond holders should see their securities convert into common shares in the event an institution’s capital ratios fall below a pre-set level, the group said in a discussion paper on Aug. 12.

Update: The AFME discussion paper, The Systemic Safety Net: Pulling failing firms back from the edge is very vague and relies on assertions, rather then evidence and argument, to make its point. It might also be dismissed as intellectually dishonest, in that it takes no account of any other proposals or academic work.

Of some interest is their view on the market-based triggers I endorse:

A trigger based on market metrics or a determination of impending systemic risk (made by a regulator) would not be effective. In addition to creating marketability issues, a trigger based on share price or market capitalisation is subject to manipulation and will almost certainly foreclose a proactive capital raise because it may fail to move the firm a safe enough distance from the trigger, which in turn will generate further negative price spirals. A trigger based on a determination of systemic risk is also unattractive, partly because it could not be used in cases of idiosyncratic risk. Waiting until firm‐specific risk has spiralled into systemic risk is destabilising.

Their preference is for a trigger based on capital ratios:

A trigger based on a core capital ratio set above the minimum core tier 1 capital requirements under the re‐invigorated Basel III capital standards would meet these criteria. Firms should have the discretion to set the trigger in accordance with their own objectives to achieve the optimal balance between prudential and economic considerations. Factors the issuer might consider in setting the trigger are:

a. To receive treatment as going concern capital the trigger should activate before any breach of the firm’s minimum regulatory capital requirements, or any other circumstances giving rise to regulatory intervention.

b. The probability of breach needs to be low enough to attract a credit rating as debt and, as such, near to subordinated debt for purposes of pricing.

I have grave difficulties with their view that market prices will be manipulated, but capital levels won’t. Additionally, as an investor, I have grave reservations about tying my investment to a capital ratio definition that will almost certainly be changed in the life of the instrument.

2 Responses to “BIS Proposes CoCos: Regulatory Trigger, Infinite Dilution”

  1. […] … and that’s a scary thing. Especially when bank regulation is heading the same way. […]

  2. […] this (mainly) refers to efforts to make the loss-absorption potential of regulatory capital more explicit (although the proposals are framed in such a way that it simply represents a regulatory-political […]

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