Paul Tucker, Deputy Governor, Financial Stability at the Bank of England, has delivered a speech to the SUERF, CEPS & Belgian Financial Forum Conference: Crisis Management at the Cross‐Road, Brussels containing a rather surprising rationale for investment in Contingent Capital:
Almost no amount of capital is enough if things are bad enough. Which is why contingent capital might potentially be an important element in banks’ recovery plans, as the Governor set out recently in Edinburgh.
This would not be the kind of hybrid capital that mushroomed in the decade or so leading up to the crisis. The familiar types of subordinated debt can absorb losses only if a bank is put into liquidation, and so really has no place in regulatory capital requirements as we cannot rely on liquidation as the only resolution tool. It has been a faultline in the design of the financial system as a whole that banks issued securities that counted as capital for regulatory purposes, and on which they could therefore leverage up, but with institutional investors treating them as very low risk investments backing household pension and annuity savings.
By contrast, contingent capital would be debt that converted into common, loss-absorbing equity if a bank hit turbulence. It is, in effect, a form of catastrophe insurance provided by the private sector.
Why should long-term savings institutions and asset managers be prepared to provide such insurance? One possible reason is that if enough of them were to do so for enough banks, it might well help to protect the value of their investment portfolios more generally. If ever it needed to be demonstrated,the current crisis has surely put it beyond doubt – not only for our generation but for the next one too – that serious distress in the banking system deepens an economic downturn and so impairs pretty well all asset values. By taking a hit in one part of their portfolio by providing equity protection to banks, institutions might well be able to support the value of their investments more widely. And the trigger for conversion from debt into equity could be at a margin of comfort away from true catastrophe; say, a percentage point or so above the minimum regulatory capital ratio.
Of course, this would entail a structural shift over time in investment portfolios. But the system might be able to manage that adjustment. After all, it managed the all together less desirable adjustment to the development of the existing hybrid capital markets. But demand for contingent capital is, inevitably, uncertain at this stage. As are the terms on which it will be provided. We welcome the growing private sector focus on this.
That has to be the craziest rationale I’ve seen yet for investment.
Contingent Capital will succeed only if it designed so that its risk/reward profile makes it sufficently attractive that investors include it in their portfolio in order to make money – some investors, some of the time, for some purposes.
To suggest that it be held in order to make the bond allocation of the portfolio be more bond-like – which is what I think he’s saying – is ludicrous.
Assiduous Readers will by now be sick of hearing this, but I thoroughly dislike the idea of making the trigger dependent upon regulatory capital ratios; this makes the investor – and, to some extent, the bank – hostage to future unknown changes in regulation. It may also make the regulator hostage to the market, if they want to make a change but have to consider the effect on triggering conversion. Making the trigger dependent upon the price of the common – if the common declines by 50% from its price on the contingent capital’s issue date, for instance – will provide a market-based conversion trigger that can be hedged or synthesized on the options market in a familiar and reproducible manner.