UK FSA Proposes New Bank Capital Standards

The UK Financial Services Authority has announced release of a discussion paper, Strengthening Bank Capital Standards 3. Contingent Capital is now official (and stupid):

The CRD amendments impose a new limit structure on hybrid capital. These instruments will now be restricted to three buckets (15%, 35% and 50%) of total tier one capital after deductions. Hybrid capital instruments will be allocated to these buckets based on their characteristics.

The 50% bucket is limited to convertible instruments that convert either in emergency situations or at our initiative at any time based on our assessment of the financial and solvency situation of the firm. We also consider that issuers should have the ability to convert at any time, as elaborated by CEBS in CP27.

Instruments with a conversion feature in the 50% bucket would be converted into a fixed number of instruments, as determined at the date of issue. This predetermination would be based on the market value of the instruments at the issue date. The mechanism, as reflected in CEBS’s guidance, may reduce this predetermined number if the share price increases, but could not increase it if the share price falls.

In other words, Contingent Capital in the 50% bucket has no first-loss protection at all. I suppose that one might justify these instruments in terms of writing an option straddle (short call, short put) but how on earth will a bank be able to issue these so that they make sense for a wide range of investors?

The lower two buckets make more sense, dependent upon implementation:

Hybrids with going concern loss absorbency features (e.g. write-down or conversion) can be included up to 35% of tier one provided that they do not have an incentive to redeem.

Hybrids that have going concern loss absorbency features (e.g. write-down), but with a moderate incentive to redeem, such as a ‘step-up’ or principal stock settlement, can be included within the 15% bucket. Hybrid instruments issued via SPVs are also limited to this bucket.

However, the first-loss protection under the new regime is severely restricted:

Incentives to redeem: CEBS clarified the interpretation of a moderate incentive to redeem in its recently published guidance. We are proposing the following changes to our Handbook to reflect these clarifications:

  • • no more than one step-up will be allowed during the life of a hybrid instrument;
  • • the conversion ratio within a principal stock settlement mechanism will be restricted to 150% of the conversion ratio at the time of issue; and
  • • instruments that include an incentive to redeem at the time of issue (e.g. a synthetic maturity) will remain within the 15% hybrid bucket allocated for such instruments even if such features remain unused.

They explain:

We consider that conversion should not be unlimited for the other buckets, because this would involve no burden sharing by the hybrid holders. So, a determination at the issue date of a maximum number of shares to be delivered that would be no more than 150% of the market value of the hybrid, based on the share price at the issue date, would be acceptable. This would limit dilution. Shares must be available to be issued, so sufficient extra shares must already have been authorised.

As far as the trigger goes, they’re obsessed with discretion:

For all hybrids, the trigger for the the write-down or conversion mechanism should, at the latest, be where a significant deterioration in the firms’ financial or solvency situation is reasonably foreseeable or on a breach of capital requirements. For the 50% hybrid bucket the trigger would be an emergency situation or the regulator’s discretion.

Q3: Trigger for activation of loss absorbency mechanism
– Do you agree that in order for the mechanism to be effective in supporting the firm’s core capital in times of stress that the trigger needs to be activated at the discretion of the firm?

I think discretion – whether on the part of the firm or of the regulator – is the last thing wanted in times of stress. In such times, investors want as little uncertainty as possible and the exercise of entirely reasonable discretion in a manner not guessed beforehand by the market can have severe consequences, as Deutsche Bank found out, as discussed on December 19, 2008.

The only trigger that makes any kind of sense to me is a decline in the price of the common. Everything else is too uncertain and too susceptible to manipulation.

Interestingly, the FSA estimates the incremental coupon on Innovative Tier 1 Capital:

The new innovative instruments will need to offer a higher return to investors to compensate for the increased risk inherent in the new instrument. It is impossible to quantify the precise increase in cost to firms of servicing such instruments. Consistent with the previous analysis, we have estimated an upper-bound for the differential in coupons between the legacy innovative instruments and the new innovative instruments of 4.7%.

3 Responses to “UK FSA Proposes New Bank Capital Standards”

  1. prefhound says:

    Aside from the ridiculous trigger mechanisms, this almost seems like a whole new hybrid designed for non-taxable investors.

    Is a 4.7% spread enough for pension plans and soverign wealth funds to replace bank equity with these instruments? The duration would be lowish and cash flows stronger than common dividends (though without uncertain growth potential).

    If this turns out to be the case, bank equity could fall in price — adding to the attractiveness of these hybrids though lower Price/Book for common equity they would get on forced conversion.

  2. […] has been discussed on PrefBlog (as recently as last week), Flannery’s proposal makes most sense to me. The Capital Insurance proposal has been used in […]

  3. […] at book value. The Rabobank issue works like straight insurance, with no actual conversion. The UK FSA proposes issues where the conversion price is pre-set. The Lloyds issue converts at the market price at time of […]

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