David Longworth, Deputy Governor of the Bank of Canada, delivered a speech to the C D Howe Institute, Toronto, 17 February 2010, titled Bank of Canada liquidity facilities – past, present, and future. It’s a good review of the actions taken by the BoC during the credit crunch to address liquidity problems, albeit lamentably short of meat.
For instance, he emphasizes the importance of penalty rates in avoiding moral hazard:
Fifth, and finally, the Bank should mitigate the moral hazard of its intervention. Such measures include limited, selective intervention; the promotion of the sound supervision of liquidity-risk management; and the use of penalty rates as appropriate.
but nowhere attempts to quantify the penalties that were actually applied.
One of the things that scares me about the regulatory response to the crisis is the central counterparty worship. Mr. Longworth lauds the BoC’s role in:
Encouraging and overseeing the implementation of liquidity-generating infrastructure, such as a central counterparty for repo trades, that help market participants self-insure against idiosyncratic shocks
Central counterparties reduce the role of market discipline in the interbank marketplace by offering a third party guarantee of repayment; I can therefore lend a billion to Dundee Bank with the same confidence that I lend to BNS. Additionally, they soak up bank capital; the counterparty has to be capitalized somehow and it may be taken as a given that the total bank capital devoted to the maintenance of the central counterparty will be greater than the bank capital devoted to the maintenance of a distributed system. Finally, while I agree that a central counterparty will decrease the incidence of systemic collapse, I assert that it will increase the severity; I claim that basic engineering good practice will seek to reduce the incidence of catastrophic single point failure, not increase it!
He also addressed the headline issue, noting the potential for:
Requiring the use of contingent capital or convertible capital instruments, perhaps in the form of a specific type of subordinated debt, to help ensure loss absorbency and thus reduce the likelihood of failure of a systemically important institution.
Footnote: The BCBS press release of 11 January 2010 entitled, “Group of Central Bank Governors and Heads of Supervision reinforces Basel Committee reform package,” announces that the “Basel Committee is reviewing the role that contingent capital and convertible capital instruments could play in the regulatory capital framework.” See also “Considerations along the Path to Financial Regulatory Reform,” remarks by Superintendent Julie Dickson, Office of the Superintendent of Financial Institutions, 28 October 2009
I have added a link in the above to the PrefBlog review of the Dickson speech; I will attend to the BIS press release shortly.
Most of the commentary I’ve seen discusses contingent capital solely as the concept applies to subordinated debt; I will assert that logically, if the subordinated debt is liable to become common equity, then more junior elements of capital such as preferred shares must also have this attribute.
Following the logic that “more junior elements of capital such as preferred shares must also have [the attribution of potential conversion into common equity]”…
In practical terms this is what happened with BofA and Citibank a year ago, without a formal “attribute” that this could happen if needed.
My question is: do you think this pref convertibility will automatically be assumed by existing outstanding prefs or do you think it will be limited to new issues sold with prospectuses clearly stating the risk and outlining the triggers?
One could imagine that if the terms of conversion are “goofy” like the UK CoCo for (Lloyds?; i.e. conversion is forced at the stock price when the issue was launched) then new pref issues would be required, if for no other reason than to set the stock price. If not, I would think outstanding bank prefs would drop quite a bit on the change of rules (a risk for us?).
do you think this pref convertibility will automatically be assumed by existing outstanding prefs
No.
do you think it will be limited to new issues sold with prospectuses clearly stating the risk and outlining the triggers?
Yes.
Holders of current preferreds have various rights – such as preferential dividends at a known rate – which are part of the legal structure of the corporation and can only be changed with their consent. This consent can be obtained by the company on a coercive basis (such as with Citibank) only if the company can make a credible threat of a worse alternative. Citi could make a credible theat to suspend preferred dividends, since under the revised statement of preferred shareholder rights, this would not involve the eternal suspension of common dividends. Preferred holders were expected to (and did) vote in favour of this abnegation of rights since they were required to in order to participate in the contemporary exchange offer, which gave them common shares in exchange for preferreds at a ratio that was considerably better than market.
Royal Bank, to name just one, cannot make such a credible threat. If they tried, preferred shareholders would tell them to stick it, preferred dividends would be suspended, common dividends would be suspended in accordance with the rights of the rebellious preferred shareholders, and the board of directors would be replaced as soon as the common shareholders had a chance to vote.
Phew! Thank goodness for us!
What a great explanation.
I should have added (looking on the plus side instead of the downside):
Do you think this situation would trigger some earlier than expected redemptions so the convertible prefs could be sold?
I recognize they would have to pay higher dividends on a CoCo, so it might not make economic sense, but maybe the rules would require some CoCo issues?
Do you think this situation would trigger some earlier than expected redemptions so the convertible prefs could be sold?…maybe the rules would require some CoCo issues?
Well, when you ask for forecasts at this level of detail, you’re really giving my crystal ball a workout!
Canada already has very high levels of Tangible Common Equity, so even if the new rules require most world banks to boost levels of common or contingent equity, I suspect that the Big 6 would not be directly affected.
In the past, extant issues have been grandfathered – this happened with the Operating Retractible issues, for instance. My guess is that extant issues would remain as Tier 1 (and, perhaps, get more valuable as time increased their scarcity value!).