Lloyds Banks has announced:
Lloyds Banking Group (Lloyds) notes recent media speculation regarding its proposed potential participation in the Government Asset Protection Scheme (GAPS). Lloyds is in advanced discussions with HM Treasury, UK Financial Investments and the Financial Services Authority regarding alternatives to participation in GAPS.
Lloyds believes that any alternative proposals to GAPS would be likely to include a substantial capital raising of core tier 1 and contingent core tier 1 capital to increase the Group’s capital ratios to an appropriate level of strength and flexibility, and would provide a strong capital base for the future stability and success of the Group. The alternative proposals would also meet the FSA’s requirements for stressed economic conditions.
Capital raising options currently under consideration include a combination of raising immediately available core tier 1 capital by way of a rights issue and generating contingent core tier 1 and/or core tier 1 capital through the exchange of certain existing Group capital securities.
Media speculation, indeed! Wealth Bulletin reports (note that the WSJ credits Duncan Kerr of Financial News for this interview):
Owen Murfin, global fixed-income manager at BlackRock in London, said that Lloyds’ plan to generate contingent capital through an exchange would only work at “attractive levels” but that if the transaction does go well, “it will probably form the template of the future of hybrid bank capital, or certainly the shape of capital going forward”.
Murfin added that for investors to get fully behind it, some key issues needed to be addressed, such as what will be used as the triggers, and who or what will decide when these measures have been breached.
He said: “Core tier-one is probably going to be the most likely trigger used. The existing regulatory minimum is around 4%, so the level would probably have to be above that and somewhere around 5%. Core tier-one capital would then be replenished at a far higher level as a result of the conversion.
Reuters also suggests a Tier 1 Ratio Trigger, but with no attribution:
The conversion trigger needs to be set low enough that it is unlikely to be reached, but high enough that it provides help before a bank hits crisis point. That could see it triggered when the Core Tier 1 equity falls below 5 or 6 percent, depending on new industry standards under discussion.
FT Alphaville quotes JPM analysts Carla Antunes da Silva and Amit Goel musing that:
What are the challenges? Several uncertainties surround these instruments including (i) setting appropriate trigger points; (ii) pricing the instruments such that they are attractive to both investors and the issuing institutions; and (iii) market treatment in terms of share count/equity.
I have real problems with using Tier 1 Capital Ratios as a trigger for conversion. Accrued Interest points out:
Look at Lehman. They had a Tier 1 ratio of 11 just weeks before they were bankrupt. Their problem was part their funding mix which was very reliant on repo and prime brokerage, and part the fact that the market didn’t believe their valuations on some illiquid assets. Maybe had either of those circumstances been different, i.e, the same leverage and assets but a more stable funding mix, they would have survived. Regardless, a regulator scheme based on leverage ratios never would have caught Lehman before it was too late. Nominally, they had plenty of capital.
…
This is why the idea of contingent capital makes so much sense to me. A bank has a ready set of equity investors whenever its needed. It instills market discipline, as the current stock price would reflect the potential for dilution, but the falling stock price wouldn’t prevent a capital raise. In effect, this is a little like a standard bankruptcy, where bond holders take control of a company, except that instead of the company actually going through such a disruptive process, ownership just transfers (in part) to the contingent capital bondholders automatically.
More generally than the anecdotal Lehman example, the IMF looked at various bail-out predictors in Chapter 3 of the April 09 GFSR:
The results in Table 3.1 show the following:
- • Capital adequacy ratios were unable to clearly identify institutions requiring intervention. In fact, contrary to the common belief that low capital adequacy ratios would signal weakness for a FI, all four capital adequacy ratios examined for intervened commercial banks were significantly higher than (or similar to) the nonintervened commercial banks as a whole (Figure 3.1). There are, of course, regional differences among nonintervened commercial banks. During 2005:Q1–2007:Q2, the capital-to-assets ratio for nonintervened commercial banks in Asia and the euro area were higher than for intervened commercial banks. However this was not the case for FIs in the noneuro area. This suggests that regional differences can make direct comparisons problematic.
- • Several basic indicators of leverage appear to be informative in identifying the differences in the institutions, although the reasons for this deserve further examination. The higher ratios of debt to common equity, and short term debt to total debt in the intervened commercial banks and intervened investment banks, all indicate that these measures of leverage are especially informative about the differences (Figure 3.2).
- • Traditional liquidity ratios are not very indicative of the differences between intervened and nonintervened institutions. In part, this is because these liquidity ratios may not be able to fully measure wholesale funding risks.
- • Asset quality indicators show a mixed picture. Similar to the capital adequacy ratios, the ratio of nonperforming loans (NPL) to total loans for the intervened commercial banks has been lower than for the nonintervened commercial banks, indicating that NPL ratios are not very reliable indicators of the deterioration in asset quality. However, the lower provisions for the loan-losses-to-total-loans ratio for the nonintervened commercial banks suggests that this is a better indicator
than the NPL ratio.- • The standard measures of earnings and profits show a mixed picture. While return on assets (ROA) for the intervened institutions are much higher than those in the nonintervened commercial banks, suggesting that elevated risks are associated with higher returns, return on equity (ROE) has not captured any major differences between the FIs that were intervened or not (Figure 3.3). This contrast between the effectiveness in ROA and ROE may reflect the high leverage ratio of intervened FIs, which typically rely on higher levels of debt to produce profits.
- • Stock market indicators are able to capture some differences. The price-to-earnings ratios, earning per share, and book value per share of the intervened investment banks have been generally higher than those in the nonintervened commercial banks, which suggest that the higher equity prices and earnings do not necessarily reflect healthier institutions, but perhaps concomitant higher risks.
I confess that I don’t understand the last point very well. Book value per share? Earnings per share? Surely these simply reflect the number of shares issued against the size of the bank. If they discussed Price-to-Book ratios, that would be one thing, but they don’t. They do, however, include Price/Earnings ratio in the various tests and find it does not discriminate between bailed-out and non-bailed-out banks.
My objection to using Capital Ratios as a trigger point is simply that they haven’t worked very well in this crisis: all the failed banks met the capital tests before being bailed out. This does not mean that I disdain Capital Ratios. On the contrary, I think they’re the single most valuable metric for quantifying the strength of a bank. “Single most”, however, has a different meaning from “Only required”. It is now accepted that a blunt leverage ratio – in Canada, the Assets to Capital multiple – is a very useful additional tool; I will not be at all surprised to see a metric based on liquidity introduced at some point.
Why do bank runs happen? Confidence. During the crisis, nobody trusted capital ratios because they are dependent upon the degree to which markdowns on bad assets had been taken; if you did not trust the accounting, you did not trust the capital ratio and – critically – you sold the stock.
I continue to believe that the most appropriate trigger is simply the common stock’s trading price. As I stated in my commentary on the HM Treasury response to the Turner Report, this has the advantage of being known in advance; no judgement by the regulatory authorities is required and therefore, in a crisis, there won’t be the chance of the market attempting to second-guess just what the authorities’ decision really means. The advantage of known conversion triggers will also allow a certain amount of arbitrage, which will boost liquidity for these instruments at a time when we may assume that such liquidity will be sorely needed.
For instance, to take my basic idea of a new issue of contingent-equity preferreds, issued at $25 at a time when the common is trading (for convenience in referring to the exchange ratio) at $50. The preferred converts to common on a one-to-one basis if the monthly (quarterly?) volume-weighted-average-price of the common dips below $25; that being the exchange price, set to one-half of the common’s price at the time when the preferred was issued.
Should bad times come and the common starts trading in the high twenties, it may well be imagined that puts on the common with a $25 strike will become very popular, going some way towards transferring the income from the prefs into the hands of speculators who don’t mind taking a chance. The preferreds will trade more and more like equity, in a smooth and transparent manner, as the equity price declines. Isn’t this exactly what the doctor ordered?
It should also be noted that the bank bailouts resulted in Tier 1 Capital NEVER falling below regulatory minima, although I have no figures on how close it got. This was a deliberate feature of the plan – the fiscal authorities didn’t want the banks to get shut down. However, this raises the spectre of the potential for a bank to be bailed out before the conversion trigger is reached, which would be a Bad Thing. Conversion is much more likely to be triggered by a decline in the price of the common.
We’ll see how it all turns out. But I think that Tier 1 Ratio triggers are simply a Bad Idea for contingent capital.
I will note that Bernanke mentioned contingent capital in passing near the end of his testimony to the House Committee on Financial Services, 2009-10-1:
In addition, we are working with our fellow regulatory agencies toward the development of capital standards and other supervisory tools that would be calibrated to the systemic importance of the firm. Options under consideration in this area include requiring systemically important institutions to hold aggregate levels of capital above current regulatory norms or to maintain a greater share of capital in the form of common equity or instruments with similar loss-absorbing attributes, such as “contingent” capital that converts to common equity when necessary to mitigate systemic risk.
Contingent Capital has been discussed often on PrefBlog of late:
OFSI Joins Contingent Capital Bandwagon
Tarullo Confronts ‘Too Big To Fail’
