CoCos

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See also capital adequacy and liquidity.

Contents

Overview

Contingent capital ("CoCo") bonds or capital insurance bonds are debt instruments with the special feature that they will convert mandatorily in ordinary shares or similar instruments of the relevant issuer, mostly banks, when one or more triggers are met.

Such a trigger could be for example reaching a certain threshold in the required capital ratio of the bank. In this aspect capital insurance bonds resemble more catastrophe bonds (more on cat bonds under www.HedgeFund-Lawyer.com) than convertible bonds.

However, as an emerging asset class there are still no clear market standards visible.

The main purpose of capital insurance bonds is to increase a bank's capital in times of distress.

Until then, or if the trigger is never met, capital insurance bonds are normal debt instruments which can count to a bank's core capital (provided the relevant regulator approves it).

Nevertheless, there may be times when a bank will not be obliged to pay interest and forgoe the relevant interest payment, in particular when not sufficient distributable profits have been earned.

Basel issues consultation on CoCos

Today, the Basel Committee on Banking Supervision of the Bank for International Settlements (BCBS) issued a proposed consultative document entitled “Proposal to ensure the loss absorbency of regulatory capital at the point of non-viability” which proposes that all regulatory capital instruments be able to absorb losses in the event the issuing bank reaches the point of non-viability. This is a supplemental proposal to the BCBS’s December 2009 consultative document entitled “Strengthening the resilience of the banking sector." The BCBS states that it believes this proposal will reduce the risk of moral hazard, noted by some finance officials as a key underlying cause of the financial crisis.

BCBS notes that, during the financial crisis, infusions of common equity and certain other forms of Tier 1 capital were a common tool used by governments to rescue distressed banks. This had the effect of supporting not only the depositors at those distressed banks, but also the investors in other regulatory capital instruments. Consequently, Tier 2 capital instruments, such as subordinated debt, did not absorb losses incurred by certain large internationally-active banks that would have failed had the public sector not provided support.

As a result, the BCBS believes that the contractual terms of capital instruments must allow them to be written off or converted to common shares in the event a bank is unable to support itself in the private market absent conversion. The “trigger event” for such conversion would be the earlier of

  1. the decision to make a public sector injection of capital, or equivalent support, without which the bank would have become non-viable, as determined by the relevant authority, or
  2. a decision that a write-off, without which the bank would become non-viable, is necessary, as determined by the relevant authority. The issuance of any new shares as a result of the trigger would have to occur prior to any public sector injection of capital so that such capital is not diluted.

After issuance of the December 2009 consultative document, in late July 2010, the Governors and Heads of Supervision, the oversight body of BCBS, announced it had reached a broad consensus on the overall design of the capital and liquidity reform package. Comments to the loss absorbency consultative document are requested by October 1, 2010, prior to the G20 Leaders summit in Seoul on November 11-12, 2010, at which time the final report, which will reflect the fully calibrated global capital and liquidity standards, will be delivered.

Lloyds raises £7bn in CoCos

"Lloyds Banking Group is to issue £7bn in enhanced capital notes (ECNs), a new form of hybrid debt, it announced on Monday, as the first part of its plans for a £22.5bn ($37.1bn) capital raising. The group also increased the amount it said it would raise from US investors in the hybrid debt from $800m to $986m...

...The new securities, the plans for which were first outlined last month, will operate like bonds, paying a coupon in ordinary times, but they can convert to equity if Lloyds’ financial position or capital ratio deteriorates, offering a capital buffer in the event of financial stress.

Also known as CoCos, or “contingent convertible bonds”, the securities have been the subject of controversy. Commentators have debated whether the “trigger” point at which the bonds convert to equity should be based on a bank’s regulatory capital level or its market capitalisation. As currently planned, the Lloyds’ CoCos will convert to ordinary equity if the group’s core tier 1 capital ratio falls below 5 per cent."

NY Fed issues paper on CoCos

The proposal for banks to issue contingent capital that must convert into common equity when the banks’ stock price falls below a specified threshold, or “trigger,” does not in general lead to a unique equilibrium in equity and contingent capital prices. Multiple or no equilibrium arises because both equity and contingent capital are claims on the assets of the issuing bank.

For a security to be robust to price manipulation, it must have a unique equilibrium. For a unique equilibrium to exist, mandatory conversion cannot result in any value transfers between equity holders and contingent capital investors.

The necessary condition for unique equilibrium is usually not satisfied by contingent capital with a fixed coupon rate; however, contingent capital with a floating coupon rate is shown to have a unique equilibrium if the coupon rate is set equal to the risk-free rate. This structure of contingent capital anchors its value to par throughout the time before conversion, making it implementable in practice.

Although contingent capital with a unique equilibrium is robust to price manipulation, the no-value-transfer condition may preclude it from generating the desired incentives for bank managers and demand from investors.

Fed and Wall St in talks over CoCos

"The US Federal Reserve is in talks with Wall Street executives and others over whether US financial groups should raise capital through a new type of bond that converts into equity when a bank is in trouble.

The talks over the hybrid security, which was pioneered by Lloyds Banking Group of the UK last week, are in their early stages but underline regulators’ desire to find novel ways to bolster banks’ balance sheets in times of crisis. The new securities – known as contingent convertibles, or CoCos – operate as bonds in normal times, paying coupons to investors.

However, they would automatically convert into equity when the bank’s finances deteriorate below a predetermined level – such as a capital ratio benchmark or other measures linked to the institution’s assets and market value.

Supporters of CoCos say they enable a bank to raise equity capital at times of stress while at the same time ensuring it will be the investors who risk losing money if the financial group is bailed out or wound down by the government.

“Talks have been frequent in recent weeks but we are still early in the process,” a Wall Street executive, who is participating in talks with the New York Fed, said.

“However, the Fed and other regulators seem determined to see whether CoCos will work.”

The New York Fed declined to comment. However, William Dudley, its president, said in a recent speech that a CoCo-like instrument “seems to hold real promise”. “If these contingent capital buffers were large . . . then the worst aspects of the banking crisis might have been averted,” he said.

Politicians have also shown a willingness to back CoCos. A bill introduced this week by the Senate banking committee calls for banks to issue “long-term hybrid debt securities that will provide them with capital during a systemic crisis so failing institutions can provide their own life support”.

The main question over the viability of CoCos is whether there would be sufficient investor demand. The best chance for creating a large, liquid market would be to tap corporate bond investors.

Standard & Poor’s, the credit rating agency, warned on Tuesday that contingent convertibles were “not a panacea” for banks’ efforts to bolster their capital.

“We see contingent capital securities as introducing another potential tool to manage the capital base in times of stress. However, they are not being designed by banks to address the need to repair existing weak balance sheets.”

Insiders involved in the talks and observers argue that a US iteration would not necessarily follow the Lloyds’ model and that more than one structure could be used.

“It is still an amorphous concept,” said Anna Pinedo of law firm Morrison Foerster. “The Lloyds product is only one possible instrument, but we have been working with clients on other structures that would be considered contingent capital.”

Bankers and analysts argue that structures such as CoCos could help banks worldwide to refinance some $7,000bn in debt that is due to expire in the next three years."

Debt which converts to senior, preferred, cumulative shares

Bail-Ins Versus Bail-Outs: Using Contingent Capital to Mitigate Systemic Risk, by John C. Coffee Jr., Columbia Law School; European Corporate Governance Institute (ECGI); American Academy of Arts & Sciences, was recently posted on SSRN.

Here is the abstract:

Because the quickest, simplest way for a financial institution to increase its profitability is to increase its leverage, an enduring tension will exist between regulators and systemically significant financial institutions over the issues of risk and leverage.

Many have suggested that the 2008 financial crisis was caused because financial institutions were induced to increase leverage because of flawed systems of executive compensation. Still, there is growing evidence that shareholders acquiesced in these compensation formulas to cause managers to accept higher risk and leverage. Shareholder pressure then is a factor that could induce the failure of a systemically significant financial institution.

What then can be done to prevent future such failures? The Dodd-Frank Act invests heavily in preventive control and regulatory oversight, but this paper argues that the political economy of financial regulation ensures that there will be an eventual relaxation of regulatory oversight (“the regulatory sine curve”). Moreover, the Dodd-Frank Act significantly reduces the ability of financial regulators to effect a bail-out of a distressed financial institution and largely compels them to subject such an institution to a forced receivership and liquidation under the auspices of the FDIC.

Believing that there is a superior and feasible alternative to forcing a strained, but not insolvent, financial institution into a liquidation, this paper recommends a system of “contingent capital” under which, at predefined points, a significant percentage of a major financial institution’s debt securities would convert into an equity security.

However, unlike earlier proposals for contingent capital, the conversion would be to a senior, non-convertible preferred stock with cumulative dividends and voting rights.

The intent of this provision is to create a class of voting shareholders who would be rationally risk averse and would resist common shareholder pressure for increased leverage and risk-taking, but who would obtain voting rights only at the late stage when the financial institution enters the “vicinity of insolvency.”

This paper discusses:

  1. the possible design of such a security,
  2. the recent experience in Europe with issuances of similar securities,
  3. tax and other obstacles,
  4. the possibility of international convergence on a system of contingent capital, and
  5. the existing authority of the Federal Reserve Board to implement such a requirement.

It submits that contingent capital is an idea whose time is coming, but whose optimal design remains debatable.

References

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