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Faculty of Economics and Business
Do CoCo’s do what they are supposed to?
By: Fabian van den Berg
10547525
Master Thesis
Supervisor: Prof. Dr. S.J.G. van Wijnbergen
Second Reader: Dr. W.E. Romp
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Table of Contents
1. List of tables ...3 2. List of figures ...3 3. List of acronyms ...3 4. Introduction ...4 5. CoCo Theory ...55.1 Why CoCo’s instead of equity? ...6
5.1.1 What are the advantages of having CoCo’s? ...6
2.1.2 What are the disadvantages of having CoCo’s? ...7
5.2 Contingent capital proposals proposals ...8
5.2.1 Flannery (2003) ...9
5.2.2 Squam Lake Group (2010) ...11
5.2.3 Flannery (2009) ...14
5.2.4 McDonalds (2013) ...16
5.2.5 Pennacchi et al. (2013) ...19
5.2.6 Calomiris and Herring (2011) ...21
6. CoCo Practice ...23
6.1: Triggers ...24
6.1.1 Non-viability trigger ...25
6.1.2 Book ratio trigger ...29
6.1.3 Mandatory Scheduled Conversion ...33
6.1.4 Voluntary conversion ...34
6.1.5 Capital reduction trigger ...35
6.1.6 Insolvency Event ...35
6.1.7 Basel III non-compliance event ...36
6.1.7 Take over event ...37
6.2 After hitting the trigger ...38
6.2.1 Contingent Convertible ...38
6.2.2 Principal write down ...40
7. Freaky CoCo’s ...41
7.1 Unclear CoCo...41
7.2 Write downs ...41
7.3 Insurance Company CoCo ...42
8. Discussion ...44
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10. Bibliography ...47
11. Appendix ...55
11.1 Non-viability trigger and other regulatory triggers ...55
11.2Book ratio trigger ...62
11.3 Mandatory Scheduled Conversion ...75
11.4Voluntary Conversion ...77
11.5Capital reduction trigger ...79
11.6 Insolvency event ...80
11.7 Basel III non-compliance event ...82
11.8 Takeover event ...83
1. List of tables
Table 1 ... 10 Table 2 ... 12 Table 3 ... 15 Table 4 ... 18 Table 5 ... 20 Table 6 ... 22 Table 7 ... 402. List of figures
Figure 1 ... 24 Figure 2 ... 27 Figure 3 ... 38 Figure 4 ... 463. List of acronyms
AT1 Additional Tier 1
BRRD Bank resolution and recovery directive CCC Contingent capital certificates
CET1 Common equity Tier 1
CoCo Refers to both contingent capital and write down bonds. COERC Call option reversed enhanced reverse convertible CRD Capital requirements directive
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FDIC Federal Deposit Insurance Corporation GAAP General accepted accounting principals MVC Market value of capital
QMVER Quasi market value of equity ratio RCD Reverse convertible debentures
RRD Resolution and recovery directive. It is the same as BRRD. RWA Risk weighted assets
TBTF Too big to fail
VWAP Value weighted average price
4. Introduction
The banks think that a CoCo is the best financial innovation that has happened since the crisis. It would promote stability and can rescue a bank from becoming insolvent. Is this true? Or is it just another way of bankers trying to get around the new higher capital requirements? I will try to address these questions by doing an extensive research in the CoCo field. So far there has not been much research on what kind of CoCo’s have been issued. However, many proposals have been written for this type of bond. One of the first proposals is written by Flannery in 2003. The whole discussion on CoCo’s did not seem relevant until the crisis of 2007. In order to improve the financial system the Squam Lake group came up with several solutions, one of them was dedicated to CoCo’s. Several more proposals were written after the Squam Lake group that I will discuss in chapter 5. In the aftermath of the crisis, many institutions agreed that governments should not bail-out banks, when banks approached bankruptcy. Instead the capital base should be strengthened by issuing more equity and adding Additional Tier 1 (AT1) securities. These AT1 securities must have a write down function or a conversion into common shares at a
pre-specified trigger point. This form of security can be counted as Tier 1, and is therefore an incentive for banks to meet certain minimum requirements. CoCo’s can be AT1, Tier 2 or not counted as any Tier depending on its properties. In this thesis I will look at what kind of contingent convertibles or write downs have been issued by banks since 2005. Contingent convertible or write down is defined as any bond or share that is being written-down or
substituted for shares in order to absorb losses and/or maintain a solvency. With CoCo I refer to contingent convertibles and/or write downs.
My main question is, will CoCo’s promote stability in the financial system? I will try explaining this by comparing the different triggers as well as on what happens after a trigger has
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been hit. A trigger is defined as anything or anyone that could initiate a write down or a conversion. Conversion is defined as the conversion of a bond into shares to strengthen the capital base. Write down is defined as a reduction in the principal amount of the bond.
In chapter 5 I will discuss why banks could issue contingent convertibles or write downs instead of equity. Then I will explain and compare several proposals for this type of security. When comparing these different proposals I will use six steps to make comparison easier.These proposals differ greatly from what has been issued and are therefore very interesting to look in to. The sixth chapter will consist of an extensive review of 83 issued contingent convertibles or write downs. First I will look into what kind of triggers companies have included in their issues. Secondly, I investigate the different events that follow once a trigger is breached. In chapter seven I will briefly discuss contingent capital bonds or write downs that have peculiar triggers and/or loss absorption mechanisms.Chapter eight will contain a discussion where I compare the CoCo theory and practice. In this chapter I will also point out a few remarkable facts. The final chapter will consist of concluding remarks.
5. CoCo Theory
After the economic crisis there was common consensus that many changes had to be made with respect to the banking system, especially with respect towards the losses that were absorbed by government funds. According to Flannery (2009) the losses incurred by banks should not be shifted towards the taxpayer, or at least minimize the losses for the taxpayer. An answer to this problem could be the issue of contingent capital or write downs. There are different views on what CoCo’s are designed to do. According to Flannery (2009) contingent capital or write downs have the potential to prevent a bank from becoming illiquid or insolvent (Flannery 2009). Pitt et al. (2011) distinguish between going-concern and gone-concern contingent capital. Going-concern is referred to as a contingent capital or write down that will be triggered well before a central bank or a government must support a troubled bank. Gone-concern contingent capital is defined as a security that is triggered once the troubled bank is insolvent. According to Pitt et al. (2010) CoCo’s should be seen as a bail-in bond. This would mean that these bonds are actually subordinated to equity holders (Pitt et al, 2010).
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5.1 Why CoCo’s instead of equity?
5.1.1 What are the advantages of having CoCo’s?
According to Maes and Schoutens (2012) there are various advantages to CoCo’s. The first advantage from the bank’s perspective is that contingent capital allows for leverage in good times serves as a buffer during bad times. The securities also have the option to defer or cancel debt interest payments.
The second advantage is that CoCo’s would be more cost efficient to instead of equity. The market sometimes demands a higher capital ratio than what is required by the regulator. It would be more cheaply, due to tax deductibility, to issue credible CoCo’s.
The third advantage from the supervisor’s point of view is that securities induce the bank to prevent the loss absorption event from happening.This is only true if the loss absorbing security is a convertible. If the management also holds shares of its own company, the threat of a losing a bigger share in the company induces conservative and prudent investment and risk management. Shareholders would rather invest in new shares than losing their share of capital. Moral hazard will be controlled if the threat is large enough and the bank is not near insolvency.
The fourth advantage is that banks have a hard time raising new equity in bad economic times. Regulators have adopted the idea of pre-arranged recapitalizations and thus gave the green light for more so-called contingent capital. This form of capital should be triggered to prevent the bank from not meeting its financial obligations. As self-insurance increases, less taxpayer money will be required to be injected into banks (Maes and Schoutens, 2012). However, a
recapitalization is not preferred by the bank management as well as the shareholders. Due to the debt overhang problem from Myers (1977, 1984), a bank recapitalization would typically increase the buffer for further loss absorption, and would benefit the senior liability holders of a bank. This is true if the bank has a substantial amount of weak assets and a high debt to equity ratio. The high amount of debt indicates a high probability of default. In this case a capital injection would only increase the claims of the debt holders. Private investors are only willing to invest if their investment is not only a direct subsidy to the debt holders.
According to Maes and Schoutens (2012) a pre-arranged recapitalization is useful because another problem arises if the market value of equity is near zero or even negative. New capital suppliers will see their investment, full or partial, leaking away to the debt holders. This will also prevent these new investors from injecting capital when it is most needed. The banks
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will then fail to meet the minimum requirements and the state will need to act (Maes and Schoutens, 2012).
In addition to the previous, the lemon problem of Akerlof (1970) also holds here. The newly offered shares could be seen as lemons, and the investors may only offer a very low price for these shares and may even back out completely (Akerlof, 1970).
The last advantage according to Hart and Zingales (2011) could be the timely
replacement of incompetent managers. New management could lead to a restructuring of the business model of a bank, or to a restructuring of the balance sheet. This can only happen if the trigger is high enough to provide the bank with enough time (Hart and Zingales, 2011).
5.1.2 What are the disadvantages of having CoCo’s?
According to Maes and Schoutens (2012) there are several disadvantages. The first disadvantage to contingent capital or write downs is that they increase systemic risk. This sounds somewhat paradoxical, because that is what they were intended to reduce. If these contingent capital or write downs are held by insurance companies, this will increase the risk of contagion from the banking sector to the insurance sector.
A second disadvantage is that once the market based ratio is near the trigger ratio a form of moral hazard could arise, the bank could be better off if it could reduce a great amount of debt. This leads to more excessive risk taking instead of reducing it. It is at the cost of the contingent capital or write downs holder and perhaps the taxpayer, provided that the dilution threat is not meaningful.
A third disadvantage is a conversion of debt into equity leads to a dilution of the incumbent shareholders. This depends on the conversion price as well as the negative market perception towards the bank. Such a conversion may also have a negative effect on the solvency and liquidity perspectives of the investors (Maes and Schoutens, 2012). According to Myers and Majluf (1984) issuing new equity is seen as a bad signal on the quality of the bank’s assets (Myers and Majluf, 1984). This could also go for a conversion, and investors might lose faith in the bank and might be reluctant to invest in an insolvent bank. This would create illiquidity.
According to Maes and Schoutens (2012) the fifth disadvantage is related to the parent-subsidiary relationship from a bank's perspective. If the contingent capital is solely triggered when the parent company is in trouble, the smaller subsidiaries may not be supported when needed most. On the other hand, if the contingent capital is solely triggered if the subsidiary is in
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financial trouble, this may have an unjustified negative effect on the perception of the investors towards the parent company that is not even near insolvency.
The sixth disadvantage is that contingent capital or write downs do not provide the bank with liquidity during a crisis. Liquidity is needed during a time of financial distress, thus these securities will not prevent the bank from going bankrupt. The solvency versus liquidity
discussion is not part of this paper, but it should be noted that contingent capital does not bring in new money.
What should be taken into consideration is the fact that not all banks are listed on a stock exchange. Therefore it could be more difficult to design the contingent capital or write downs appropriately for the unlisted ones. It should also be pointed out that if the government steps in before a contingent capital or write down is triggered, it does not shift the risk from the taxpayer towards the investor (Maes and Schoutens, 2012).
The last disadvantage according to Hart and Zingales (2011) is that contingent capital or write down will only delay the default and does not address the problem of inefficient managers. If a bank has made a lot of bad investments and is therefore experiencing big losses, the
inefficient managers should be fired. Debt in fact puts a limit to the amount of resources a manager can waste, and by eliminating the event of a default; contingent capital or write downs will increase the inefficiency of the banking system as a whole without eliminating systemic crises. (Hart and Zingales, 2011)
5.2 Contingent Capital proposals
This section is devoted to a few important proposals. As one can see the dates after the author’s names are not sequentially. This is because some of the proposals were publicised later than they were written. The proposals are correctly ordered and are more detailed as we move in time. One thing to note here is that in the literature there are no proposals for write down securities.
I will discuss every proposal in six steps. Firstly, I will start off with the goal of the proposal. This differs for every proposal and should be taken into account when discussing its usefulness. Secondly, I will discuss the trigger design. Thirdly, the features that would certainly influence the outcome of a CoCo will be shown. Fourthly, I will provide a simple example that shows what happens to the balance sheet, to get a feel for the academic CoCo proposal. Fifthly, the authors always have some notes with respect to their own proposal and will be discussed here. Finally, I discuss the proposal in its entirety to see if it is implementable.
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5.2.1 Flannery (2003)
Flannery (2003) is one of the first that introduced a framework for contingent capital. He refers to it as Reverse Convertible Debentures (RCD). In his proposal he only considers conversion to equity securities. This is because the important part is that the RCD restore the debt to equity ratio. The bonds are used to absorb small losses and will have to be replenished timely. The reason for his proposal is that market discipline fails as governments are reluctant to let too big to fail (TBTF) banks go bankrupt. RCD should discipline the market instead of using regulatory measures.
Trigger
The trigger is a market based trigger. Equity as well as asset value is calculated using an
appropriate average of market based prices. It is not further specified what kind of average would seem appropriate. This trigger should be a pre-specified trigger for instance 8% in case of an equity divided by assets ratio. It is not further specified at whose discretion the pre-specified trigger is set. If this trigger is breached the RCD will be automatically converted at the current market price for shares, just enough to restore the required trigger ratio. The current market price for shares should also be an appropriate average as it could induce price manipulation
Assumptions
It is assumed that the market for RCD is very liquid and the RCD value that is lost should be immediately replenished. The expectation is that shareholders will buy the newly converted shares from the bondholders, and the bondholders will buy new RCD with the value they get for their shares. This way the investors lose no principal amount on their investment, and the bank can continue operating. The reason for rebuying the RCD is that it is assumed that the old RCD is exactly as safe the new RCD. Flannery also assumes that shares can be sold continuously, and indirectly assumes the bank will not be in a bad state in which no investors wants to buy any of the banks shares.
Features
The way at which RCD for all banks should be absorbed is not on pro rata basis nor randomly selected. He argues that the oldest RCD should be absorbed first. By doing this it would be easier for the issuer to issue new RCD. On the other hand if the market for RCD is very liquid, the investors holding the old debt would like to sell them.
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The maturity of RCD should be linked with the next conversion date. The maturity should be at least later than the next conversion date, it is suspected that a conversion could happen next month and an appropriate maturity would be 1 to 2 years. It would be less costly to maintain an RCD portfolio if the maturity is longer, but for the RCD market to be liquid, it will need shorter maturities.
Example Table 1
Flannery (2003)
T=0 T=0.5 T=1
Assets Liabilities Assets Liabilities Assets Liabilities
$100 $92 Deposits $97 $92 Deposits $97 $92 Deposits
$4 RCD $4 RCD $0.15 RCD
$4 Equity $1 Equity $4.85 Equity
Ratio: 4% Ratio: 1,03% Ratio: 5%
Source: Flannery (2003)
The bank starts off at T=0 and an equity to assets ratio of 8%. Flannery finds this a decent ratio but does not focus too much on the exact number. What happens is that the bank’s assets drop to $97 and the equity drops by three as well to $5 at T=0.5 causing the ratio to drop to 5.15%. This is below the required eight percent. At T=1 a part of the RCD will convert into equity to restore the ratio to eight per cent. The conversion thus causes a reshuffling of the junior claimants. Notes
Flannery (2003) points out that his proposal only considers large banks, supervisors are reluctant to act appropriately and the GAAP book values that could be used as a trigger values are usually overstated and not updated frequently. The GAAP values therefore also make it more difficult for supervisors to act timely. The market signal of a conversion is considered positive as it short circuits the bad events to feed upon themselves (Flannery 2003).
Discussion
Flannery assumes that the market signal caused by conversion is positively interpreted by the investors. The bank is now in a more stable condition. This is a bold assumption, and makes it easy to stop another drop in the equity to asset ratio. In reality this market signal will most likely be negative. Flannery’s proposal to convert just enough of the RCD into equity might in reality end up in several conversions instead of one appropriate and credible conversion to restore confidence in the bank.
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Flannery assumes that the market for RCDs is a very liquid. In reality it is hard to issue more of these bonds quickly. There is a lot of administrative work required and the bank needs
permissions to issue more bonds. All of this takes time. The proposal also prefers tranches that will be absorbed first rather than pro rata (example longest outstanding first). In his proposal there is no foundation for why this would be better than pro rata. Another unrealistic assumption is the fact that the RCD will be replenished immediately just after the conversion. The maturity should be after the next possible conversion date. He does not specify how this date is derived. So the bank also needs to know when it expects a conversion. This would seem ridiculous, especially because Flannery prefers short maturities preferred, and mentions a month in specific. A conversion would then happen monthly or more. This would make the CoCo a lot more like equity. According to Allen and Overy (2013) several countries will not treat the CoCo’s as debt if this is the case. This will disincentive the banks form issuing CoCo’s according to his
proposal. His proposal also does not address market manipulation, which is odd because the whole idea is founded on market based values.
5.2.2 Squam Lake group
The Squam Lake group is a group of 15 financial economists who proposed several reforms regarding the financial system. Among the proposals is one for contingent capital. Their proposal for contingent capital is not as specific as the other proposals.
Trigger
According to Kenneth et al. (2010) the conversion should depend on the two following conditions:
1. The regulator declares the event of a financial crisis 2. The violation of one of the terms stated in the contract
The group states that the second condition could be filled in by using the ratio of Tier 1 capital to risk adjusted assets. The Squam Lake group does not go in further detail on the trigger.
Assumptions
Kenneth et al. (2010) assumes that a conversion should happen with minimal disruptions. After a conversion the bank would no longer have an excessive amount of debt. This allows the bank to raise private capital more easily. Another assumption is the fact that a conversion will positively influence the view of short-term creditors and other counter parties towards the banks future.
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Specific features of their proposal do not go so far. They state that the maturity of the contingent capital should be long. When it comes to conversion, the bonds could either be converted by using a conversion price with a fixed equity value or a fixed quantity of equity shares. Each of them with their own advantages and disadvantages (Kenneth et al., 2010)
Example
The group does not specify a specific example. When it comes to the fixed equity value conversion, it will most likely be similar Flannery’s proposal. However, the conversion into a fixed quantity of shares is new. The proposal does not contain specific trigger ratios, but I will use numbers for illustration.
Table 2
Squam Lake Group
T=0 T=0.5 T=1
Assets Liabilities Assets Liabilities Assets Liabilities
$100 $86 Deposits $97 $86 Deposits $97 $92 Deposits
$10 CoCo’s $10 CoCo’s $0 CoCo’s
$4 Equity $1 Equity $7 Equity
Ratio: 4% Ratio: 1,03% Ratio: 7,22%
At T=0 the bank is still sound. The bank experiences a major loss at T=0.5 causing a violation of one of the banks covenants. The regulator then decides that a systemic crisis is ongoing, causing a conversion. The $10 worth of contingent capital will be converted into a fixed quantity of 10 shares at a price of $0,6. The bondholders take a direct loss of $4 and the equity to asset ratio is restored. The chosen conversion price will need more explanation. The proposal does not contain anything that specifies whether the conversion price should be above, at or under the current market price. The important thing might be that the investors will suffer a loss and therefore do not want to trigger a conversion.
Notes
Kenneth et al. (2010) point out that a double trigger is good for three reasons. If the conversion solely depends on the equity to asset ratio, the debt will turn into equity whenever it experiences losses. This undermines the disciplining of the management. The second reason is that if the conversion would only depend on regulator, the contingent capital will not be more beneficial than other debt. Thirdly, the supervisor would be under a lot of pressure if it depends only on his declaration of a systemic crisis. The regulators declaration cannot be replaced with a systemic
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crisis indicator, because this will cause a conversion for sound banks. This would decrease the banks willingness to stay sound. However, this is only true if it depends only on this indicator.
The group points out at few things with respect to the conversion price using a fixed equity value. The market value based triggers are subject to manipulation. If the conversion price is the current market value of a share, an investor could easily drive the price down for a short period of time causing a conversion. The stock price will then go back up, and the investor could make a profit. This could be solved by using an average over a longer period. This however has its own downside. The stock price could experience a one day giant drop, causing a conversion. The stockholders will not experience as much a dilution if the conversion price was more appropriate. The bondholders will also experience a huge loss if this remains the stock price, because they can only sell their shares at the current market price. The last note on this kind of conversion is the fact that it could cause a “death spiral”. By this is meant that a conversion will dilute the claims of current shareholders, causing a lower shareholder price. This will then lead to more dilution and an even lower share price. A fixed quantity conversion would solve the death spiral problem, but it also has its downsides (Kenneth et al., 2010).
Discussion
This proposal is the most undetailed version. However this version shows up in almost every other proposal as discussion material. The biggest upside as well as downside is that it has a lot of good ideas, but it needs a lot more working out. Their ideas are also incorporated in a lot of CoCo’s as we will see in chapter 6.
When it comes to the dual trigger, the regulator might be reluctant to call a systemic crisis. This signal might have a big impact on the financial system and regulators might want to stall this as long as possible. This could be replaced by an indicator, but an appropriate indicator is a discussion on its own and goes beyond the scope of this paper.
The group also perceives a conversion to be positive for the banks future perspective. This is very debatable and can only be proven by the next systemic crisis.
5.2.3 Flannery (2009)
Flannery (2009) proposes a somewhat similar design as his 2003 version. His view from his previous proposal has not changed. This new form of contingent capital is designed to discipline the market and TBTF banks in particular. He maintains that triggers should be market-based
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values. The main reason is that he does not expect the market to have a big enough influence to manipulate the market prices for common stock.
Trigger
Flannery (2009) proposes that the trigger should be specified as follows:
The supervisor establishes what the minimum trigger point should be as well as the minimum target ratio that should be reached after conversion. The minimum capital ratio should be based on market values of common equity and the once the trigger is breached the conversion should happen rapidly.
Assumptions
This proposal does not have many assumptions. However an important assumption is that the bonds that are being issued must have a high enough ratio and continuous asset value
fluctuations. Through this way the firm could issue riskless a Contingent Capital Certificate (CCC). It is also assumed that large asset value fluctuations are unlikely and recapitalizations are automatic, provided that capital ratios are published daily.
Features
The conversion occurs solely on the violation of the minimum trigger point. A financial crisis or any other reason why the firm should convert should have no influence on the conversion.
A systemically important firm should be required to maintain either of the two ratios. ● With CCC’s, the common equity ratio should be 4% of total, given that the firm also has
4% of total risk weighted assets in CCC outstanding.
● Without CCC’s the common equity ratio should be 6% of total risk weighted assets. After a conversion the minimum target capital ratio of 5% should be reached, and the total value of debt that is being converted will be fully replaced by a number of shares with the on that day implied market price of common shares. These numbers are for illustrative reasons in order to explain the idea. Supervisors can set minimum ratio levels and firms are free to have higher capital ratios in the CCC terms. The maturity of this CCC is not fixed. It could be either one of the following:
a) Convert the ones that are closest to maturity
b) Have different “seniorities” for different CCC’s. This could help the sale of new CCC’s as they could be of highest seniority.
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Flannery (2009)
T=0 T=0.5 T=1
Assets Liabilities Assets Liabilities Assets Liabilities
$100 $92 Deposits $97 $92 Deposits $97 $92 Deposits
$4 CoCo’s $4 CoCo’s $0.15 CoCo’s
$4 Equity $1 Equity $4.85 Equity
Ratio: 4% Ratio: 1,03% Ratio: 5%
Source: Flannery (2003; 2009) customized by me Notes
Flannery’s (2009) proposal does have some advantages that should be taken into account when comparing the several proposals.
The first advantage to CCC’s is that market values are used instead of book values. Market values reflect the bank's financial position more accurately and timely. This could ensure that the CCC’s will be converted before the bank gets into financial trouble. According to
Kuritzkes and Scott (2009) Book values tend to lag severely during financial distress, because most “well capitalized banks” under the Basel standards had problems financing their activities (Kuritzkes and Scott, 2009). Flannery (2009) also points out that GAAP values allow for some flexibility that could positively impact the balance sheet of a bank.
Secondly, a conversion event depends solely on the financial state of the financial firm. Supervisors that could decide on a conversion are probably too late to prevent insolvency as well as other political considerations that could increase a delay in conversion.
Thirdly, the CCC’s should be safer than today's subordinated debt. With a high enough ratio and continuous asset value fluctuations a firm could issue riskless CCC’s. The CCC’s will be repaid at maturity in cash or in similar value of common shares. After a conversion it should be relatively easy to issue new CCC’s as the firm is well recapitalized above the trigger ratio. It is assumed that large asset value fluctuations are unlikely and recapitalizations are automatic, provided that capital ratios are published daily.
Fourthly, Flannery (2009) suggests that the bond should have a clause that covers a special conversion price in case of negative equity and no actual share prices. If a conversion happens and the current price is zero, the conversion will not lead to a recapitalization of the firm. Therefore a somewhat arbitrary price is recommended.
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Fifthly, CCC yields might have the ability to provide the market with information on the adequacy of the bank’s minimum common equity ratio. Yields on a CCC could go up if the bank is more likely to go bankrupt and could indicate whether the minimum ratio that was set was appropriate (Flannery, 2009).
Discussion
The proposal also has several disadvantages. The most important fact is the use of market values. These values are easily manipulated and could have a big influence on the conversion of bonds. Book values may tend to lag, but deciding on whether a bank needs new capital is a difficult decision as it could have consequences for the market perception of the firm.
The second problem is that systemic crises will not be averted, as supervisors have no influence on the conversion. A conversion could be useful if most firms are in trouble. Once the system wide conversion happened, many banks could be safe and the market will have a more positive view on the banking system as a whole.
The third disadvantage to this proposal is that it almost assumes CCC’s are riskless. The argument that continuous asset values and high ratios cause riskless CCC’s, do not seem
plausible. High ratios in the real market imply higher risk, because a higher coupon payment will be demanded, as can be seen from the appendix 11.1 and 11.2. The proposal does not propose a specific maturity. A longer maturity will increase risk and a higher coupon payment as can be seen from the appendix 11.1-11.8.
After a conversion the bank should be able to reissue the lost CCC’s relatively easy. A more logical response of investors would be a reduced willingness to invest.
5.2.4 McDonald (2013)
McDonald (2013) has a different view on contingent capital than the previous section. The dual trigger contingent capital should be used as a safety net in case of regulatory failures and/or unanticipated market events.
Trigger
The first trigger is a stock price trigger. If the stock price falls below a certain value the trigger is breached. The stock trigger also has to be adjusted for stock splits and dividends. The conversion only happens if the second trigger is also violated. The second trigger is a financial index value. This financial trigger has to fall below a certain value in order to be violated. Due to these two triggers, no regulator is involved and the bank is able to fail during normal economic times.
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These triggers are market based values. They are continuous and are exposed to market manipulation.
Assumption
One assumption that has been made is the assumption related to conversion. The market signal it creates is not seen as positive nor seen as negative. In the example I also keep the stock price the same after conversion.
Features
McDonalds (2013) proposes that the amount of CoCo’s that need to be issued should be equal to the amount of equity. The bonds should be of long maturity, he specifically mentions 5 years in his example. To reduce market manipulation the following should be incorporated in the securities:
A. Fixed share conversion
B. The shares must have a conversion price higher that the market price at conversion. C. The stock price trigger should be an average over time
D. Bonds need to be retired gradually and randomly
Due to A and B, market manipulation in this design is more difficult than with only a stock price trigger. The financial trigger is hard to drive down as an investor, so the only manipulation would be a threat if the financial index is already below the trigger value. A short-selling strategy could drive the stock price down temporarily, the bonds would convert and the price of stock could go back up, creating a profit for the contingent capital bond holder. McDonald (2013) therefore proposes a fixed share premium conversion. This conversion structure causes a significant loss in case of conversion. C is important so that the market cannot reduce the stock price over a significant amount of time to cause a conversion, in order to gain a profit. D is in place in order to avoid large gains from manipulation around the maturity date,
Example
McDonald (2013) did not include assets or deposits. So the numbers chosen at T=0 in table 4 are only for illustrative purposes. Ex-ante, the stock price trigger is set at 0.5 and the financial index trigger at 90. The CoCo’s will be converted into 20 fixed shares with a premium conversion price. Equity is made out of 10 shares at a price of $1. At t=0.5 the stock price falls to 0.45 which is lower than the proposed stock price trigger of 0.5. The financial index falls to 90, which means the CoCo’s have to be converted. At T=1 the premium price is set to 0.5, or at
((0.5/0.45)*100)-18
100=11.11% premium. The CoCo’s now only add $0.45*20=9. The CoCo holders lose $1 on their investment and equity becomes $13.5. What is very different here is that after conversion the assets experience another drop equal to the losses incurred by CoCo holders.
Table 4
McDonald (2013)
T=0 T=0.5 T=1
Assets Liabilities Assets Liabilities Assets Liabilities $100 $80 Deposits $94.5 $80 Deposits $93.5 $80 Deposits
$10 CoCo $10 CoCo $0 CoCo
$10 Equity $4.5 Equity $13.5 Equity
Stock price:$1 Financial Index:100 E-A Ratio: 10% Stock price:$0.45 Financial Index:90 E-A Ratio: 4.76% Stock price:$0.45 Financial Index:90 E-A Ratio: 14.44%
Source: Flannery (2003) and McDonald (2013) customized by me.
McDonald (2013) did not include assets or deposits. So the numbers chosen at T=0 are only for illustrative purposes. Ex-ante, the stock price trigger is set at 0.5 and the financial index trigger at 90. The CoCo’s will be converted into 20 fixed shares with a premium conversion price. Equity is made out of 10 shares at a price of $1. At t=0.5 the stock price falls to 0.45 which is lower than the proposed stock price trigger of 0.5. The financial index falls to 90, which means the CoCo’s have to be converted. At T=1 the premium price is set to 0.5, or at ((0.5/0.45)*100)-100=11.11% premium. The CoCo’s now only add $0.45*20=9. The CoCo holders lose $1 on their investment and equity becomes $13.5. What is very different here is that after conversion the assets
experience another drop equal to the losses incurred by CoCo holders. Notes
At the end of his paper, McDonald (2013) points out that contingent capital should only be seen as a buffer for banks in stressful times without changing the financial system. The second note is on the premium conversion. If the CoCo’s are converted at a premium it could cause multiple equilibria. This problem is explained but not fixed in his proposal.
Discussion
The first thing that comes to mind after reading his proposal is the fact that he uses a simple example to show what CoCo’s can do. After this the possible implications are looked at, but not all problems are solved. It is also not very clear what kind of assumptions he makes in his example, and he did not look at the total balance sheet changes or what Tier 1 ratio might be required by law. What is also of concern is the second drop in assets. The higher the premium the
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higher this drop will be. This needs to be carefully chosen, because if the drop did not happen equity would equal $14.5 and assets would be $94.5. The equity to assets ratio would then be about 15.34%. This ratio is higher than the example at T=1 and would seem like a waste of money.
5.2.5 Pennacchi et al. (2011)
COERCs are Call Option Enhanced Reverse Convertible.
Pennacchi et al. (2011) have modified the Flannery (2003, 2009) proposal to deal with three important issues. Firstly, the “death spiral” needs to be prevented. Secondly, the concern for a not large enough CoCo, market has to be addressed. Finally, the multiple or no equilibrium problem pointed out by Bond, Goldstein and Prescot (2009) had to be solved. The general goal is also different. The securities are designed such that benefits of debt over equity are used, but the costs related to financial distress are lower. The securities are called Call Option Enhanced Reverse Convertibles (COERC).
Trigger
The trigger is again market based, but the trigger is different. The trigger is now based on market value of capital (MVC) divided by assets. MVC means equity+COERCs=assets-deposits. They propose that the MVC trigger ratio should be set at 6.5%. They choose MVC instead of equity to assets, because this would lessen the incentive for market manipulation as well as avoid
problems with respect to equilibria. Assumptions
It is not specifically stated, but the markets would be indifferent to whether a conversion happens or not. The stock price will not be affected nor will it create a positive or negative market signal, Features
One of the most important features is that the COERCs are designed to heavily dilute. For this to happen the conversion price needs to be far below the market price for shares. The second feature is the fact that after a conversion the initial shareholders have a right to buy the shares obtained by the COERC holders. This will be clarified in the example.
The authors have also included some features if it were to be implemented in the real world. Pennacchi et al. (2011) requires the COERCs market to be liquid. The amount of risk due to the right to buy feature is very low and would improve liquidity. COERCs would also have to be subordinated debt like a CoCo for both tax reasons as well as liquidity reasons. Simply
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because tax deductibility will make it easier to issue and the market for subordinated debt is more liquid than the market for corporate bonds.
Example
The following example needs some more explanation due to the features that have been
incorporated. Equity equals 7 shares worth $1. What happens is that assets drop to 106.5 due to losses. The trigger ratio of 6.5% has now been reached and the COERCs convert into equity. Due to this conversion the E-A ratio has gone up from 3.3% to 6.1%. The bank now has a “safe” equity to capital ratio.
Table 5
Pennacchi et al. (2010)
T=0 T=0.5 T=1
Assets Liabilities Assets Liabilities Assets Liabilities $110 $100 Deposits $103.5 $100 Deposits $106.5 $100 Deposits
$3Coercs $3 Coercs $0 Coercs
$7 Equity $3.5 Equity $6.5 Equity
MVC Ratio: 10% E-A ratio: 6.4% MVC Ratio: 6.5% E-A ratio: 3.3% MVC Ratio: $6.5% E-A ratio: 6.1%
The conversion price is set to $0.1. So the COERC investors would receive 30 shares. The total amount of shares outstanding is now 37. This means that the COERC investors now own 30/37 of the company. An important part is that at conversion the COERC investors would receive (30/37)*$6.5= 5.27 if the total capital would be $6.5. The price per share would now be $65/37=0.176. Thus 7*0.176=1.23 would be the initial shareholders value.
One of the features of the COERC is a right for the shareholders to but the 30 shares at the conversion price of $0.1. According to Pennacchi et al. (2011) any rational investor would exercise this option, because 0.1<0.0176. It could be that the investors do not have funds to afford the shares. The investors could sell their right to other investors that do have the funds. The COERC holders would receive their $30 investment in cash and do not make a loss on their investment. The banks equity has fallen from $7 to $6.5. Therefore the shareholders are exposed to all the risk. The rights will be exercised as long as the conversion price is lower than the stock price. Put differently a drop assets to 103.7 would mean a total market value of capital of $3.7. This means that the share price would be 3.7/37=$0.1. The key idea would be that the conversion price is chosen in order for this not to happen. If this would happen anyway the COERC would still strengthen the capital base like a normal CoCo. It is also possible that the drop in assets is
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larger than the total value in COERCs and equity, both the shareholder and the COERC holder will be wiped out. Such a fatal event cannot be stopped (Pennacchi et al., 2011).
Notes
Pennacchi et al. (2011) point out that COERCs due to the right to buy option, the shareholders might not like that they are pressured into buying such shares. However, ex-ante, the
shareholders can lend at a rate close to rate paid by the government. Another point with regard to the selling of a right to buy option is that, brokers in many countries already sell unexercised right if investors do not inform them of their choice. It is highly likely that this would also go for COERCs. The last point is related to the diluted earnings per share. Many investors focus on such a ratio. COERCs are contingent capital and could at any time dilute heavily, causing a huge drop in diluted earnings per share. How this will impact an investment decision cannot be
addressed until they are issued. Discussion
This proposal is very detailed and perhaps useful structured CoCo. A big disadvantage is the fact that they assume that a conversion will not be followed by a negative market signal. This could jeopardize the whole proposal, if the equity drops below the trigger value for a second time and the bank does not have any COERCs for another conversion.
A that question arises here is, what should a CoCo be designed to do? Should it only be used in dire times like a systemic crisis as we have seen not long ago? Or should it be designed to make it easier for bankers to gain capital when the bank itself is performing badly, regardless of a systemic crisis? In my opinion this design makes it easier for shareholders to take a lot of risk and even more cheaply than before. What if banks just simply have to issue more equity? This would have the same result as the COERCs only more costly. Would it not be an idea to simply make equity cheaper to issue?
5.2.6 Calomiris and Herring (2011)
Calomiris and Herring (2011) have a different view on contingent capital. Rather than having enough equity to main solvent, they focus on the incentive to issue new capital before the contingent capital is converted.
Trigger
Calomiris and Herring (2011) propose a different trigger ratio. The trigger ratio is calculated by a 90-day moving average of the market value of capital divided by the sum of the market value of
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equity plus the face value of debt. This is done to reduce fluctuations related to share prices and lowering the noise due to market value signals. The trigger ratio should be set at 8%, in order to trigger conversion long before the bank is insolvent. This should give the bank enough time to reassess their risk management as well as replacement of senior management. If the trigger ratio is breached for the second time, prompt corrective action should be taken. According to Spong (2000), this US law enables the Federal Deposit Insurance Corporation (FDIC) to temporarily take over management in order to minimize losses to the FDIC.
Assumptions
It is assumed that conversion does not happen very often due to the large amount of issued CoCo’s.
Features
Calomiris and Herring (2011) suggest the amount of contingent capital should be roughly equal to the amount of equity that is required. The amount of equity that is required should be about 10% of the quasi market value of equity ratio (QMVER).
The fear of a conversion should be ‘big’ for both the managers and the shareholders. Therefore they suggest an approximately equal amount of CoCo’s and equity. All of the contingent capital should be converted and the price of the new shares should be 5% above the face value. This should maximize the effect of dilution and shareholders would fear the risk of dilution and will most likely fire the management team if a conversion happens.
Example Table 6
Calomiris and Herring (2011)
T=0 T=0.5 T=1
Assets Liabilities Assets Liabilities Assets Liabilities $100 $80.5 Deposits $95 $80.5 Deposits $95 $80.5 Deposits
$10 RCD $10 CoCo’s $0 RCD
$9.5 Equity $4.5 Equity $14.5 Equity
QMVER=9.5% E-A ratio=9.5% QMVER=8% Ratio: 4.74% QMVER=11% Ratio: 15.26%
At T=0 Calomiris and Herring (2011) recommend a 10% contingent capital, because they expect that Basel III would require a 9.5% equity over assets ratio. In other words, contingent capital should be about as big as the amount of equity required. At T=0.5 the QMVER ratio of 8% has been violated. The equity ratio is also a lot lower. Calomiris and Herring (2011) explicitly mention the conversion of all contingent capital in order to increase impact. At T=1 the equity to
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capital ratio has increased sizably, making the bank relatively “safe” compared to other
proposals. The QMVER ratio chosen at T=0.5 and T=1 have no actual base. This is because it is a 90-day moving average and cannot actually be explicitly calculated.
Notes
This moving average should smooth share price fluctuations and noise in market value signals. On top of that, this 90-day average allows for policy makers to respond to infrequent disruptions and bank management to be replaced if needed. A 90-day average also insures that a decline in market price is not due to market manipulation or irrational shareholder behaviour.
A last suggestion would be to only allow non-bank institutional investors to invest in contingent capital, as well as forbid them from having a short position in equity. This will not prevent short-selling, but it will stop CoCo holders from a coordinated short-selling strategy to initiate
conversion. Discussion
The 90-day moving average is both the strongest and the weakest part of this proposal. The strong part is the fact that it avoids easy manipulation by the market. However, because it is a 90 day average, will the conversion be timely? This could be solved by increasing the QMVER trigger ratio if the 8% is considered too low. One of the strongest points of this proposal is that a conversion is undesired. Whereas the other proposals see conversion as a positive thing or in the Pennacchi et al. (2011) proposal, the shareholders only bear the risk. This proposal forces bank management to not want a conversion as well as bondholders. Simply because bank management will most likely be fired after a conversion and the bondholders will make an immediate loss on their investment. On top of that if the QMVER trigger ratio is violated for the second time, the FDIC steps in and replaces current management to minimize losses. A good point in this
proposal is the fact that a holder of this security cannot be able to hold a short position in equity. Investors could find their way around such a constraint, but this would definitely help any academic CoCo proposal. By issuing a great amount of CoCo’s the capital base will be properly strengthened.
6. CoCo Practice
I’ve just discussed several academic CoCo proposals. The issued contingent capital and write downs however do not incorporate their ideas. I will first show what kind of triggers have been issued and then I will look at what happens after the trigger has been hit.
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6.1 Triggers
Triggers that have been proposed vary widely and so does the actual issued contingent capital. The issued bonds can contain a mix of these triggers. The triggers can be split into the eight categories and therefore the headings are named after them.
1) Non-viability trigger and other regulatory triggers 2) Book ratio trigger
3) Mandatory Scheduled conversion 4) Voluntary conversion
5) Capital reduction trigger 6) Insolvency event
7) Basel III non-compliance event 8) Take over event
In figure 1 is shown how many of each trigger has been issued. Figure 1 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% triggers
The percentage total adds up to more than a 100%, because a CoCo can have several triggers
Composition of different triggers
Non-viability triggerBook ratio trigger
Mandatory Scheduled Conversion
Capital reduction trigger
Insolvency event
Basel III non Compliance
No longer state owned
Voluntary Conversion
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6.1.1 Non-viability trigger and other regulatory triggers
In this section I discuss all regulatory triggers. I will start off with the most widely issued non-viability event. After this I will discuss which other insolvency and/or bank run prevention measures have been issued.
When a bank reaches point of non-viability, the regulator or any other relevant authority can decide on a conversion or a write down. The point of non-viability can also be referred to a viability event. Sixty-five percent of the 83 CoCo’s have the non-viability event or will be subject to this measure in the future.
A non-viability event can solely be triggered by the regulator. The regulator could be the central bank of a country, a banking authority or a financial market supervisor. This is always defined in the contract. The regulator decides when a conversion or a write down is necessary. Basel III states that there is a point of non-viability, but as one can see later in the quote from the Credit Suisse CoCo, there is not a single number or anything explicit about the point of non-viability. From an investors perspective this would create a lot of uncertainty, because an
investor cannot read a regulator’s mind. Despite this fact, China CITIC Bank, UOB Group, UBS, Hoist Finance, Julius Baer Group, Nomura and Suncorp have successfully issued or are still selling contingent capital bonds with only this trigger. On top of that investors are willing to buy these securities. They simply gamble that the bonds will mature before the bank is non-viable, or perhaps sell them before a financial crisis. The contingent capital bonds with only this trigger have lower interest rates than the contingent capital securities with more triggers. The markets might expect that a conversion or write down event will happen earlier if the securities have another trigger and a book ratio trigger in specific. The book ratio trigger will be explained in more detail in the next paragraph.
Will a non-viability event prevent a bank from becoming non-viable or will it serve as a loss absorption mechanism once the non-viability trigger is hit? In the Credit Suisse (2011, February 22) prospectus from the Credit Suisse group (CSG) the non-viability trigger is specified as follows:
“Viability Event” means that either:
(a) the Regulator has notified CSG that it has determined that Conversion of the Tier 2 BCNs, together with the conversion or write off of holders’ claims in respect of any other Buffer Capital Instruments, Tier 1 Instruments and Tier 2 Instruments that, pursuant to
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their terms or by operation of law, are capable of being converted into equity or written off at that time, is, because customary measures to improve CSG’s capital adequacy are at the time, inadequate or unfeasible, an essential requirement to prevent CSG from becoming insolvent, bankrupt or unable to pay a material part of its debts as they fall due, or from ceasing to carry on its business; or (b) customary measures to improve CSG’s capital adequacy being at the time inadequate or unfeasible, CSG has received an irrevocable commitment of extraordinary support from the Public Sector (beyond
customary transactions and arrangements in the ordinary course) that has, or imminently will have, the effect of improving CSG’s capital adequacy and without which, in the determination of the Regulator, CSG would have become insolvent, bankrupt, unable to pay a material part of its debts as they fall due or unable to carry on its business.
From (a) you would expect that the conversion or write down would prevent the bank from becoming non-viable. Thus a bank can continue its business. However, from (b) the contingent capital securities are only used for loss absorption. The public sector injects capital and the securities are used to minimize losses for the taxpayer. Calomiris and Herring (2011) argue that the regulators have always been reluctant to take action and recognize losses timely when it comes to systemically important financial institutions. The bank may have already become insolvent and/or bankrupt, when the bonds are written off or converted. The bonds can be seen as gone-concern and will not contribute to systemic stability. How this will turn out can only be shown by the next crisis or failure of bank management.
Not all the contingent capital securities have a non-viability event. Twenty three percent of the total regulatory triggered CoCo’s do mention in the risk factors that the securities might be subject to this in the future as can be seen from figure 2.
At the issue date the banks could not know what the specifics would be, and therefore a prospectus even states that either conversion or write down might occur despite the fact that the convertible only has a conversion event and a write down security only has write down triggers. Looking at the contingent capital securities that have a write down function and a non-viability event, a write down is the only thing that will occur. A contingent convertible bond will thus only be converted. An investor need not worry about a write down being converted at an unspecified price or the other way around.
27 Figure 2
When it comes to the convertibles, a price for such a conversion, where the non-viability trigger is not specified and will be subject to this in the future, I can only speculate on how this will turn out. However, most CoCo’s use the same conversion price or price set for different triggers. In case a CoCo will be converted due to non-viability despite the price not being explicitly stated, the conversion price will most likely be the one from the book ratio trigger or any other trigger.
Eight banks have issued CoCo’s with bankruptcy measures instead of a non-viability event. Two CoCo’s from Banco Popular simply state that if the issuer is declared bankrupt, then conversion shall occur. This trigger is to make sure that the CoCo’s in such an event will absorb losses before a taxpayer will. The banks management would not include such a trigger. It would seem that the regulator had a big influence in designing this CoCo. Six out of six CoCo’s issued by Russian banks have included that write down or conversion shall occur if the deposit
insurance agency of Russia implements bank run prevention measures. This would seem a standard requirement by the Russian government to minimize losses for the taxpayer.
0% 10% 20% 30% 40% 50% 60% 70%
Non-viability Event In the future Bankruptcy prevention measures
Other
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The last three “other” CoCo’s have included a clause that looks very similar to the non-viability event. The regulator can decide whether a write down or conversion is necessary because the bank is either insolvent or would become non-viable.
A different option which France and the United Kingdom have incorporated is the bail-in option. The Barclays contingent capital securities contain a clause on “U.K. bail-in power”. This bail-in power allows the regulator to modify contracts, override decisions and use the contingent capital to recapitalize the firm or absorb losses. The following conditions need to be met for the U.K. resolution authority to exercise this power:
(i) The regulator determines that the bank is failing or likely to fail
(ii) It is not reasonably likely that any other action can be taken to avoid the bank’s failure and (iii) The U.K. resolution authority determines that it is in the public interest to exercise the bail-in power.
There is no specific point when this happens, and when the bail-in option is exercised, the investor will not know what will happen to the bond.This bail-in option is incorporated in the Banking Reform Act which is adopted in 2009 and amended in 2013. The U.K. bail-in option is part of the bank resolution and recovery directive (BRRD or RRD) which was adopted by the European parliament on the 15th of April 20141 (Great Britain. Financial Services Act, 2013).
France has a similar bail-in option. This option is also included in the Crédit Agricole (2013 September 13) CoCo. On July 27, 2013 the French government enacted a banking law which allows the regulator to implement measures for prevention and resolution of banking crises. The following conditions need to be met before the bail-in option can be used: (i) If the bank no longer complies with regulatory capital requirements
(ii) The bank is not able to make payments that are, or will be imminently, due (iii) The bank requires extraordinary public financial support.
The bail-in option can be used to fully or partially write down, convert or cancel subordinated instruments. Seniority is taken into account and the conversion price will be fair and realistic. Contingent capital securities are part of this group and can be fully written down if a bank has reached the point of non-viability (Crédit Agricole, 2013 September 13).
What should be pointed out is the fact that, there are multiple resolution regimes being implemented by countries such as the U.K. and the French bail-in option and the BRRD and the
1
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capital requirements directive (CRD) trying to achieve the same thing. Investors might not know which resolution regime is in effect and especially which will act first to initiate a conversion or write down.
6.1.2 Book ratio trigger
The book ratio trigger is widely used for contingent capital. In order for contingent capital to qualify as Additional Tier 1, it requires a pre-specified trigger point (BIS 2010). This trigger point has been set in several ways. 1) The simplest form is that the common equity tier 1 (CET1) falls below a certain ratio. This ratio is the total book value, adjusted for risk, of the assets divided by the book value of the common equity. The book value is subject to the countries own laws and the country specific accounting principles. The violation of the trigger value can be determined at the discretion of the issuer, the regulator or both. For convenience I assume that if a bank prospectus states that the conversion happens automatically, the issuer calls the
conversion. Once the trigger is breached, this does not always mean that the bonds will be converted or written down. The regulator in some cases has an option to prevent the conversion event if it expects the institution to perform well in a timely matter. Where Basel III is only an advice for future legislation, it is up to the countries or supranational authority like the European Commission to implement the new legislature. The European Commission has adopted the CRD IV which specifies the requirements on the contingent capital securities for it to be AT1 or Tier 2. The two most important features for a CoCo to be Additional Tier 1 are the required CET1 trigger ratio minimum of 5.125% and the maturity has to be perpetual. If these are not met, the CoCo will become Tier 2 and otherwise a subordinated debt instrument. Financial institutions will have to increase their capital over the coming years due to the previous crisis. According to Allen and Overy (2013) AT1 securities are treated as debt except in Australia. Therefore, a cheaper way of strengthening your capital base would be to issue AT1 instruments.
I will now show the conversion process works to keep in mind when evaluating the different book ratios later on.
The bank or other financial institution will publish its financial statements and thus a CET1 ratio. Then the regulator as well as the holder of contingent capital securities will be notified that the trigger is breached. This means for the issuer there is no way back in not converting or writing down their securities. However, all the Swiss banks have a covenantin their contingent capital
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prospectus stating that the write down or conversion could be prevented if the issuer has taken reasonable action to restore the CET1 ratio in timely manner.
The question then arises is, will the conversion or write down be in time to prevent insolvency and bankruptcy? I will try to answer this question by picking out a few different contingent capital securities containing different ratios as well as time before conversion.
The plainest form of a book ratio trigger is found in the Barclays (2013, December 3). The following is taken from the prospectus:
A “Capital Adequacy Trigger Event” shall occur if the fully loaded CET1 Ratio as of any Quarterly Financial Period End Date or Extraordinary Calculation Date, as the case may be, is less than 7.00% on such date.
The securities will convert only if the calculation of the CET1 ratio in accordance with the Basel III rules is below 7.00%. The CET1 ratio can be calculated quarterly or at any other date that the CET1 ratio is calculated upon the instruction of the prudential regulation authority or Barclays itself. After it is established that the CET1 ratio is below the trigger ratio, the bonds will be fully written down Barclays (2013, December 3). A more risky trigger that has been set is the one’s set by Gazprombank, Home Credit Bank and Sberbank. They require a write down or conversion if the reported CET1 ratio is below 2%. It is safe to say that the securities will then be used for loss absorption and not for strengthening the bank.
A more adjusted version of this is the one taken from the Banco Popular (2012, June 26). Any of the following will trigger a conversion:
a) Core Tier 1 ratio of total group is below 7%
b) CET1 ratio of group or any of subsidiaries is below 5.125%
c) CET1 ratio is below 6% due to losses over the last 4 quarterly financial reports and the reserves and capital have decreased by a third or more
a) Is the same as discussed previously, except now it uses a different risk weighted assets. Core Tier 1 is a measure used in Basel II rules. This is adjusted for less risk and therefore also has a higher ratio. On the other hand, b) takes into account that a certain subsidiary might be near bankrupt. Because if any of the subsidiaries have a CET1 ratio below 5.125% the bonds will be converted into ordinary shares. The reason that they chose a lower CET1 ratio for any of the subsidiaries might be that otherwise conversion would be too likely and investors would want compensation in the form of a higher coupon rate. A good reason might be that a bank would not
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want a conversion, because a conversion sends a signal to the markets about the condition of the bank. One can easily say that if there is already some speculation on the solvency or financial condition of the bank, that a conversion or write down might be the last straw that breaks the camel’s back. If the trigger appears high enough and after the conversion or write down, the bank is seen as solvent, then the trigger might have the effect it was intended to do. The last trigger c) could lead to more negative signals for the market. Whenever the bank suffers big losses and reserves and capital base have decreased over one third, then and only then will conversion happen. This means that if the bank is in very big trouble. The losses could be much bigger and a conversion might not even make a significant difference when it comes to increasing the capital base. If this is the case, the conversion will only be used to absorb losses and will reduce the losses for current shareholders, or in an extreme scenario, the taxpayer. What might be more important is the fact that the losses will have to be during a year, and consecutive quarterly reports. By selling one subsidiary or any other asset, the bank might not suffer a loss on paper, but the bank is still insolvent. Conversion will not be triggered, and that is something to worry about. Banks could use such a method to prevent conversion and thus prevent negative signals towards the market.
The Marfin Popular Bank (2011, May 19) has as slightly different version. It comes down to any of:
a) Core Tier 1 ratio below 5%, after Basel III adoption, then required minimum b) CB if Cyprus believes a) is likely to happen in the near future
c) CB of Cyprus determines the issuer is non-compliant with any of the regulatory capital ratio requirements.
Requirement a) is relatively straight forward. The Core Tier 1 definition was used at the moment of issue and now that Basel III is adopted the minimum requirement is a CET1 ratio of 5.125%. But the issuer also included or was forced to include b). This is completely at the discretion of the central bank of Cyprus. There is no precedent or any base on which the central bank can decide that a breach of the book ratio is near. This extra possibility could give rise to a timely call for conversion or the market could react in a negative way as the central bank has to take measures. The last option c) was included to make sure that the contingent capital securities are not in non-compliance with any of the regulatory requirements. This is more likely to be found for contingent capital securities issued in or before 2011 as Basel III was not completed or future
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legislation could alter the requirements. This option c) is the only trigger that was included in all the convertibles that were issued by the Bank of Ireland Group. These were issued in beginning of 2005 and 3 more times during 2006. It is safe to say that this requirement is vague, but if changes in law are likely to be near then, such a requirement is quite safe from a bank's perspective. The investor on the other hand, can be subject to anything. These securities were redeemed or exchanged on the 12th of August or shortly after this date (Bank of Ireland Group, Exchange Offers and Consent Solicitations, 2011 June 8).
Credit Suisse (2013, September 2) uses a more risky book ratio trigger. It consists of the sum of the CET1 ratio and the higher trigger capital ratio. The higher trigger capital ratio is calculated by dividing the risk weighted Assets (RWA) with the face value of all the instruments that can be converted or written down if the threshold ratio is breached. The whole idea of strengthening the capital base in difficult times is no longer applicable, because the securities are already used for the capital base. The bank is the only one that profits from this, because
contingent convertibles or write downs are cheaper to issue.
BBVA (2014, February 11) states that it has trigger ratio set as the CET1 ratio of 5.125%. This ratio is calculated by the bank and has no option where the regulator can request an extra calculation. This ratio is calculated quarterly and is shown in the quarterly financial reports (BBVA, 2014).
A different trigger is that one of Banco Popular (2013, October 10) it requires either of the following:
a) CET1 ratio below 5.125%
b) Tier 1 ratio is below 6% due to losses over the last 4 quarterly financial reports and the reserves and capital have decreased by a third or more
(Banco Popular, 2013 October 4)
The second trigger is of interest, because this allows the bonds to convert at a higher ratio. The idea would be to convert earlier if the bank is incurring large losses over the last year. This could be the case if the whole system is not performing well or just a result due to mismanagement. The trigger is might try to address the problem of system wide defaults. However, if one of the recent quarterly reports does not report a loss, the bond will not be converted earlier. The financial system might still be functioning badly or the banks management is still performing badly and the banks strength will decrease until it hits the lower trigger.