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Author Meta Zähres +49 69 910-31444 meta.zaehres@db.com Editor Bernhard Speyer Technical Assistant Sabine KaiserDeutsche Bank Research Frankfurt am Main Germany Internet: www.dbresearch.com E-mail: marketing.dbr@db.com Fax: +49 69 910-31877 Managing Director Thomas Mayer
Following the recent financial crisis the minimum requirements of debt instruments that may be counted towards regulatory capital are being adjusted. In January 2011 the Basel Committee on Banking Supervision presented rules supplementing the Basel III regulations on capital adequacy and liquidity requirements. These stipulate that only hybrid capital instruments with full loss absorbency count towards regulatory capital.
The banks will have to bring their capital management into line with the new regulatory requirements. Recently, different forms of contingent capital have begun to emerge that could be integrated into banks‘ funding structures but do not yet, or no longer, meet the criteria for regulatory capital. Contingent convertibles (CoCos): The next generation of subordinated bonds? The term CoCo is used to describe a new type of convertible bond that is automatically converted into a predetermined amount of shares when a predefined trigger is breached. Since this type of bond is transformed into equity upon con-version, it would be available for further loss absorption and therefore satisfies the new regulatory requirements of hybrid capital instruments.
The right structuring is essential for the marketability of CoCos. Depending on the choice of trigger and the conversion rate, CoCos can be used to pursue different aims from a regulatory and financial point of view. Their structuring must take account of this.
Investor interest: Still uncertain. Given that CoCos are a new type of instrument in which the conversion rights are not placed in the hands of the investors, who would moreover tend to become shareholders at an unfortunate time, the capacity for placement of these bonds remains an open question that is difficult to assess. Ultimately their marketability will hinge on whether it is possible to find sufficient – particularly institutional – investors willing and able to hold these securities.
The future of CoCos stands and falls with the regulatory initiatives. The possibility of counting CoCos towards regulatory capital under Basel III acts as an incentive to issue instruments of this kind. Going forward, the concept of mandatory convertible bonds could thus gain ground; in the long run CoCos could replace the previous subordinated bonds. So far, however, regulators such as the Basel Committee provide for conversion at the behest of national regulatory authorities. This could cause difficulties with the placement of CoCos in that it creates uncertainty over the timing and circumstances of conversion. It makes the likelihood of default more difficult to assess and CoCos (even) more difficult to price.
May 23, 2011
Contingent Convertibles
Introduction
The recent financial crisis has highlighted the importance not only of the absolute amount of a bank‘s equity position but also the quality of the capital it holds available to absorb losses. In response to this, the Basel Committee on Banking Supervision has now tightened up its requirements of the quality of core capital. What will be decisive in future under these new regulatory intentions is the hard, core Tier I capital, i.e. common shares and retained earnings, since this can be used fully and immediately to absorb losses. With regulators pressing for higher loss absorbency for hybrid forms of capital, only very few of the old hybrid capital instruments are to be recognised as regulatory capital. This applies in particular to subordinated debt. The aim is to have subordinated creditors participate in the recovery phase, and hence in the costs of crisis management, just like providers of equity capital. During the financial crisis bondholders escaped largely unscathed since banks that were technically insolvent were bailed out by their governments owing to their significance for the financial system; even holders of subordinated bonds retained their entitlement to payment. Investors in sub-ordinated bank bonds were held liable only in the event of a gone concern. The moral hazard problem to which this gave rise is now to be reined in by involving subordinated creditors at an early stage, the intention being to reflect the risks entailed in subordinated bonds adequately in their pricing and to close the door on investors bene-fiting from the assumption of risk taking by the government while the taxpayer is obliged to foot the bill. It is therefore planned to have investors in subordinated bonds assume liability for losses once banks are no longer able to obtain private funding.
Driven by these motives, two fundamental approaches have evolved to improve bondholder liability. One is a new hybrid capital
instrument in the form of fixed income securities serving as an equity buffer in times of financial distress and termed contingent convertibles (CoCos); the other is bond creditor ―bail-ins‖. The two ideas differ in terms of their basis: CoCos are market-based instruments, while bail-ins rest on the principle of discretionary intervention. They share in common the wish to strengthen the stability of the financial system – a consideration that, in principle, also enjoys the support of the financial industry.
Contingent capital: A definition
The banks will have to bring their capital management into line with the altered regulatory requirements and the new standards applying to their core capital. Issuing bonds that are available to absorb losses under the new rules thus forms a necessary part of forward-looking capital management by the banks. Various alternative ways of including different types of contingent capital in their capital structure have already been devised, but it is not yet clear whether and how these instruments will count towards regulatory capital. Essentially the term contingent capital is used very generally to describe a kind of put option enabling the issuer to issue new equity at pre-negotiated terms. As a rule issuance is triggered by the occurrence of certain risk-based events defined ex ante in the contract conditions. Many constructions and terminologies currently in circulation can be subsumed under the heading contingent capital; CoCos are also a variant. Often, however, constructions
resembling contingent convertibles and called CoCos prove, on closer inspection, not to qualify as such, although they are a type of contingent capital:
— Write-down bonds: write-down instead of conversion Write-down bonds are a market-based financing instrument. Rather than being converted, as is the case with CoCos, their value is written down instead. The difference is that no additional capital is made available; the liabilities are simply reduced as a result of the valuation adjustment. So while the company‘s financial position looks better on paper, equity is ―created‖ only to the extent of the write-down made, since ―release‖ of the
liabilities generates exceptional gains that can be allocated to retained earnings.
— Temporary write-down bonds
Temporary write-down bonds – also known as up, step-down bonds – are debt instruments which, on the one hand, can have their liabilities reduced once a pre-determined trigger event occurs but, on the other hand, also have upside potential. In other words, a valuation adjustment can also step up their value proportionately, meaning that the bonds are written down only temporarily.
Bonds structured this way already exist in the marketplace. So far, however, accounting regulations have prevented bonds of this kind from being counted towards regulatory capital ratios.1 Rather, the Basel proposal provides for permanent, partial loss absorption, which is not the case with temporary write-down bonds.
— Call Option Enhanced Reversible Convertibles (COERCs) So far this is nothing more than a theoretical proposition describing a bond that is automatically converted when a pre-determined trigger is met. The conversion rate is below the price that triggers conversion and the bonds feature a buy-back option for existing shareholders, i.e. a kind of subscription right. To what extent instruments of this kind are fit for purpose is an open issue. Nor is their regulatory recognition clear.2
In view of their features, CoCos (in the narrower sense) are attracting a great deal of attention in the current debate on
recognition as regulatory capital. In the following we examine what is behind them and just how promising the new type of bond is.
Contingent Convertible Bonds
Contingent convertible bonds (CoCos) are long-term subordinated debt securities with a fixed coupon rate that can be converted automatically from debt into equity when certain predetermined triggers are met, turning what were previously providers of debt capital into shareholders. Given that these hybrid bonds can be converted into liable capital as required, they have the ability to improve the issuer‘s capital resources under adverse circumstances
1
The recognition of temporary write-down bonds in earnings should be adjusted and could be justified with the prudential filter mechanism. Prudential filters ensure that funds recognised as regulatory capital serve the purpose of acting as a risk buffer even when banks base calculation of their consolidated own funds on IFRS. 2
and to absorb losses. If the conversion trigger is not met CoCos are simply ―normal‖ bonds that are redeemed at maturity.
The recapitalisation achieved takes place on the capital market and thus through the private sector. Upon conversion the banking institution immediately receives fresh equity, while at the same time reducing its interest payment obligations. It is important here to differentiate between liquidity and capital: Although CoCos do not introduce any fresh cash into the company they transform a debt instrument into new common stock, enabling better absorption of (future) losses. Converting CoCos is tantamount to an immediate improvement in the quality of the company‘s capital. Conversion is carried out at a time when the bank, although still deemed to be a going concern, is nonetheless prevented by the market situation from strengthening its equity base by issuing new shares. Indirectly, this could also facilitate access to other sources of private sector funding, which would ultimately make government intervention unnecessary or at least less likely.
From the point of view of financial stability, CoCos have the further advantage that, unlike shares, they do not profit from the earnings potential of high risk. And since the risk premium for CoCos is likely to increase with a bank‘s risk, the convertibles could also have a disciplining effect.
The conditions at which a CoCo is converted comprise the conversion ratio and the price and time at which conversion takes place. They are laid down in the bond terms. The specific features are determined by the individual credit institution.
Conventional convertible bonds are related to CoCos, but with the difference that the traditional version does not convert automatically. As a rule the conversion right and option rest with the investor (see table for a comparison of the different convertible bond types).
Different types of convertible bonds
Conventional convertible bonds
A fixed income security that grants the holder the right to exchange the bond for common stock of the issuing company during a conversion period at a pre-determined ratio.
Exchangeable bonds A bond granting the investor the right to convert the debt at any time into a fixed, given number of shares. In contrast to the convertible bond, the issuer of an exchangeable bond is not the company that issues the underlying stock but typically a (principal) shareholder.
Mandatory convertible bonds A version of the conventional convertible bond in which the investors‘ rights are restricted. Whereas investors in conventional convertible bonds have the option until maturity of the debt to convert into stock or not, mandatory convertibles feature an obligation to exchange for the underlying common stock before or on maturity. Consequently the risk of yield losses in the event of falling share prices is greater with mandatory convertibles. The requirement to convert, which takes place through the issue of new shares, means that mandatory conversion constitutes an indirect capital increase with the attendant dilution effect for existing shareholders.
Contingent convertibles (CoCos)
Convertible bonds that convert automatically into common stock at a predetermined ratio during their maturity when a pre-arranged trigger is met.
Bonds with warrants In addition to the customary legal claims (entitlement to the payment of a coupon and to redemption of the bonds), warrant bonds also carry a warrant conferring a right to subscribe to shares in the issuing company. As with issues of mandatory convertibles and (non-)contingent convertible securities, the issue of warrant bonds is also contingent on a conditional capital increase. But in contrast to conventional bonds, warrants may be detached from the bonds with which they are issued and traded separately.
Specific design at individual bank level is essential for the marketability of CoCos
The trigger level also decides on the purpose of CoCos
Success depends on the set-up
Basically, for a CoCo structure to establish itself successfully in the market three groups pursuing different interests need to be reconciled. First are the regulators, who must be convinced that the CoCo bond has full loss absorbency in the recovery phase. Second are the shareholders, whose stock is diluted by the automatic capital increase and who are therefore eager to avoid dilution where possible or keep it to a minimum; and third investors, who do not yet really know what to expect or whether they will even be able to hold these instruments. Consequently, both shareholders and investors still have mixed feelings about CoCos. This makes it essential that the individual banking institutions get the individual design of their bond terms just right, difficult as this may be. For even though an established price formation mechanism exists for the two basic elements of CoC os, i.e. subordinated bonds and equity, pricing CoCos themselves presents a real challenge.
The choice of conversion trigger and the terms on which a CoCo bond is converted are the crux in any discussion on the practicability of these bonds. There is no single one-size-fits-all structure for designing their features. A decision must always be tailored to the individual company‘s situation.
Choosing the trigger: when to convert?
The trigger denotes the event that sets off conversion. Meeting the trigger is thus the key criterion for automatic conversion to stock. But it is precisely in determination of this trigger that the difficulty lies. The complex structure of CoCos may provoke information
asymmetry between the issuing bank and investors. For this reason the trigger should be as simple, transparent and easy to understand as possible. Also important is the trigger level, because this
determines how ―soon‖ conversion occurs. Basically, a distinction can be made between high and low conversion triggers.3 A high trigger (such as falling below a core capital ratio of 7%) means that the bonds can be converted relatively quickly when a bank suffers losses. Already, contingent capital with a high trigger – and hence CoCos too – have a positive impact with rating agencies and on ICAAP stress tests. On the other hand, a low trigger (e.g. falling below a 5% core capital ratio) would result in conversion taking place only in an ―emergency‖; in that case CoCos would act as insurance against hard times. This kind of instrument would appeal more to institutional investors as it clearly targets exceptional crisis situations and is thus easier to assess.
The trigger level can therefore also be used to help fine-tune the purpose of CoCos: are these convertibles intended more as catastrophe bonds providing capital insurance in systemic crises (low trigger) or as a ―continuous‖ pre-emptive buffer in hard times (high trigger)? There is another factor, too: the higher the trigger, the more expensive the CoCo because from the investor‘s point of view a higher trigger implies a greater conversion risk. Market interest rates rise with the conversion risk. A low trigger, by contrast, would have the merit of making conversion less likely, and the risk premium for CoCos would therefore presumably be lower.
3 In this context a high trigger means that the threshold on which conversion is contingent is reached relatively quickly, i.e. comparatively little needs to happen before conversion becomes necessary. With a low trigger precisely the reverse applies, with conversion not taking place until relatively late.
Leaving the decision on conversion to regulators introduces uncertainty into the default probability
Triggers could be based on:
— book values / balance sheet values; — risk-weighted assets / capital ratios; — market prices / share prices.
Then there is also the possibility of combining different triggers. One example is a dual trigger that must satisfy two conditions at the same time, e.g. the institution‘s share price and an industry-wide index. With a dual trigger, conversion would take place if the bank‘s share price dropped below a certain level and simultaneously a broad, bank-based index, for example, fell short of the pre-set trigger. Essentially this dual trigger permits the recapitalisation of all issuing banks during a crisis whilst also allowing individual financial institutions to go bankrupt in ―normal‖ periods. Whether a trigger linked to an industry-wide index makes sense for CoCos is questionable in the context of the current debate since triggers of this kind do not seem crucial to systemic stability. Indeed, it is far more likely that even a trigger specific to an individual bank would lead to all banks distressed by a crisis having to convert. What is more, since CoCos are an institution-specific instrument the decision to convert should also be taken individually.
In addition to triggers geared to a company‘s value or to the market, it would also be possible to place the decision on conversion in the hands of regulators. However, that harbours the danger for investors of adding an element that is very difficult to assess to their analysis of the probability of conversion risks materialising. It would
complicate assessment of precisely these conversion risks and create additional volatility in the bond markets.4
Trigger: simple and transparent
So which trigger is best suited to supporting the optimal functionality of CoCos? Basically, the choice is between triggers based on market values with the attendant downside that these are subject to stochastic processes, and triggers based on balance sheet ratios entailing the disadvantages of potential manipulation.
Whilst balance sheet ratios relate directly to the state of the company, as a rule they are reported only quarterly rather than on an on-going basis. Since this means that the firm‘s financial situation becomes apparent only every three months, the trigger is likewise updated quarterly. A special audit would be possible at any time, but it would have to be conducted very quickly and independently. Another crucial disadvantage of balance sheet figures is that they always depend on the underlying accounting methods, which may be exposed to political pressure and subject to arbitrage.5 A trigger based on book values thus always depends on the availability and quality of the balance sheet information.
Another possibility would be to use the risk-weighted equity or capital ratios. Again, risk-weighted assets are determined only at the end of each quarter, but here too a special audit would always be possible. This method would have the added advantage of making conversion a more risk-appropriate event.
A third possibility would be to use market prices, e.g. in the form of share prices. Bearing in mind that triggers should be as simple and transparent as possible, share prices would have the edge
inasmuch as they can be followed and monitored regularly by
4
The US Shadow Financial Regulatory Committee (SFRC). 5
The danger with share price manipulation lies in the artificial generation of conversions
Share price volatility can negatively impact a market-based trigger
investors as well as by the bank. The use of share prices also means that recapitalisation is an event in conformity with the market and not dependent on regulatory assessments. The downside, however, is that share prices are subject to stock market volatility. What is more, it would be possible to influence the conversion trigger through stock price manipulation.6
Possibilities to manipulate share prices could create incentives to profit from the price movements generated by manipulation.7 This could be attractive for investors wishing to mount attacks on companies, for instance. They could try to provoke an ‗artificial‘ conversion with the aim of profiting from the resultant dilution of the share capital. If traders hold positions in market-triggered CoCos in addition to stock positions, an arbitrageur could buy a contingent convertible and short-sell shares in the institution to drive the price down towards the trigger level, whereupon conversion would take place. The arbitrageur would then benefit from the gain on the newly converted shares once the stock recovered to its ‗correct‘ level. However, these manipulation possibilities can be avoided, or at least contained, by setting ex ante the number of shares into which the bond would convert. If the number of shares that investors receive on conversion is fixed in advance it is not ‗worth‘ influencing prices in order to provoke conversion artificially.8,9
As regards stock price volatility, the trigger could be negatively affected if stock prices behave irrationally or collapse unexpectedly for reasons unrelated to the situation of the company – as happened with the May 2010 ―flash crash‖. In that instance, extreme stock volatility might have led to the conversion of market-triggered CoCos even though no crisis or deterioration in the market situation had arisen.
Weighing the pros and cons described above, triggers based on risk-weighted equity or on capital ratios would appear to be the most suitable.
Setting the conversion rate: how to convert?
The conversion rate stipulated in the bond terms determines the value and number of shares that investors receive for a correspond-ing amount of bonds followcorrespond-ing conversion.
As with the trigger level, the value of the conversion rate can also decide on the purpose of CoCos: For example, a conversion rate below the nominal value of the bonds can help reduce the possibility of manipulation, particularly if a market-based trigger is used.10 Conversely, a conversion rate above par value could hold out a greater incentive to the issuing bank to avoid conversion by taking timely corrective action, as conversion would seriously dilute the stock and upset the previous investors.11 Another important positive
6 An added drawback is that no stock market quotations are available for non-listed banks.
7
Bank of Japan Working Paper (2010). 8
The alternative would be conversion at a fixed sum of money. This would result in a flexible number of shares, determined on conversion with reference to the aforementioned cash sum. That might offer investors an incentive to drive down the price in order to receive a larger quantity of stock in return for the same (fixed) amount. Setting the quantity also corresponds to customary practice with (previous) convertible bonds.
9
McDonald 2010, p.7.
10 A lower conversion rate limits the inherent danger of share price manipulation at least partly since conversion of the CoCos takes place in such a way that it is not worth bringing it about ―artificially‖.
11
Conversion advisable at par value at least
Potential and rationale for issuing CoCos to employees
Rationale: In the course of discussion on the difficulty of finding buyers for CoCos, attention is increasingly focusing on banks‘ staff as potential ―investors‖, the idea being to issue CoCos to employees as part of their variable compensation. From a regulatory point of view this would have the added positive side-effect of coaxing staff incentive structures in the desired direction since it would be in the employees‘ interests to act with a sense of risk awareness in the medium to long term as well, in order to avoid conversion of the bonds. The theoretical background for this is the principal-agent-theory: the incentives to the risk takers in the bank are aligned with those of the bond creditors – and not with those of the shareholders, i.e. the stability of the bank rather than its (short-term) profitability determines the amount of compensation.
Potential: Whilst the proportion of staff entitled to receive CoCos as part of their variable compensation would probably account for a fraction of the potential CoCo market, overall it would be too small to represent large market shares. Depending on the scenario, the variable compensation could absorb roughly 10-25% of the potential CoCo market. Problems could also arise with the practical implementation of assigning CoCos to employees as part of their variable pay packages: Were compensation to revert to the bank as the result of an employee (who would in this case also be an investor) departing the company prematurely as a ―bad leaver‖ (and consequently also exiting the investment), the bank would have to consolidate the trust and take the CoCos onto its balance sheet. The consequence would be a withdrawal from the regulatory capital towards which the CoCos would previously have at least partially counted.
effect of a higher conversion rate would be to increase the attraction for investors – which could ultimately result in a lower risk premium. Conversion at least at par value would therefore be advisable both from the banks‘ point of view and from a regulatory perspective. Maturities
Besides the conversion rate and trigger, maturities also have to be set for CoCos. These should accommodate the different investor groups and their interests. According to the IIF, the most important groups of investors expect maturities of between three and seven years. However, CoCos could conceivably also become part of a long-range financing structure with maturities of at least 30 years, for example.12 The Credit Suisse CoCo bonds successfully placed in February 2011 featured a 30-year maturity. But it must be borne in mind that such long maturities also imply a correspondingly long commitment on the part of investors. At all events, it should be possible in principle for a company to issue different CoCos with different maturities and triggers.
Investor interest: An element of
uncertainty
Finding sufficient customers prepared to hold CoCos remains the biggest problem. Institutional investors such as investment funds, insurers, pension and provident funds, and other fixed income investors or banks spring to mind as traditional bond purchasers. At present, however, the way the instruments are designed is still deterring these types of bond investor, not least because it is not yet clear how the bonds will be treated for accounting purposes. If CoCos had to be reported in future as shares (instead of as bonds) many previous bond investors would be prevented by their
investment guidelines from purchasing them. Fixed income investors in particular would have problems holding CoCos once they were converted. And many institutional investors have been barred thus far by their guidelines from including mandatory convertible bonds in their portfolios. One instance is funds specialising in subordinated debt – hitherto the main clientele for bonds. Their investment guidelines explicitly do not provide for commitments in convertible instruments.
And in future insurers are likely to rethink their investments in bonds anyway, especially in the context of Solvency II requirements, with the new rules making it more difficult and expensive for them to invest in instruments such as CoCos, lower Tier II bonds or senior bank bonds.13
Ultimately, though, participation by traditional bond investors, most importantly investors in fixed income, will be vital to create a
sufficiently large potential market for CoCos to tap. Another decisive factor will be whether traditional bond investors with a low to
medium appetite for risk, such as pension funds for instance, will be prepared to venture into riskier territory with CoCos.
12
von Furstenberg (2011), for one, is in favour of such long maturities. 13
Under Solvency II insurers must hold more capital than previously against stock and bond investments, particularly against shares and corporate bonds.
New target groups with higher risk/return profile, such as hedge funds, will emerge
To be included in bond indices, CoCos must be rated
Alongside traditional bond investors, some of whom may not be in a position to hold CoCos, new target groups with a higher risk/return profile than investors in previous hybrids are also likely to emerge as potential buyers of CoCos. These include hedge funds or high-net-worth individuals utilising CoCos to diversify their portfolios, and similarly the expanding market for responsible investments.
All told therefore, CoCos have three potential customer groups: traditional bond investors, hedge funds / high-net-worth individuals and the banks‘ staff. This could give rise to an investor base that would also permit the placement of CoCos on a larger scale. That said, initially CoCos will not be able to tap the previous bond market to the extent previously customary for subordinated bonds.
Rating agencies & bond indices: impact on marketability For fixed income investors in particular, their ability to invest depends partly on whether CoCos can be included in debt security indices. But since contingent convertibles also contain equity-like features, the jury is still out on whether they are admissible for inclusion as debt securities in the leading bond indices. Until clarification, index-based financial products are likewise still excluded.
Normally, eligibility for inclusion in bond indices is contingent on a rating. The way that rating agencies treat CoCos is therefore an important factor in marketability of the instruments. Difficulties could arise with calculation of the conversion probability, changes in this, and the issue of the extent to which these changes depend on adjustments in the issuers‘ ratings.14
Particularly for institutional investors – traditionally the main target group for fixed income bonds – rating is essential as they are (so far) permitted only to hold rated securities.15 Ratings could thus help improve the market eligibility of CoCos for potential investors.
In principle altered risk constellations for CoCos make lower ratings likely relative to conventional bank bonds. In late 2010 the ratings agency Fitch announced that its ratings on hybrid capital securities issued by banks in compliance with the proposals by the Basel Committee would be notched from its existing unsupported Issuer Default Rating (IDR) regime.16 As a guideline Fitch quoted a
14
von Furstenberg (2011), p. 13.
15 At present there is a regulatory drive to improve the role of ratings. 16
The reason given was that capitalisation at the security loss or at capital conversion is tantamount to a default, even if there is no de facto default. The criterion applied: ―Rating Hybrid Securities‖, December 29, 2009.
Debt capital Corporate bond Hybrid capital Hybrid bond Equity Share
Risk / margin of fluctuation Yield expectation Inspector perspective Company perspective
Return and risk of corporate financing instruments
downgrading by at least three notches on the IDR, (Fitch, November 8, 2010).17
Theoretical approaches: impact on marketability
A theoretical possibility to increase investors‘ interest in CoCos and make it easier to place these instruments in the market would be to set up special purpose vehicles that would take over the shares after conversion.
Similar, in the sense that creditors of the original bonds would hold the bonds but not the converted instruments, is the proposal to have CoCos feature a buy-back option from the outset.18 The option to buy back the converted shares from the previous bondholders at the conversion price would create a kind of subscription right for existing shareholders. From the shareholders‘ point of view this implicit call option can ―reverse‖ the dilution effect caused by conversion of the bonds into stock and possible welfare transfers are neutralised. It would have the positive side-effect of also reducing the risk for providers of external funds. This risk reduction would make the instruments more tradable, improve their market eligibility for fixed income investors, and lower risk premiums. As a necessary incentive for existing shareholders to exercise the call option, however, the conversion price would have to be well below the share price that activates the trigger. This incentive is given for at least as long as the share price including all dilution effects is higher than or equal to the conversion price, because non-repayment would then lead to massive dilution for the existing shareholders and to a welfare transfer from the shareholders to the providers of debt capital.
But it is questionable just how realistic the implementation of such a buy-back option is, because the existing shareholders‘ interest in buying the converted debt, and their willingness to do so, depends to a very large extent on how liquid and inclined to invest they are at the time of conversion; most importantly, the existing shareholders themselves could also be affected by the crisis. As a general rule, the incentive structure underpinning the above reasoning will pre-sumably apply only to financially strong institutions whose share-holders assume that the faltering financial situation at the time of conversion will ultimately see a return to profitability. Shareholders of financially weaker banks, on the other hand, may lack the incentive to acquire (more) shares at a time when the company‘s situation is deteriorating.
Underlying national law: restriction on marketability
Another factor, aside from investor interest, that may restrict CoCos‘ marketability is the possibility of constraints resulting from relevant national legislation. In Germany, for instance, national legislative framework conditions could restrict the issuance of CoCos since the German Joint Stock Corporation Act (AktG) limits stock issues ex-rights – which would be the case with CoCos – to a maximum of 10 percent of the share capital. Moreover, the AktG makes it
compulsory to grant investors an option.19 It is therefore vital to
17
By way of illustration, Fitch assigned a BBB+ rating to the CoCos issued in February 2011 by Credit Suisse, four notches below Credit Suisse‘s IDR. 18
Pennacchi et al. (2010).
19 With CoCos the option could be made feasible by integrating an out-of-the-money call option, for example, in which the price of the underlying security (in this case the CoCo) is below the strike price – in other words, the price at which the underlying security can be purchased.
CoCo scenarios to help estimate the size of the market Taking the first steps
— November 2009: The Lloyds Banking Group floated Enhanced Capital Notes (ECNs) in exchange for existing hybrid bonds. The ECNs convert if the core capital ratio drops below 5%. The conversion rate was set ex ante based on the observed share price. The ECNs have the same priorities as conventional supplementary Tier II capital and maturities of between 10 and 15 years. The premium on the hybrid bond coupon is between 1.5% and 2.5%. When assessing this markup, however, it must be remembered that at the time of the issue Lloyds was partly nationalised and therefore not permitted to redeem any bonds or pay interest. In these
circumstances the swap for ECNs offered a key advantage in that ECNs carried a higher coupon and, once converted into ordinary shares, could be sold and turned into cash. It is not therefore clear how representative the coupon offered is. — March 2010: The Dutch Rabobank issued
Senior Contingent Notes (SCN). This type of bond makes allowance for the problematic feature of CoCos, which by definition have only downside and no upside potential. Unlike the Lloyds exchange, Rabobank‘s SCN are a new issue. Their core characteristic is that if Rabobank‘s equity ratio falls below 7% before the notes mature the par amount and unpaid coupons will be written down by 25% and the investors paid off in cash. However, the SCN are not covered by the Basel proposals and do not therefore count towards regulatory capital. The coupon was set at 6.875% and demand was twice as high as planned. These SCNs are an exceptional case inasmuch as Rabobank is the only bank with AAA rating, meaning that investors‘ appetite for its debt is likely to be correspondingly higher than for other banks.
— A different type of bond featuring upside potential in its reimbursement structure is the step-down, step-up bond. The idea behind it is similar to the SCN and has been used by Barclays, among others. Investors accept a haircut of as much as 30% if the bank‘s core capital ratio falls below 7%. If the bank‘s performance improves such that it is able to pay a dividend again, a higher coupon rate is possible. In September 2010 Intesa SanPaolo floated a bond with similar features. But in the present environment this bond would not qualify as regulatory capital either, since the Basel proposal stipulates permanent partial assumption of losses, which is not the case with step-down, step-up bonds.
Sources: Reuters, Bank of Japan
observe the relevant corporate legislative framework when implementing regulatory reforms into national law.
CoCo scenarios in Europe
Going forward, the mandatory convertible bond format could gain ground as the hybrid capital utilised so far is no longer recognised for regulatory purposes on the customary scale. In the long run CoCos could replace the previous hybrid bonds. In the following we therefore examine scenarios for the potential size of the CoCo bond market. The intention is to get a feeling for roughly how large the market could become, making it easier to assess the investor demand needed.
Switzerland offers an example that could be used for this purpose. There, a progressive capital component equivalent to 6% of the risk-weighted assets has been set as an additional capital buffer, consisting entirely of CoCos with a relatively low trigger. The construction thus constitutes a basic insurance against hard times. Further components of the Swiss capital requirements are a non-risk-weighted leverage ratio and a loss-absorbing capital buffer of 8.5%. 5.5 percentage points of the 8.5% must be made available from hard equity and up to a maximum of 3 percentage points may consist of CoCos with a relatively high trigger. The systemically important Swiss banks would thus each be faced with having to assemble a share of up to 9% of their risk-weighted assets by issuing CoCos to strengthen their equity base.
Since Switzerland is something of an exception owing to the size of its banking sector relative to GDP20, in the model for Europe as a whole it would seem plausible to factor in a maximum ratio of 6% of risk-weighted assets (RWA). CoCos could then gradually make up a part of this buffer. The scenarios considered in the following are based on the following assumptions:
— the calculations are based on the RWA forecasts taking Basel III into account;
— the 25 biggest banks in Europe must hold up to 6% of RWA in addition to the new Basel III capital rules;
— depending on the scenario, the share of CoCos in the additional buffer equals 1.5, 3, 4.5 or 6 percentage points of the RWA; — CoCos pay interest of 9%.
On the basis of these assumptions the CoCo market could ultimately grow to between EUR 138 bn (1.5% scenario) and EUR 550 bn (6% scenario).21 By way of comparison, the volume of hybrid bonds in the current Tier I capital of the 20 largest banks in Europe amounts to roughly EUR 150 bn. In this light, the more conservative estimates of the potential CoCo market (1.5% and 3% scenario) do not appear implausible. This does, however,
presuppose that investors will take up CoCos as readily as they have so far hybrid bonds.
The first CoCo-like bonds have met with quite a good market reception so far (see sidebar). Just how indicative these issues are of the market as a whole is, however, open to question. One of the banks involved, Lloyds from the UK, was partly nationalised at the time of issue, as a result of which it was not allowed to redeem
20
The total assets of the two big banks UBS and Credit Suisse add up to a multiple of Swiss GDP.
21
Cost of equity capital vs. debt capital As a rule the cost of debt is less than the cost of equity. One reason for this is the tax bene-fits with interest payments, which can act as a powerful incentive to issue debt securities rather than equity.
In Germany, for example, tax advantages result because corporations can claim their interest payments on debt capital as operating expenses. Unlike dividend payments, interest payments are not liable to corporation tax. Issuing debt capital thus avoids one of the two taxes that would be due when granting equity. This effect is at least beneficial in cases where interest and dividends are subject to the same rate of income tax for the shareholder. The same principle would be applied to CoCos, but only if they were treated as debt capital for tax purposes.
subordinated debt or pay interest.22 The other example refers to Rabobank, one of the ―best-rated‖ banks in Europe, meaning that the underlying terms of the issue cannot be considered
representative.
Successful CoCo placement by Credit Suisse in February 2011
Credit Suisse‘s placement of CoCos in February 2011 shed some light on the situation. Under the new Swiss capital regulations (see above) CoCos were placed in the market in a comparable way for the first time, as opposed to previous issues of bonds similar in nature to CoCos. The CoCos featured a 30-year maturity, a coupon of 7.875% and a trigger deemed to have been met if the core capital ratio drops below 7%. Conversion may also be made if the national supervisory authority is of the opinion that the bank would reach the point of non-viability without such a swap. Fitch assigned the instruments a BBB+ rating.
The successful Credit Suisse placement signals that CoCos do realistically have the potential to be taken up by the market at an acceptable price. Even so, it must be borne in mind that Credit Suisse also benefited from having at its disposal strategic investors and a network of high-net-worth individuals to whom it could sell the CoCos. This leaves open the question of whether sufficient – also traditional – bond investors would be available for the placement of a substantial volume of such debt on acceptable terms for the banks.
Factors impacting on pricing
If CoCos, like subordinated bonds so far, are to be used to
strengthen regulatory capital, it is relevant from a bank‘s perspective whether they are more cost-efficient than equity. So basically the cost of equity capital to the bank can be taken as the upper limit on the cost of CoCos. Since contingent convertibles convert
automatically once the trigger is met and investors thus bear the risk of becoming shareholders at an inconvenient time, it may be
assumed that CoCos will generally carry a higher coupon than traditional bank bonds. From an investor perspective, on the other
22 At the time of issue, ―in return‖ for government aid being granted to the banks the European Commission demanded the suspension of payment on coupons and other discretionary payments on subordinated bonds and a waiver on exercising call options on hybrid capital within a two-year period. By exchanging subordinated bonds for CoCos that promised a fixed remaining maturity and the payment of coupons it was thus possible to ―get round‖ the European Commission‘s restrictions. Von Furstenberg (2011), p. 11ff.
1 2 3 4 5 J a n / 0 5 J u l/ 0 5 J a n / 0 6 J u l/ 0 6 J a n / 0 7 J u l/ 0 7 J a n / 0 8 J u l/ 0 8 J a n / 0 9 J u l/ 0 9 J a n / 1 0 J u l/ 1 0
over 3 up to and including 4 years over 4 up to and including 5 years over 5 up to and including 6 years over 6 up to and including 7 years
Interest rates head sharply south
Current yields on German bearer debt securities in %
Source: Deutsche Bundesbank 3
138
275
413
550
1.5% 3.0% 4.5% 6.0%
CoCos CoCos CoCos CoCos
CoCo scenarios in Europe
EUR bn
hand, the crux lies in the risk/return constellation. Whilst the
relatively high risk premium demanded by the market for CoCos will make the bonds an attractive option for investors, especially in the present comparatively low interest rate environment (see chart 3), issuing these instruments will be relatively expensive and thus unattractive for the banks – particularly those that view their own financial future optimistically. The higher the CoCo coupon the market requires, the closer the costs will approach those for additional equity, in which case CoCos might not then be financially worthwhile for their issuers.
With the placement of CoCos, and hence the likelihood of their being successful and fit for purpose, depending on the issuer‘s individual situation and capital structure, pricing must take different factors into account – the most central being the coupon rate.
Detailed results of the CoCo scenarios
EUR m*
RWA RWA forecast CoCos CoCos CoCos CoCos
End-2010 under Basel III rules 1.5% 3.0% 4.5% 6.0%
France BNP Paribas 601,000 685,483 10,282 20,564 30,847 41,129 Société Generale 334,800 369,527 5,543 11,086 16,629 22,172 Credit Agricole 371,700 441,700 6,626 13,251 19,877 26,502 Natixis 148,000 181,900 2,729 5,457 8,186 10,914 Germany Deutsche Bank 346,000 529,000 7,935 15,870 23,805 31,740 Commerzbank 268,000 279,017 4,185 8,371 12,556 16,741 Italy Intesa SanPaolo 354,970 365,570 5,484 10,967 16,451 21,934 Unicredit 453,478 492,426 7,386 14,773 22,159 29,546 Nordic countries DnB NOR 117,037 140,140 2,102 4,204 6,306 8,408 Danske 113,293 120,512 1,808 3,615 5,423 7,231 Nordea 214,760 236,240 3,544 7,087 10,631 14,174 Sv. Handelsbanken 59,174 78,285 1,174 2,349 3,523 4,697 SEB 79,633 82,758 1,241 2,483 3,724 4,966 Spain BBVA 313,327 378,942 5,684 11,368 17,052 22,737 Banco Santander 604,885 699,005 10,485 20,970 31,455 41,940 Switzerland Credit Suisse 173,474 261,756 3,926 7,853 11,779 15,705 UBS 157,748 265,722 3,986 7,972 11,957 15,943 UK Barclays 468,526 645,106 9,677 19,353 29,030 38,706 HSBC 840,155 1,018,393 15,276 30,552 45,828 61,104 Lloyds 478,381 484,121 7,262 14,524 21,785 29,047 RBS 544,573 648,166 9,722 19,445 29,167 38,890 Standard Chartered 135,202 162,434 2,437 4,873 7,310 9,746 Benelux ING 321,103 332,101 4,982 9,963 14,945 19,926 Dexia 140,834 122,858 1,843 3,686 5,529 7,371 KBC Group 132,000 151,000 2,265 4,530 6,795 9,060 7,772,052 9,172,162 137,582 275,165 412,748 550,330
* For national currencies other than EUR, exchange rate = 2010 average. Source: OANDA
All regulatory initiatives so far include intervention by supervisory authorities
One of the most important determinants of the coupon rate is the trigger point and the conversion risk associated with it. The higher the conversion risk, the higher the risk premium. In turn, the conversion risk is influenced by the following factors:
— The institution’s business model and the attendant volatility in its earnings: The higher the volatility, the greater the conversion probability and, by corollary, the higher the risk premium on the CoCos.
— The Tier I capital: The lower the Tier I capital, the more likely conversion is to occur and consequently the higher the risk premium on the CoCos.
At present many European banks do not yet appear to have formed sufficient core capital to provide CoCo investors with a sufficiently comfortable buffer above the trigger level. In other words, banks would first need to build up more core capital to make a CoCo issue economically worthwhile. The situation is compounded by the fact that the eligible (hard) core capital will be reduced significantly due to the more stringent deductions under Basel III than under Basel II.
— The degree of probability that CoCos actually will be converted: The many (new) discretionary intervention rights available to national regulatory authorities, which can step in very early on (e.g. if the regulator considers certain business models too risky), could ultimately make it very unlikely that CoCos will be utilised at all. Instead, CoCos would be a ―theoretical‖ construction, i.e. the more convincing the supervisory prevention, the more unlikely conversion becomes and the lower the risk premium on the CoCos.
Pricing could also lead to spin-off effects on further areas of funding costs. For instance, the successful placement of CoCos could have positive implications for the costs of senior debt. The reduced probability of insolvency resulting from the use of contingent convertibles would also lessen the risk of default – with the upshot of lower rates of interest on senior debt.
Coupons of 8% to 9% expected
It is not yet clear how high the risk premium required by the market for CoCos will ultimately be, and it will differ from bank to bank. At present it is assumed that CoCos will pay coupons of between 8% and 9%.
Regulatory approach: bail-ins
In response to the recent financial crisis, in recent months we have seen the emergence of the first concrete regulatory initiatives addressing alterations in lender liability. So far the initiatives all contain a regulatory approach involving ‗bail-ins‘, with (national) supervisory authorities intervening in emergencies to rope bond-holders into waiving claims. In a bail-in a company is e.g. refinanced through a debt for equity swap.23 These constructions are agree-ments in which claims on a borrower are converted into shares in the company. For the borrower it means a liability is converted into equity, while the lender undertakes to repay part of the debt in exchange. A bail-in could be a last-ditch option to stave off
23
A buffer for the buffer?
If CoCos are made mandatory as part of a capital buffer by the regulator, it is important to know what is to happen after they have been converted. Were it compulsory to hold CoCos as a buffer, the cushion would be ―used up‖ once they had to be converted. Therefore, rules would either have to be established in advance on replenishment of the buffer, specifying the time by which it must be stocked up again after conversion, or the banks would effectively have to hold a buffer for the buffer in order to comply with the (actual) buffer even when conversion had to take place. Which of these two versions is chosen is evidently also of relevance to the size of the (potential) CoCo market.
insolvency, i.e. only after the company has exhausted all business avenues. The long-range objective is to recapitalise the bank so that it can be restructured and/or sold off.
Difference between CoCos and bail-ins
Bail-ins are in line with new intervention rights for financial market regulators, with a supervisory authority deciding on the right time for a haircut that would then affect all bondholders alike. No automatic triggers are used. As a rule bail-ins are implemented in the course of restructuring a company rather than as part of an early rescue package.
CoCos, on the other hand, are a novel type of convertible bond, an innovative financial market product. They feature predetermined, legally set, automatically triggered, observable and transparent conversion terms and conditions, i.e. new bonds on fixed terms are issued ex ante enabling the company to strengthen its capital base ad hoc as the necessity arises. Only the CoCos would be affected in the event of conversion.
Two factors are thus key to differentiation between bail-ins and CoCos: the timing of and responsibility for the measure. CoCos are an independent, ex ante precautionary measure, while bail-ins are subject to a statutory process and constitute an ex post measure. Bail-ins: Current regulatory initiatives
A European Commission Communication (EU COM 2010/579) explores a resolution framework making it possible for the debt of a credit institution in distress to be converted into equity in order to restore the institution‘s equity base and thereby maintain the entity (either temporarily or permanently) as a going concern.
In Germany bank bonds are already subject to new regulations. Where a bank is in imminent danger of failure (and not just once it has de facto already become non-viable), the German Bank Restructuring Act (Bankenrestrukturierungsgesetz) that came into force at the beginning of 2011 permits regulators to make bond-holders share in the institution‘s losses by having them write off claims. The ‗Reorganisation Procedure‘ (Reorganisationsverfahren) permits intervention in creditors‘ rights, e.g. by means of haircuts, and in shareholders‘ rights, e.g. through the conversion of debt into equity.
In January the Basel Committee set the minimum requirements that debt instruments must in future meet in order to count towards Additional Tier I and Tier II capital. These rules supplement the Basel III capital and liquidity requirements finalised in December 2010. The new minimum requirements stipulate that in order still to be recognised as regulatory capital hybrid capital, instruments must share fully in absorbing a bank‘s losses at the point when the institution becomes non-viable. This is to be implemented in the form of a write-off or conversion at the behest of the regulator in the relevant national jurisdiction. As the ―trigger event‖ for this, the Basel Committee takes the point at which the bank would no longer be viable without recourse to the hybrid capital. The Basel Committee‘s timetable provides for the requirements to enter into force at the beginning of 2013. This means that bonds issued on or after January 1, 2013 must satisfy the new criteria in order to count towards regulatory capital. Bonds issued before the appointed date that do not comply with the requirements will be phased out over a
In the medium to long term the market for bank bonds will undergo major structural changes
Two types of CoCo could evolve in the medium to long run
period of ten years in a portfolio approach by disallowing all non-qualifying instruments in ten-percent stages.24
Conclusion: Impact on the bond market
For banks, the bond market will undergo a structural sea change in the coming years. Risks will alter, and with them the risk premiums on the banks‘ subordinated bonds, as the provisions governing default risks have to be adjusted. The new regulatory initiatives will make the previous types of hybrid capital less important. Room could be made for new types of bonds, such as CoCos. In the medium to long term their loss-absorbing capacity would give CoCos the potential to act as a substitute for the hybrid debt that has counted towards the banks‘ regulatory Tier II capital so far. This could give rise to a whole new generation of bank bonds which, in turn, could at least partially be counted towards regulatory Tier I capital. It is not clear at present what form the new-look bondholder liability will ultimately assume. Regulation has an important part to play here: Firstly, it can be seen as the driving force behind the issue, at least partially; and secondly, targeted design of the regulatory framework can help new instruments – such as CoCos, for example – gain market credibility and acceptance.It is right to make subordinated bondholders share the costs of bailing out an institution. And ultimately it is essential that the banks themselves should bear the brunt of relevant moves to stabilise the financial system. It is however open to question whether the right way to achieve this is by letting bank regulators alone decide when a conversion-triggering event has occurred. From the perspective of potential investors, placing the decision on conversion in the hands of a supervisory body rather than leaving it up to market
mechanisms introduces a discretionary element into the probability of default occurrence that is very difficult to assess. This is likely further to complicate the calculation of risk premiums. And the Basel Committee‘s decision to entrust regulators with the conversion right will also hinder the placement of CoCos.
If only bonds that can be converted by order of the regulator count towards regulatory core capital, there will be no CoCos featuring a purely market-based or equity-oriented trigger. Instead, there will be bank bonds that can be converted at any time the regulatory authority deems necessary. This runs counter to the aim of more risk-related bond valuation and can be expected to create un-necessary volatility in the banks‘ funding.
If, on the other hand, scope is given to the creation of CoCos with a market-based or equity-based trigger, over the medium to long term two types of contingent convertibles could evolve to suit investors‘ different interests. One type would be ―going-concern CoCos‖ with a high trigger that kick in early enough to prevent a bank ever
reaching the point at which it can no longer operate as an essentially viable business. CoCos with a high trigger would presumably appeal to investors only if issued by stable banks. The second type would be CoCos with a relatively low trigger that was fairly unlikely to be met. But if the trigger were met, it would mean that the bank had reached a point at which it could no longer engage in normal business, in which case attention would focus on
24
This could conflict with existing EU law, as the amendment to the Capital Requirements Directive (CRD II) that recently came into force contains ten-year grandfathering provisions.
preventing government funds having to be used to bail it out. CoCos with a low trigger could be easier to issue as they would be geared clearly to the default risk and would hence be more calculable. How-ever, this would only be the case if the decision on conversion was a transparent event that did not rest with the regulatory authorities alone. Recent developments on the regulatory firmament do not suggest that this aspect is receiving sufficient attention.
Given the still-prevalent uncertainty at present, all that should be required by law is the issuance of instruments serving to absorb losses. Definition of the terms and conditions should be left up to the issuers themselves, because ultimately CoCos only ever make sense when tailored to the issuers‘ individual situation, capital structure and the national regulatory framework in which they operate.
Selected literature
Flannery, M. (2002). No Pain, No Gain? Effecting Market Discipline via ―Reverse Convertible Debentures‖. Working Paper.
November 2002.
Flannery, M. (2009). Stabilizing Large Financial Institutions with Contingent Capital Certificates. Working Paper. October 2009. IIF Working Group on Definition of Capital (2010). Straw Man
Industry Contingent Capital Considerations. May 2010. Kamada, K. (2010). Understanding Contingent Capital. Bank of
Japan Working Paper Series, No. 10-E-9. October 2010. McDonald, R. L. (2010). Contingent Capital with a Dual Price
Trigger. Working Paper. February 2010.
Pennacchi, G., T. Vermaelen and C.C.P. Wolff (2010). Contingent Capital: The Case for COERCs. Insead Business School Working Paper. August 2010.
Plosser, C. I. (2010). Convertible Securities and Bankruptcy Reforms: Addressing Too Big to Fail and Reducing the Fragility of the Financial System. Conference on the Squam Lake Report: Fixing the Financial System. June 2010.
Sundaresan, S. and Z. Wang (2010). Design of Contingent Capital with a Stock Price Trigger for Mandatory Conversion. Federal Reserve Bank of New York. Staff Report No. 448. May 2010. Squam Lake Working Group on Financial Regulation (2009). An
Expedited Resolution Mechanism for Distressed Financial Firms: Regulatory Hybrid Securities. Working Paper. April 2009. The US Shadow Financial Regulatory Committee (20010). The
Case for a Properly Structured Contingent Capital Requirement. Statement No. 303. December 2010.
von Furstenberg, G. M. (2011). Contingent capital to strengthen the private safety net for financial institutions: Cocos to the rescue? Deutsche Bundesbank Discussion Paper, Series 2. Banking and Financial Studies. No. 01/2011. January 2011.
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