Flipping the capital structure || erutcurts latipac eht gnippilF | FT Alphaville

Flipping the capital structure || erutcurts latipac eht gnippilF

Spotted late on Thursday — one massive change for banks’ capital structures appearing just on the horizon.

The Basel Committee published a 20-page consultative document on loss absorption in capital instruments — something that’s (finally) gaining some serious regulatory attention after the recent financial crisis. Then the tendency was for shareholders to bear the burden of bank losses, while bondholders were bailed-out by the government, with the banks.

This, many regulators thought, was not an equitable thing. Hence, we’ve seen proposals for things like contingent capital (CoCos) — debt that would convert to equity should a certain ‘trigger’ such as a bank’s capitalisation falling below a certain level, be breached — and something that might go someway towards alleviating the bond-equity imbalance.

In the consultation, the Committee is considering requiring all bank capital debt (hybrid, subordinated etc.) convert into equity before any government rescue could take place — the so-called ‘bail-in’ option. In other words, a bank would be declared non-viable, its bonds would be written off, and only then could a state-sponsored bail-out take place.

But this, we think, is the key bit from the document:

A write-off can be viewed as a transfer of wealth from the instrument holder to the common shareholders, as the common shareholders escape the liability and the net assets to which they have a claim grow.

If the Basel Committee carries through with its proposals, it will effectively turn the uncertainty profile of bond and equity investors on its head. Bondholders now get lots of potential downside risk, equity holders get lots of upside.

That’s not exactly what your average debt investor wants, so finding buyers for such securities could be difficult.

It’s worth remembering that previous contingent capital issues — like the seminal Lloyds ECB Exchange offer — were by and large only achieved with a little ‘help’ from regulators. The buyers of Rabobank’s recent hybrid and semi-contingent capital issue — which we described back in March as a litmus test for real demand for CoCos– have yet to be identified.

Here’s Gary Jenkins — of Evolution Securities — with a bond market perspective:

Can’t argue with the idea that lenders should be subject to normal risks of non repayment however uncertainty surrounding the development of a contingent capital market remains, with many questioning whether such instruments sit comfortably under the remit of bond investors. In addition there is the risk / reward concern that contingent capital instruments carry all the upside of bonds, and the downside of equities. Not a great combination. Their exact status was a bone of contention around the time of the Lloyds ECN exchange, with index providers changing their minds on whether they would or would not include them, eventually deciding to leave them out. Rating agencies too seem uncertain as to whether they want to rate them. All-in-all the market is likely to remain fragmented until regulatory certainty returns, clarity on what exactly would result in a trigger event, and in which, if any, indices they would be included. If I can be cynical I would also add that a little bit of certainty about the direction of the economy would help too. In the meantime someone should tell the BIS that there is already a “regulatory capital instrument issued by banks that is capable of absorbing losses” . . . it’s called equity . . .

But at least Basel’s aware of this potential problem.

One of the points of the Committee publishing the consultation is, as the FT notes, to solicit opinions on this very issue.

So if you have them, email to baselcommittee@bis.org and make them known.

Related links:

Casing the capital structure, calling a crisis– FT Alphaville
I should not have CoCo-ed?– FT Alphaville
The perils of fail-safe capital – Business Spectator