If you’re still trying to get your head around how contingent convertible notes — CoCos — might help the banking sector the following will be of interest.
First, consider the below table from Barclays Capital analyst Bruno Duarte:
The table shows the average breakdown of assets/liabilities over time at financial entities in three hypothetical countries: A, B and C.
As Duarte explains: ‘A’ has not really grown its loan book but has a high proportion of its assets invested in securities; ‘B’ has grown its loan book but has done so without increasing wholesale reliance and ‘C’ has grown its loan book with greater reliance on the wholesale market.
So which is the weakest? According to Duarte it’s obviously ‘C’ because the underlying quality of private sector loans and other assets of ‘A’ and ‘B’ will ultimately determine which one is in a better position. However, in today’s conditions the market is obviously more concerned about ‘B’ over ‘A’ .
The thing is, a financial system gets into stress as concerns over solvency lead to liquidity crises. That said, no leading financial player in Europe has yet been declared insolvent from a capital perspective. According to Duarte that means:
…the quality of capital, ie, loss absorbing, remains a more important component than the absolute quantity of capital.
All of which, he says, should make CoCos — which automatically change into equity when certain capital triggers are breached — a genuinely helpful instrument for dealing with all three scenarios:
In our view, CoCo’s could be a novel way to help normalise the differential in T1 leverage between UK banks and their continental peers due to their core capital treatment. Given their automatic convergence to equity capital at a pre-determined rate (most likely at issuance) after crossing a pre-determined trigger (most likely balance sheet/solvency), these instruments could go some way to alleviate future solvency concerns and potentially prevent a future liquidity crunch.
For the scheme to work, though, CoCos would genuinely have to develop into a firm asset class of their own, says Duarte — although there is a good chance that will happen in the current market:
One of the biggest unknowns, however, is whether there will be sufficient investors in these new instruments to make it an asset class of its own. At a time when consultants are pushing for T1 securities to be excluded from indices due to their volatility over the past few quarters, one would have to be extremely sceptical about an instrument with mandatory equity convertible features being allowed into a real money fixed income index.
However, the same could have been said five years ago when the first institutional non-step preference share was issued. At the time, the initial reaction was very apathetic though once a few were printed, other issuers followed and a new asset class subsequently emerged. With risk-free rates having collapsed some 200bp over the past year, current yields on senior and LT2 bullets have halved from 6% to 2.5-3.5%. Not only have fixed income investors been forced to move down the capital structure in an unrelenting hunt for yield, but with uncertainty prevailing in the equity market towards future rights issue and the sector’s longer-term profitability, equity investors have sought subordinated bank debt to obtain higher return for arguably a lower risk.
As to the hypothetical examples, we’ll leave it to readers to guess which three countries they are really based on.
I should not have CoCo-ed? – FT Alphaville
Stability concerns over CoCo bonds – FT
Contingent capital comes to pass, with a little help from the EC – FT Alphaville