Break out the contingent capital.
Contingent capital is an idea that is gaining some credence. Fed chairman Ben Bernanke mentioned it in a speech late last month. It has also garnered a few mentions in academic texts, notably Squam Lake Group’s report on debt that can be converted to equity in times of financial stress.
On Tuesday, JP Morgan analysts Carla Antunes da Silva and Amit Goel pick up the contingent capital thread, in relation to reports that Royal Bank of Scotland could be looking at the measure as a way to increase its capital (that or a rights issue).
Here’s what they say:
What is contingent capital? — This is a relatively new area that has been mentioned in regulatory papers, but with little detail so far. We believe it relates to the mechanism the regulator uses to determine capital requirements, in particular the Pillar 2 ‘top up’ based on the stress testing of the balance sheet. The idea is to have instruments that convert into common equity in times of stress (historically there have only been instruments that convert into preference shares). This would result in a lower share count in ‘normal’ times, but would provide increased insurance in times of economic stress. It would also go some way to mitigate the pro cyclicality of capital requirements, namely if the stressed scenario does not occur, banks could become over capitalised. Both the FSA and the US treasury have highlighted the desirability of such instruments, but there are several challenges in implementation.
Darn right there are challenges. For a start regulators would have to come up with some sort of convertible capital trigger — one that couldn’t be manipulated or ignored in the bad times. Secondly there’s the potentially thorny issue of getting the market on board. This is what JPM says:
What are the challenges? Several uncertainties surround these instruments including (i) setting appropriate trigger points; (ii) pricing the instruments such that they are attractive to both investors and the issuing institutions; and (iii) market treatment in terms of share count/equity.
We think such securities could be designed, and if afforded favourable regulatory treatment (such as partial recognition prior to trigger) could be issued by the banks. This in our view could make the banks look optically more attractive for a market expecting a benign economic environment, the flipside being that if there is a further downturn, then dilution will be much greater.
In any case, the JPM analysts are intrigued by the possibility:
Conclusions and read across to Lloyds — We can see both options being considered and would see (i) a £4bn rights issue not being a game-changing event for RBS and it could be structured to appear accretive; (ii) we find the concept of contingent capital more interesting, potentially allowing more room for manouevre in terms of restructuring the APS. For both RBS and Lloyds this may be another way to pass the FSA stress tests with reduced reliance on the APS. It does nevertheless add further complexity, especially surrounding the treatment of no. of shares. The outcome still remains highly uncertain and we remain UW on both RBS and Lloyds Banking Group.
Related links:
More capital will not stop next crisis – FT
Tear down this hybrid capital wall – FT Alphaville