As outlined in our criteria, we do not consider contingent capital securities to be a form of common equity. We can include them as hybrid equity depending on their exact features. If the conversion trigger is set at a level that we think would lead to a conversion occurring too late, then we will treat the contingent capital security according to its initial format when considering how much “equity credit” to give to the instrument. For example, if a contingent capital security initially takes the form of a nondeferrable subordinated bond, we would treat it as having “Minimal” equity credit according to our criteria. In this case, we would see the conversion as happening too late to give equity credit in our broad measure of capital–adjusted total equity, which includes hybrid capital securities subject to strict limits.
Oops.
That’s from Standard & Poor’s. The rating agency has on Tuesday issued a special report on Contingent Capital — the newest bit of armour in the arsenal of banking capital, and affectionaly known as `CoCo’ bonds, short for Contingent Convertibles. Lloyds tried to give them the much less interesting name of Enhanced Capital Notes (ECNs) when it announced its £21bn fundraising last week, but FT Alphaville refuses to adopt such an uninspired apellation.
In any case, CoCos made their (modern) debut as part of the Lloyds’ fundraising, but the capital structure has been bandied about by European and US regulators as a possible way of helping banks build their balance sheet strength. The basic idea is that the bonds convert into loss-absorbing equity once a certain trigger is breached — in Lloyds’ case if its core Tier 1 ratio falls below 5 per cent.
But what S&P seems to be hinting at in the above is that CoCos might not convert into capital early enough to help the bank in times of stress and act as a buffer for senior bondholders. Indeed, Lloyds’ issue seems feasible only because the trigger is set low enough that some analysts will think there is a very small probability of it being breached. The European Commission’s imposition of `burden-sharing’ for hybrid bond holders also is a bit of a stick.
Indeed, there’s been the suggestion that CoCos are basically hybrid bonds `take two’. The failings of hybrid bonds — that banks were reluctant to halt coupon payments or refused to use them as if they were loss-absorbing equity in times of market stress — are supposed to be corrected with that non-negotiable trigger.
Only, as the above bit from S&P should suggest the trigger could end up being too low and too late, thus affording the CoCos `minimal’ equity credit.
Instead the rating agency says:
We see contingent capital securities as introducing another potential tool to manage the capital base in times of stress. However, they are not being designed by banks to address the need to repair existing weak balance sheets. They are one potential answer to one capital management question, but many banks will still need to address their capital positions through traditional forms of tangible equity.
Related links:
Stability concerns over CoCo bonds – FT
Contingent capital comes to pass, with a little help from the EC – FT Alphaville
CoCo nuts – The Economist
Equity credit for hybrid securities – Standard & Poor’s