CoCo *pops.* Curtains for CoCos. And so on.
Late on Thursday the Basel Committee released its final (and curt) rules on loss-absorbing bank capital, including the mandate that all Tier 1 and Tier 2 instruments are able either to be written off or converted into equity at the behest of regulators.
What, however, do the Basel rules mean for CoCos? Remember, CoCos (contingent convertibles) are a form of debt that was designed specifically to convert into equity once a certain ‘trigger’ was breached. It’s now not looking very special at all.
So we’re seeing people like Gary Jenkins, over at Evolution Securities, say the final rules have effectively killed-off the CoCo dream. Here’s his reasoning:
First of all there were reports that the Basel Committee will require the countercyclical buffer (0-2.5%) to be comprised solely of common equity, having previously indicated that the buffer over the 4.5% minimum capital requirement could be made up of common equity or loss absorbing capital depending on national circumstances.
Then the Basel Committee issued a press release detailing the criteria required for debt securities to be considered fully loss absorbing capital, the document upon which the future of the contingent capital (Coco) asset class is to be based. To satisfy the necessary criteria after the 1st January 2013 (beginning of the phase out period) all instruments are required to have “a provision that requires such instruments, at the option of the relevant authority, to either be written off or converted into common equity upon the occurrence of the trigger event”. The trigger event which is defined as the “earlier of (i) a decision that a write-off, without which the firm would become non-viable, is necessary, as determined by the relevant authority; and (2) the decision to make a public sector injection of capital, or equivalent support, without which the firm would have become non-viable, as determined by the relevant authority.”
Now maybe the individual authorities will decide that as conversion is at their option they should publish a specific trigger point such as a breach of a certain Tier 1 level (for example the Lloyds ECN’s trigger point is 5%). That is what the Swiss did when they announced the so called “Swiss finish” for large companies. If they do not then bond investors are being asked to buy a product that would convert into a product (shares) that many of them cannot hold; that is unlikely to have a rating; that is not eligible for inclusion in the leading bond indices; that have all the upside of bonds with all the downside of equities and could be converted into equities at the whim of the regulator. In an environment where regulatory uncertainty is leading to concerns regarding investing in banks senior debt it is difficult to see how the Coco market is going to grow into a viable market.
Now it might be that I have got this totally wrong and that Coco’s become a major asset class. But just for fun let us pretend that they do not and that even individual regulators who have included trigger points like the Swiss cannot persuade investors to participate in this market. What would that mean for the Swiss banks specifically? Well for Credit Suisse and UBS the authorities have determined that they hold a total of 19% of total capital comprising at least 10% of common equity and up to 9% of Cocos. At the time it was estimated that the 9% of Cocos would equate to some €53bn of issuance. So if they were to stick to 19% and the Coco market does not exist that is a heck of a lot of equity (or retained profit) that needs to be raised between now and the end of 2018*. Now clearly this is all hypothetical and as above, the Swiss have included trigger points but it will be fascinating to see whether or not this market can really develop over the next few years.
And check out this — rather important — footnote:
*The actual document stated “If Coco capital cannot be accumulated to the level envisaged… specific requirements will have to be adjusted …Banks may be required to offset coco capital either by accumulating other capital with an equally effective or better loss – absorbing capacity, or by taking more incisive organisational measures.”
Well. At least there’s only €53bn of that to source!
Update: Worth noting the diametrically-opposed opinions of Jenkins’ colleagues at Evolutions European banks team. They reckon banks will have to use CoCos to replace current Tier 2 subordinate debt, under the Basel rules.
Which means you could see potential CoCo-issuance like this:
Related links:
Basel hardens bank hybrid bond rules - FT
The problem with Europe’s bail-ins – FT Alphaville
Not convinced by CoCos? How about COERCs? – FT Alphaville