To understand Andrew Haldane’s latest — all you have to do is glance at these charts.
One is regulatory bank capital, the other is a market-based signal of bank solvency:
See the change? In the run-up to the financial crisis there was little difference between the Tier 1 ratios of ‘crisis’ banks — those that would eventually be bailed-out by their governments — and banks that would escape without intervention.
But based on market measures — the difference was clear as early as 2006.
According to Haldane, executive director of financial stability for the Bank of England, the solution is clear. He wants regulators to start looking at market-based metrics of bank solvency, and specifically, market-based Contingent Convertible capital.
So instead of all that Basel-esque modelling of Tier 1 capital needs (some 200,000 risk buckets need to be accounted for under Basel II) you’d get much ‘simpler’ CoCos:
Alongside equity, banks would be required to issue a set of contingent convertible instruments – so-called “CoCos”. These instruments have attracted quite a bit of attention recently among academics, policymakers and bankers, though there remains uncertainty about their design.12 In particular, consider CoCos with the following possible design characteristics.
- * Triggers are based on market-based measures of solvency…
- *These triggers are graduated, stretching up banks’ capital structure.
- *On triggering, these claims convert from debt into equity.
The benefits or CoCos according to regulators should be familiar by now — but this market-based tweak by Haldane is slightly different, and could prove controversial.
Mostly since there’s been lingering concern that CoCos in banks capital structures could lead to a bad-tasting speculatively-driven *pop* — or death spiral.
So here’s Haldane’s response:
… Might market-based triggers invite speculative attack by shortsellers? The concern is that CoCo holders may be able to short-sell a bank’s equity to force conversion, then using the proceeds of a CoCo conversion to cover their short position.
There are several practical ways in which the contract design of CoCos could lean against these speculative incentives. Perhaps the simplest would be to base the conversion trigger on a weighted average of equity prices over some prior interval – say, 30 days. That would require short-sellers to fund their short positions for a longer period, at a commensurately greater cost. It would also create uncertainty about whether conversion would indeed occur, given the risk of prices bouncing back and the short-seller suffering a loss. Both would act as a speculative disincentive.
A second potential firewall against speculative attack could come from imposing restrictions on the ability of short-sellers to cover their positions with the proceeds of conversion. Restrictions on naked short-selling are applied around the time of seasoned equity offerings in some jurisdictions. A rule to prevent the covering of short positions with the proceeds of a CoCo conversion could provide a further disincentive to destabilising short-selling of banks’ equity.
We love Haldane – and his restrained evisceration of Basel I and II in this paper is fantastic. But there’s something about a recommendation to fight complex regulatory capital regulation (Basel) with more market regulation (short-selling restrictions) that sits uneasy. Meanwhile it’s totally unclear that modelling CoCos, and their required hedges, will be so simple (we’ve seen analysts make attempts recently).
Nevertheless, one thing is for certain.
Regulators ♥ CoCos. In bonuses. Dividends. Pretty much everywhere.
Related links:
Bank of England official calls to simplify CoCos - FT
This is why Tier 1 is irrelevant – FT Alphaville, 2009