Category / Capital and Contingent Instruments

Accounting for the future March 30, 2011 at 2:28 pm

Deutsche Bank (HT FT Alphaville) have analysed the fraction of bad assets in the Cajas under various definitions of ‘bad’:

Caja NPLs

In the Alphaville article this leads to a discussion of the varying amounts of capital the Cajas might need under different scenarios: €15B, €24B, €30B, even €69B. For me though what is striking is the spread of these numbers. Obviously if you give the Cajas €50B and they turn out only to need €15B, you look like a doofus, while giving them €15B for now and hoping that they don’t need more risks having a rolling banking crisis that plays out over three to five years (see ‘Ireland’).

Note that the use of historic cost accounting means that the Caja are solvent under all the possible scenarios until the loans are actually written down, and we know from the example of Japan that that process can be delayed for many years. In other words, part of the reason we don’t know how much capital we need is that we don’t have a precise definition of solvency. The accounting model these banks have means that, at the moment at least, there are literally tens of billions of euros of uncertainty about their solvency. So much for the much vaunted Spanish model.

Update. The Daily Telegraph, commenting on RBS, highlights the same issue:

According to RBS’s latest accounts, which were calculated using IFRS, the bank has tangible shareholder assets of £58bn and core tier one capital of 10.7pc.

Tim Bush … has calculated that under pre-2005 UK GAAP … RBS would have a tangible shareholder assets of £33bn and a core tier one capital of just 6pc.

IFRS … allows banks to disguise the build-up of risks within banks because distressed loans are not reported until they default.

Now I am not sure that this in itself is sufficient reason to move to fair value for the whole of a bank’s balance sheet – that too can be subjective for illiquid assets – but I certainly think that an objective standard with less uncertainty about whether a bank is or is not solvent would be a good idea.

Covering up the capital structure March 10, 2011 at 8:50 am

FT alphaville earlier in the week pointed out the continuation of a trend we discussed earlier, the increase in the use of covered bonds. Indeed, according to UBS, some Spanish banks in particular are close to their limit for issueing covereds. In other words, all the mortgages that can be used to support covereds, have been.

Now the problem with covered bonds is that they reduce the assets available to senior unsecured creditors in the event of default. If you combine higher covered issuance, then, with the (in my view reasonable) Irish burden sharing, whereby senior unsecured creditors will be on the hook to share some of the costs of a bailout, then the picture for bank senior debt is pretty bleak.

The hard part here is managing the balance between moral hazard and pragmatism. A credit spread is a return for risk, so there should actually be risk. And I don’t just mean liquidity risk. Bank bond holders should actually have capital at risk from default or restructuring (or bail in/resolution) losses. But if we dramatically change both the chances of those losses happening and the size of the loss when it does happen, then bank debt gets a lot more expensive. At a time when bank supervisors want banks to issue more long term debt (see, if you must, the Basel 3 liquidity rules), that might not be the best outcome.

Floored CoCo February 14, 2011 at 8:42 am

From today’s Credit Suisse Coco annoucement (they call them BCNs or buffer capital notes):

The BCNs will be converted into Credit Suisse Group ordinary shares if the Group’s reported Basel III common equity Tier 1 ratio falls below 7%. The conversion price will be the higher of a floor price of USD 20 / CHF 20 per share, subject to customary adjustments, or the daily weighted average sale price of the Group’s ordinary shares over a trading period preceding the notice of conversion.

Interesting: the holder gets at least twenty bucks a share on conversion, regardless of the equity price, yet the notes still qualify as capital. I’m fairly sure the Lloyds and Rabo Cocos did not have a floor – I now need to check…

Resolving a CCP February 9, 2011 at 6:06 am

Trick question of the day: how do you bail out a CCP?

It’s a trick question because the answer, in some jurisdictions at least, is that you can’t. Some CCPs are banks, so they can be resolved using the bank regime. But many aren’t, and often there is no special mechanism for central banks to lend them money. This is partly mitigated by the CCP’s default funds, but nevertheless the problem remains: if a CCP loses enough money to blow through margin and default funds, then they often have rather little equity and no way of getting more.

So what? Well, by analogy with bail in bonds, aka Cocos, should CCPs be forced to issue material (in the context of the losses they might sustain) amounts of convertible debt? These bonds would be subordinated and convertible into equity in the event of a CCP stress event. They would have a number of advantages including enhanced market discipline, a route to non taxpayer funded recapitalisation of CCPs, and enhancing the financial resources of a CCP.

A nice cup of CoCo December 7, 2010 at 9:08 am

The idea of paying bankers’ bonuses in stock or stock options always struck me as odd. After all, equity is a call on the value of the firm after debt has been paid, and you maximise the value of the call by increasing volatility. Stockholders, then, naturally prefer risky high leverage structures – hardly the behaviour you want in a banker. It would make a lot more sense to force the banker to write the bank a put, so that they are incentivised to prevent disaster.

Now, according to Reuters, Barclays might be about to do just that. Specifically they are apparently looking into paying bonuses partly in contingent convertibles:

These securities are bank bonds that turn into equity when things go awry, for instance when losses mount and the bank’s equity capital ratios fall, thereby boosting capital. So, in essence, adding CoCos to the bonus mix would be a novel way for BarCap to force bankers to contribute some of their loot to their employer’s capital cushion, thereby helping to minimize political opprobrium over pay.

OK, this is not quite as good a paying them in reverse convertibles, but it is a good start. Throw in a five year vesting period, clawback provisions for individual malfeasence, and you have the start of something interesting and worthwhile.

Seniority destruction through resolution and covering November 14, 2010 at 6:06 am

The Bond Vigilantes point out that in the new post-Basel III world, bank capital structure may well get a lot simpler:

deposits, covered bonds, senior notes, CoCo’s and equity

The covered bonds will be needed to meet funding requirements, but of course this process removes assets which would otherwise be available to meet senior creditors. As the vigilantes point out, if bank resolution regimes make senior creditors share the pain, then this will have the effect of making bank senior debt a good deal less attractive:

If you imagine a situation (shouldn’t be too hard) where a bank gets into difficulty, its CoCo’s are triggered but still falls into bankruptcy. The equity will be wiped out leaving a senior debt holder not only at the bottom of the pile in a liquidation, but also with a claim over fewer assets than they historically would have had, since most of the mortgages would have been pledged to the covered bond pools.

Epistemic capital November 4, 2010 at 1:03 am

In the old days, we used to say that a firm had enough capital if it could withstand a particular event and still be solvent. Thus we’d say $10B of capital is enough if, on a one year in a hundred event, you’d only lose $9B.

That was a terrible idea. Just being solvent is not enough. The market withdraws funding long before insolvency, typically. So the real safety threshold is being able to roll your funding.

The problem is, this is an epistemic soundness criteria. That is, it depends on others’ beliefs. What we are really saying is that a firm is well capitalised if it can undergo a stressful event and still be able to fund itself – but ‘still be able to fund itself’ means ‘debt buyers believe that it will repay its bonds’. Hence there is an inherent reflexivity in the requirement. That’s not to say that the idea is a bad one, just that we need to understand that capital isn’t really about withstanding losses; it is about maintaining confidence.

The last resort September 29, 2010 at 3:33 am

Last week Reuters reported that

French Economy Minister Christine Lagarde said … that a capital surcharge was not a “panacea” for addressing the risk of systemically important banks, and she favored resolution mechanisms and tighter regulation

In contrast yesterday it reported

Financial Stability Board (FSB) chief Mario Draghi said there had been “unanimous” agreement among regulators on the need to strengthen big banks beyond the levels of the Basel III capital requirements announced this month.

I wonder in passing if this is the American definition of ‘unanimous’ – everyone we care about agrees – or whether the French really have changed their minds. But in any event, I think that Ms. Lagarde has a point: capital is important, but it is not the only defense. Nor, would I respectfully suggest, is it even the most important one. Effective supervision that is mindful of the risks that the firm runs, for instance, is more important; as is that little remembered defence against disaster, firms’ management. Now I suppose you can fix deficiencies in either of these with more capital, but it would take an awful lot more capital, and that really isn’t feasible. In bang for your buck terms, supervising banks properly is much more effective than doubling their tier 1 ratio.

What is a capital standard? September 4, 2010 at 2:16 pm

Let’s imagine a conversation between banker Bob and a regulator Reg.

Reg: OK Bob. You screwed up big in 08. This time, I’m gonna make sure that your bank is safe. Damn safe.

Bob: Very well, Reg, I see your point. But what exactly do you mean by safe?

Reg: I mean that you have enough capital so that you can withstand losses. Any losses your stupidity might lead you to make.

Bob: Any losses?

Reg: Yep.

Bob: What is Godzilla climbs out of the Hudson, walks down 42nd street, and eats our headquarters. At the same time all our assets, including US treasuries, fall to zero, while all of instruments we are short go up. Do we need enough capital for that?

Reg: Well, no, obviously not, that’s stupid.

Bob: Of course – no one uses 42nd street if they can avoid it. 44th would be much faster.

Reg: You’re gonna have to have enough capital to withstand a real crisis.

Bob: What kind of crisis?

Reg: A bad one.

Bob: You will forgive me if I suggest that that is less than specific.

Reg: I know your game. If I say ‘once in a hundred years’, you buy billions of once in a thousand year risk. If I say ‘once in a thousand years’, you take a leveraged position in once in ten thousand year risk. I’m not gonna get caught out like that.

Bob: So I can’t take any risk?

Reg: Well obviously you can take some. Just not too much. And we want you to keep lending to the real economy, of course.

Bob: So ordinary banking – the kind of banking that has been responsible for banks failing for hundreds of years – is fine. But anything else is to be done in moderation. How much of that is too much pray tell?

Reg: Nothing that might make me have to rescue you.

Bob: This conversation is getting a little circular…

What is, and isn’t possible with capital rules August 29, 2010 at 6:23 pm

Yves Smith at Naked Capitalism was kind enough to refer to some remarks I and the Streetwise Professor had made about Basel III. That got me thinking about what you can hope to achieve with any set of rules for internationally active banks.

First, some general points:

  • The Basel II rules are far too complex. I think I finally lost it when I got to the section on early amortisation provisions for ABCP conduits. (Hang on, I said to myself, they know about conduits – a reg cap arb device – and instead of banning them, they write rules to distinguish slightly better from slightly worse ones? You what?) Therefore I’d set an arbitrary limit, 100 pages say, and require the rules to be no longer than this, ever.
  • Basel is meant to be for internationally active banks. Not for hedge funds, not for investment managers, not for corporate finance advisers. The sooner the European Commission picks up on this and implements Basel not, as currently, for tens of thousands of firms, but instead for the twenty or thirty financial institutions with more than $100B of assets in the EU, the better. Everyone else is much less likely to be systemically important, and anyway have different businesses. Write rules that suit these different types of firms: don’t impose rules designed for BofA/Deutsche/HSBC on everyone in the name of the level playing field.
  • Stop fighting the last war. The number of rules or proposed rules that address what happened to AIG is absurd, for instance. You might as well ban all capital markets participants whose names begin with A and have done with it.

Given this, what can we support in Basel III?

  • Capital = net tangible equity. The redefinition of regulatory capital to be based on core tier 1, or something similar, makes sense.
  • Gone Concern Capital. A mechanism which would allow banks to be recapitalised by converting sub debt into equity would also clearly enhance financial stability.
  • Leverage. A backstop leverage ratio provides a useful mechanism to ensure that if risk based capital rules are wrong, the resulting distortions cannot become too large. Personally I would make it inversely proportional to asset size, so the bigger you get, the lower the leverage you are required to have.

These parts of Basel III, then, are reasonable. But beyond that, what can we do with capital, and what can’t we?

  • Capital requirements can make the financial system safer. There is no doubt that better capitalised firms are safer, all things being equal, than less well capitalised ones.
  • However, capital is not the only tool. Indeed, there is a sense in which it is the last tool, in that if you need it, it’s a bit late. Good risk management and plentiful liquidity are vital too – and it is typically a lack of these, rather than a lack of capital, that causes firms to fail.
  • Broadly, risk sensitive capital requirements are bettter. This is so obvious that it hardly needs explaining. However,once you definite a particular notion of risk, there are issues. It may be feared for instance that firms might take risk in ways that are not captured by the notion chosen, or that they might concentrate on that notion at the expense of others. The answer here is not to keep on making capital requirements more complicated until the arbitrages become hard to find, but rather for supervisors to actually understand firms’ risk taking, and to fix any obvious flaws in risk management or in capital via pillar 2.
  • Thus, I wouldn’t write thousands of rules. Instead I would say something like ‘Firms must have sufficient capital to cover the losses which might be expected in a one in a hundred year financial crisis. They must be able to demonstrate that this is so, and the full details of this demonstration must be published on a quarterly basis.’ This, in Krugman’s terminology, would be a greek rather than a roman rule.
  • All of this would mean that there are distortions. Bank A would have more capital for a given activity than Bank B. But that happens already – in part due to the use of internal models. But at least rather than getting false comfort from hundreds of pages of rules, supervisors, investors, counterparties and analysts would know that they had to analyse bank’s risk disclosures and capital calculations carefully.

Tiered gamble June 18, 2010 at 6:57 pm

Bloomberg reports:

HSBC Holdings Plc’s $3.4 billion issue of undated 8 percent notes marks the first sale of debt securities designed to qualify as capital under current and proposed bank regulations.

The bonds count as so-called Tier 1 capital under current rules by permitting HSBC to defer coupons in some circumstances and benefit the bank because it pays interest from pretax earnings, according to the deal’s prospectus. To meet new terms proposed by regulators, HSBC can convert the notes into preference shares that pay dividends from after-tax earnings…

The Basel Committee on Banking Supervision proposed in December phasing out so-called innovative hybrid securities such HSBC’s because they failed to absorb losses during the financial crisis. When the rules change, set for the end of 2012, innovative securities issued after the proposal date won’t qualify as Tier 1 capital.

Close, but no cigar. It is not clear when the grandfathering date will be: it certainly might be earlier than the end of 2012. So this is a ballsy play from HSBC. They are essentially gambling that these notes will count as capital: and they have a par call in Dec 2015 in case they don’t.

Investor demand for this issue was immense: initial guidance was 300 million, so the deal was upsized over ten times. This shows that the lack of recent bank issuance – caused by uncertainty over what will count as capital in Basel 3 – has left investors panting for good quality names. We will surely see other banks issuing similar deals in the coming months. Once it is clear what will count as capital, everyone will be coming to market: the smart players will get ahead of that wave.

Valuation uncertainty and leverage April 13, 2010 at 6:06 am

I like Steve Randy Waldman so I don’t want to cricitise him too much, but I think he makes an error in the following:

On September 10, 2008, Lehman reported 11% “tier one” capital and very conservative “net leverage“. On September 15, 2008, Lehman declared bankruptcy. Despite reported shareholder’s equity of $28.4B just prior to the bankruptcy, the net worth of the holding company in liquidation is estimated to be anywhere from negative $20B to $130B, implying a swing in value of between $50B and $160B. That is shocking. For an industrial firm, one expects liquidation value to be much less than “going concern” value, because fixed capital intended for a particular production process cannot easily be repurposed and has to be taken apart and sold for scrap. But the assets of a financial holding company are business units and financial positions, which can be sold if they are have value. Yes, liquidation hits intangible “franchise” value and reputation, but those assets are mostly excluded from bank balance sheets, and they are certainly excluded from “tier one” capital calculations. The orderly liquidation of a well-capitalized financial holding company ought to yield something close to tangible net worth, which for Lehman would have been about $24B.

What’s wrong? I suspect at least the following:

  • First, the costs of bankruptcy are considerable. The Enron liquidation, for instance, involved fees of more than $600M, and Lehman is a lot more complicated than Enron. Therefore we can chalk up at least a couple of billion to bankruptcy costs, and probably more.
  • In bankruptcy you are a known, forced seller (and terminator of derivatives contracts). The Lehman bankruptcy happened in a crisis – indeed in some ways it caused it. This meant that Lehman’s assets were liquidated under the worst possible conditions. The fact that they were sold for less than their holding value is unsurprising. A 20% discount to sell an illiquid asset in hurry would not be surprising – and Lehman had at least $300B of illiquid assets. So perhaps $60B here.
  • More to the point, while Lehman sailed fairly close to the wind on its valuations, what it did not do – what few firms do – was be honest about the uncertainty in those valuations. If you read the detail of the valuation section of the Valukas report, you will find that a lot of the time, the correct value of assets is simply impossible to determine. What Lehman did was not perhaps conservative, but it was not illegally aggressive according to Valukas. Given Lehman’s assets, a 5% uncertainty in valuation is not surprising. That’s another $15B.

The real point is leverage. If you have (in round numbers) $30B of capital supporting $600B of assets, then $30B of uncertainty in valuation wipes you out. If you were half as leveraged, you could tolerate twice as much uncertainty. No financial will ever be liquidated for anything close to its accounting value, particularly in a crisis. But if firms are less leveraged, then they are more likely to have higher recoveries. Given Lehman’s leverage, going from a going concern value of +$30B to a bankruptcy value of -$50B is not at all surprising.

Pass the Dutchy on the tier 1 hand side? March 9, 2010 at 6:39 pm

Rabobank can’t issue Cocos as, being a complicated cooperative, their equity is not traded, so there is nothing sensible for the Coco to convert into. So they have decided to issue an innovative (Tier 1?) instrument where, if their capital is eroded sufficiently, the investor’s principal is written down. From FT alphaville:

Instead of converting into equity when a certain Tier 1 level is triggered (à la Lloyds’ CoCos), the securities are simply written down by 75 per cent of their face value, with the remaining 25 per cent paid to investors. Otherwise they act like normal bonds… Rabobank currently has €29.3bn of equity capital. To hit the trigger, capital would have to fall by €12.9bn

I wonder where they will price.

The devil comes to Norwalk February 8, 2010 at 8:50 pm

That’s Norwalk, Connecticut.

In Risk, we find:

faced with accounting changes that would result in more financial instruments being reported at fair value through the income statement – meaning changes in value would appear as profits or losses – regulators have been quietly discussing radical new rules that would separate profits into buckets depending on the liquidity of the underlying assets.

The new reporting regime would then allow regulators to restrict how gains on less-liquid instruments are used. As a result, derivatives and structured product businesses could find a huge chunk of their profits fenced away.

This is a variant on an idea I suggested earlier, and a bad variant to boot. The good thing about separating realised from unrealised gains is that only the latter are a good form of capital. If you have rigourous valuation risk management, then the P/L on the illiquid books is just as good as the P/L on the liquid ones, since both have sufficient valuation adjustments to cope with the uncertainties involved. Supervisors would be better off doing the boring (but hard) job of ensuring that firm’s are valueing their books properly, and then treating all unrealised profits as potentially suspect, not just level 2 and level 3 ones.

Indeterminate cheer from Basel December 20, 2009 at 8:56 am

The market’s reaction to the latest Basel committee document was swift and severe: bank share prices fell significantly. However, a close reading of the proposals suggests that those falls might be overdone. Here’s the good news/bad news skinny: (where I’ve used ‘good’ to mean ‘good for the banks’ – the skeptical might well take that to mean ‘bad for financial stability’)

Bad news: the predominant form of capital will eventually be common equity and retained earnings. Funkier capital instruments, such as innovative tier 1 instruments (a form of callable step up bond) will be phased out.

Good news: not yet. Moreover, existing instruments will likely be grandfatherered. Furthermore, the calibration of the new capital levels is going to be based on an impact study, making it likely that banks that are average or better will be fine. There is no firm indication, in this document at least, that most banks will have to raise more capital.

Bad news: unrealised gains on available for sale instruments may not be acceptable capital.

Good news: that was only important in a few places, such as Japan, anyway.

Bad news: goodwill and deferred tax assets are a deduction from capital.

Good news: the market thought that they were anyway.

Bad news: significantly higher capital requirements for counterparty credit risk.

Good news: this provides a great lever for firms to use to persuade their counterparties to sign tighter margin/collateral agreements. Renegotiation of credit support annexes could remove much of the extra capital required.

Bad news: an overall constraint on balance sheet leverage.

Good news: again, set using an impact study, and hence likely only to impact outlier institutions.

All in all, this is much better than the industries’ worst fears. Whether you think that is good news or bad news depends on your perspective.

Pricing the rescue option November 16, 2009 at 7:55 am

Capital is protection against loss: the more capital you have, the more losses you can withstand without being insolvent. So far so obvious.

One popular way of thinking about this is to think of the value of a firm’s assets as varying: the firm is insolvent if the value of their assets falls beneath the value of their debt (or liabilities or whatever). Clearly the more capital a firm has, the less likely this is, as the further the assets must fall before disaster strikes. But with any leverage at all – any non zero amount of debt – insolvency is possible.

Suppose that a bank is a entity that the state must rescue (or at least protect some of the depositors of). Further suppose that the state demands fair compensation for this protection from bank shareholders. If liquidity risk is not an issue (which in reality it is, but bear with me), then the state should charge an appropriate amount given the risk of insolvency.

How might we work that amount out? This is essentially a problem in the theory of capital structure: we have to figure out what the appropriate model of asset value is, and hence how likely it is for the asset value to fall beneath the liability value. The simplest model that would allow that to happen is Merton’s: there are a number of more sophisticated alternatives.

The basic idea, though, is quite simple and interesting, even if the details are complex. Banks pay a premium each year to the deposit protection agency (FDIC, central bank, whatever) based on their actual risk including how volatile their assets are and how much capital they have. These numbers will be large, too, especially for firms whose capital ratios are not substantial. Institutions would be able to choose higher leverage structures, but only at a very considerable immediate cost to their shareholders. Safer banks would pay less.

Of course, the devil here would be in the details. We would want to ensure that the state got an appropriate return for the expected costs of rescues, plus sufficient compensation for bearing the risk that those costs would be larger than expected. The estimates of those costs would be rather sensitive to the assumed asset dynamics. But there has been a lot of work in this area that could be applied, and advantages in terms of reduced moral hazard would be considerable.

Pop goes the Coco November 13, 2009 at 5:32 am

One more thought about contingent convertibles. Clearly as designed having one of these convert is a really bad sign: they are designed to convert only in event of severe stress. Indeed the Lloyds structure was tweaked to go from converting at a Basel ratio of 6% to 5%, in order to make conversion less likely. This of course makes the instrument more attractive to investors. But I think from a stability perspective, it is a bad thing. What we want instead is a structure that converts gently and much more often. That way, conversion is not confidence sapping.

How about this. Ten year structure. Each month, a percentage max(0%, 12 x (12% – Basel ratio)) converts. The monthly observations fits with regulatory capital reporting. It means that even mild losses cause a topping up of capital to occur. Of course you can tweak the thresholds and multipliers, but the basic idea of an instrument that converts early and often is I think much better than one that converts only in an emergency – and by so doing, screams this is an emergency.

Capital history November 9, 2009 at 1:28 pm

Historic capital ratiosMy apologies for the chart overload of late: this is the last one for a while, I promise. But it is a good one. Taken from the Turner Review (discussed previously here), it shows the very long term trend in capital adequacy for UK banks calculated by various authorities. The hint from FSA is clear: capital used to be higher, and it might well have to be higher again…

Update. An excellent commentary, from Piergiorgio Alessandri and Andrew G Haldane, illustrates the point very well:

[The ratio of] UK banks’ balance to GDP … is flat for almost a century, at around 50%… But from the early 1970s, this pattern changed dramatically. By the start of this century, bank balance sheets were more than five times annual UK GDP. In the space of a generation, the insurable interests of the state had risen tenfold.

By itself, this expansion of balance sheets need not imply that the state was bearing greater implicit risk. For example, banks could have self-insured by holding larger buffers of capital and liquidity. In practice, the opposite happened…

Since the start of the 20th century, capital ratios have fallen by a factor of around five in the US and UK. Liquidity ratios have fallen by roughly the same amount in half that time. Taken together, these balance sheet trends indicate a pronounced rise in banking system risk and hence in potential demand for state insurance. They have also affected the returns required by bank shareholders…

Between 1920 and 1970, the return on UK banks’ equity averaged below 10% per annum, with low volatility of around 2% per year. This was roughly in line with risks and returns in the non-financial economy… The 1970s signalled a sea-change. Since then returns on UK banks’ equity have averaged over 20%. Immediately prior to the crisis, returns were close to 30%. The natural bedfellow to higher return is higher risk. And so it was, with the volatility of UK banks’ returns having trebled over the past forty years.

This regime shift upwards in the risk and return profile of UK banks can be explained by the fall in their capital ratios. Higher leverage boosts required returns on equity because it simultaneously makes the banking system’s balance sheet more fragile.

I should Coco November 3, 2009 at 6:07 am

All consultants have some subjects they spend a little too long on. Things they think should be better known or more popular than they are; things they thing are cute; things that amuse them. For me, contingent capital is one of those topics. The idea that you can keep capital levels low, and ROE high, when things are going well, but have access to more capital in a crisis is just too good not to be widely known.

Now it seems that contingent capital is coming of age. In particular, Lloyds is reported by the FT to be about to issue £7.5bn of a contingent capital instrument called a contingent convertible, or Coco.

Cocos behave like bonds until the bank finds itself in a crisis situation, at which point they convert into equity… A definition of a stress scenario that would trigger the instruments’ conversion would be Lloyds’ core tier one ratio falling below about 6 per cent

That 6% might change before the deal is done, but the basic idea is clear. You have a tier 1 bond with an attractive coupon most of the time – a coupon that escapes the European Commission rules on forced deferral by the way – and you only end up with equity if Lloyds’ Tier 1 ratio gets in a really bad state. Further discussion of the concept can be found here.

Update. Not entirely unexpectedly, the 6% has become 5%. That puts the contingent conversion option further out of the money, and should make the Cocos cheaper for Lloyds. The EU is however playing hardball, at least according to this LSE regulatory update. It seems that: the European Commission intends to require a commitment that members of the Group will not make a discretionary payment of coupons or dividends on hybrid capital securities pretty much regardless of the nature of the hybrid.

Changes to the Capital Requirements Directive 2 – VAR and Stressed VAR October 29, 2009 at 9:09 am

I have blogged before about most of the proposals in this document from the commission, including the incremental risk charge in the trading book and the revised treatment of resecuritisation (CDO squared) positions, but I have not said much about stressed VAR. So without further ado:

Each institution must meet, on a daily basis, a capital requirement of:

  1. The higher of (1) its previous day’s value-at-risk number; and (2) an average of the daily value-at-risk measures on each of the preceding sixty business days, multiplied by the multiplication factor;

  2. The higher of (1) its latest available stressed-value-at-risk number; and (2) an average of the stressed value-at-risk numbers over the preceding sixty business days, multiplied the multiplication factor (m);

  3. The sum of its weighted positions (regardless of whether they are long or short) resulting from the application of point 16a of Annex I (the treatment of securitisation positions);

  4. The higher of the institution’s most recent and the institution’s 12 weeks average measure of incremental default and migration risk according to point 5a (the IRC charges).

(Note those pluses.)

The description of stressed VAR is fairly vague:

Each institution must calculate a ‘stressed value-at-risk’ based on the 10-day, 99th percentile, one-tailed confidence interval value-at-risk measure of the current portfolio, with value-at-risk model inputs calibrated to historical data from a period of significant financial stress relevant to the firm’s portfolio. This stressed value-at-risk should be calculated at least weekly.