What happens when they are gone? September 3, 2012 at 6:35 am

What is bank capital for? It is a good question, with many possible answers including going concern loss absorption, giving confidence to debt buyers and gone concern loss absorption. There is no need for these functions to be performed by the same security and indeed there are some benefits to separating going and gone concern issues. Given that banks will typically be resolved these days rather than going into bankruptcy, gone concern is mostly about resolution. Suppose then that we have a security that only suffered losses in resolution, when it is available to absorb any losses that equity is not sufficient to deal with. It would sit between equity and more senior debt instruments. It could even be convertible into new equity supporting a bank recapitalisation (although you might not want that, as you might not want the holders of these instruments to try to hedge the embedded equity option). However it would not be convertible before resolution, nor would its coupons be deferrable except during resolution. The price of such an instrument would therefore precisely reflect the market’s perception of the probability of resolution of a bank. The existence of such an instrument would allow regulators to intervene rather later than if it did not exist, as the instrument would be available to reduce losses to deposit protection schemes. The moral hazard whereby regulators seize a bank from its existing shareholders would be mitigated as seizure would only occur when the equity was worth close to nothing anyway.

I know that the history of bank hybrid capital instruments has not exactly been glorious, but I think a lot of prior problems relate to the lack of a clear trigger for taking losses/deferral. A pure play on resolution might just work.

7 Responses to “What happens when they are gone?”

  1. […] – How bank hybrid capital instruments might just work. […]

  2. The first Basel III compliant Tier 1 hybrid capital instrument is being roadshowed in Australia this week by the Commonwealth Bank of Australia.

    It includes provisions whereby mandatory conversion occurs if the regulator determines that the bank is non-viable.

    There are other conversion triggers too, but this seems to be stepping in the direction you describe.

    The prospectus is available on http://www.asx.com.au/

  3. UBS Contingent Capital Bonds Got $9 Billion Orders, CFO Says

    By Elena Logutenkova on August 13, 2012

    UBS AG (UBSN), Switzerland’s biggest bank, received orders of $9 billion for the contingent capital bonds issued last week, or 4 ½ times the amount sold, Chief Financial Officer Tom Naratil said.

    About 58 percent of the $2 billion in notes were placed with investors in the U.S., Naratil said in a phone interview today. Another third was sold in Europe, including Switzerland, and the rest in Asia, he said. Institutional investors such as asset managers took up about 70 percent, he said.

    The 10-year securities, which carried a 7.625 percent coupon, will be written off if UBS’s common equity ratio falls below 5 percent or the bank faces a bailout.

    Under Swiss rules, UBS and Credit Suisse Group AG (CSGN) need to hold contingent capital with a 5 percent trigger amounting to 6 percent of risk-weighted assets. That means UBS may need to raise a total of about 14.4 billion Swiss francs ($14.8 billion) in contingent capital if it cuts risk-weighted assets to the targeted 240 billion francs. Last week’s sale adds to $2 billion of such notes sold in February.

  4. Interesting issue. Is this stuff just simply B3-compliant AT1 / T2 but with no conversion trigger (ie the T&C simply say that in resolution, you’ll get written down)? Struggling to see a difference.

    You are doubtless aware the HMT White Paper on banking reform looks at having a new tier of instrument to sit between T2 and senior, which would be subject to bail-in during resolution. HMT seem bit luke-warm on it but float the idea nonetheless.

    Another thought on contingent capital. What happens if you have high trigger T2? Converts to equity before any AT1 holders have been hit with losses (eg via coupon non-payment). Kinda messes up the capital hierachy, no?

  5. HFS – Thank you. The PERLS presentation is here
    http://www.asx.com.au/asxpdf/20120903/pdf/428g5yh9g90lkl.pdf
    and the presentation is here
    http://www.asx.com.au/asxpdf/20120903/pdf/428g5wwd3jcsfl.pdf
    and interesting they are too…

  6. Carter – Yeah, what is interesting about the UBS offering is that UBS (unlike CS) were pretty vocal in their opposition to Cocos, as they were worried about people hedging the embedded conversion option, i.e. shorting their common into a crisis. The write off makes that less easy to do, but it is still interesting that Finma has made them toe the line. Market gossip is that the headline yield would have been substantially tighter for a pure Coco rather than something that writes down.

  7. QM –

    “Is this stuff just simply B3-compliant AT1 / T2 but with no conversion trigger”

    No, as you can’t defer until resolution either. I wouldn’t make these callable either, as the roll-over risk is nasty. Just perps that only write down/defer in resolution. I guess they have to be sub, but if you are seldom putting the firm into bankruptcy, usually resolving it, then that doesn’t matter so much.

    “You are doubtless aware the HMT White Paper on banking reform looks at having a new tier of instrument to sit between T2 and senior, which would be subject to bail-in during resolution. HMT seem bit luke-warm on it but float the idea nonetheless.”

    (As you can tell), I quite like that idea.

    “Another thought on contingent capital. What happens if you have high trigger T2? Converts to equity before any AT1 holders have been hit with losses (eg via coupon non-payment). Kinda messes up the capital hierachy, no?”

    Yeah, and you get hit faster as people hedge it, and the gamma close to the trigger is likely to be nasty.