Coco volatility threatens bank regulatory capital targets

Extreme volatility in a small corner of the securities market has called into question the ability of some European banks to meet stringent capital requirements by 2019.

The epicentre of those concerns was found in the market for so-called contingent convertible bonds (cocos), sometimes known as additional Tier 1 (AT1) bonds. From late 2015 to early February, yields have blown out, moving from 5% to 8% to rise to 8% to 12% in the secondary market.

Coco cools down

The excessive volatility sparked some talk over whether the coco investor base may have been permanently hollowed out. “Some of the traditional credit investors who bought these bonds have vowed never to touch them again because of the volatility,” says one banker with a knowledge of the bank debt market.

And a number of bond fund redemptions, including by some coco specialists, have led to high-quality names being dragged down in the process. “When fund managers liquidate, they may only be able to sell good names in a negative market,” says the banker. Nonetheless, no one is writing off the coco market just yet. Many investors will stick with the bonds, seeing them as good value and as having attractive yields.

Cocos were conceived as an elegant solution for managing bank failures as hybrid instruments that could be converted into equity or simply written down. They can account for up to 1.5% of a bank’s risk-weighted assets (RWA) and are much favoured by European regulators. Typically, high-trigger cocos convert to equity when the bank’s common equity Tier 1 falls below 7%, and for the low triggers the threshold is 5.125%.

As part of their remit of giving flexibility to bank management, cocos have a number of features built into them, which do not sit well with many fixed-income investors. One of them is that coupon payments, which are non-cumulative, can be skipped at management’s discretion without activating a bank default, even as dividends and bonuses continue to be paid.

It is a feature that has rattled numerous investors and led to many cocos pricing in two to three years of coupon skips – a big over-reaction, according to market sources, but also a reflection of the market’s immaturity. And coupon skips do not necessarily lead to conversion – it would depend on how impaired the balance sheet is.

In practice, it is highly unlikely that a bank would stop paying its coco coupons while doling out dividends and bonuses because it violates the accepted hierarchy that bond coupons take priority over shareholder dividends. “If a bank did that, I doubt it would be able to sell its bonds to its investor base ever again, even senior ones,” says Olaf Struckmeier, a portfolio manager with Union Investment in Germany, who continues to support the asset class. Another market source was blunter, describing such a move as "suicidal" given banks rely so heavily on debt to fund themselves.

A chest-beating exercise?

Another possibility is for a regulator to order a cessation of coupon payments, but it might hesitate to do so for fear of alienating a bank from its creditors. Therefore, maintaining coco coupon payments is important for keeping debt markets open to a bank and for it to be able to fulfil subordinated bond issuance programmes to meet total loss-absorbing capacity (TLAC) requirements, for example.

Indeed, this partly explains the great lengths Deutsche Bank co-chief executive John Cryan went to when reassuring investors that the bank’s coco coupons can easily be met for two years. Not only that, but the bank offered to buy back €3bn and $2bn of its senior unsecured debt as it endured a hail of credit downgrades.

Some saw this as ‘chest beating’ to quell negative sentiment and it was certainly effective. The icing on the cake for Deutsche Bank is that it can book a profit from repurchasing these instruments as it is paying less than it sold them for.

Deutsche Bank became a highlight of the coco troubles after making net losses of €6.8bn in 2015. It stirred up worries that its capital buffers are uncomfortably thin, potentially jeopardising its coco coupons. Some other banks, such as UniCredit, have also been subject to the same speculation for similar reasons.

The other troubling coco feature for many fixed-income investors is that they lie at the bottom of the creditor pile in terms of claims on a bank’s assets. That makes them particularly sensitive to any hint of bank fragility.

Deadline worries

Although the worst of the carnage afflicting the coco market appeared to be over by late February it did raise concerns about whether some banks will be able to raise enough capital ahead of the 2019 deadline set by regulators.

The banks with the heaviest capital burden are the 30 identified as global systemically important banks (G-SIBS). They are expected to have TLAC levels of at least 16% of RWAs by 2019, rising to a minimum of 18% in 2022. Emerging market G-SIBS are expected to reach those levels by 2025 and 2028, respectively. This is in addition to various other capital buffers.

Although they were relatively unaffected by the coco storm, there was some nervousness over subordinated bonds, which are a much more important funding instrument for banks. But subordinated debt ranks above cocos in seniority, and is well established and understood by the fixed-income community.

The negative mood music behind the coco plunge was down to worries over the global economy, negative interest rates and the commodity price collapse, all of which hurt bank earnings.

However, the actual trigger for the sell-off was, according to a number of sources, down to an own goal by regulators. One source blamed the way the European Central Bank (ECB) communicated supervisory review and evaluation process results on Italian banks. It apparently gave the impression that these banks had been specially singled out when in fact the ECB was conducting a routine exercise. But there is another view of the regulatory angle.

“Certainly, regulatory developments have had an impact on investor appetite for bank instruments,” says Alexandre Birry, a director at the bank ratings team at Standard & Poor’s. One of those, he adds, was a clarification from the European Banking Authority over what would constitute a maximum distributable amounts (MDA) calculation, potentially leading to coco coupons being culled.

It turns out that banks not only have to meet Basel pillar one along with other buffer requirements, but also pillar two as part of an MDA calculation. “Some investors had not accounted for this,” says Mr Birry.

This made a small number of banks look even more vulnerable to coupon skips. Another factor is that though they are perpetual in nature, they are callable on certain dates. They now look unlikely to be called as they are trading below par, meaning investors may have to wait longer to see them redeemed.

Local differences

Another issue is Europe’s messy patchwork of rules that apply in the event of a bank having to wind down. The various Basel methodologies and standards may be common to all EU countries, but their interpretation and application varies across jurisdictions.

For example, in Germany bond investors are subordinated to depositors, while in the UK depositors take priority over bond holders. Although that looks like mere semantics it could have legal implications. “With slightly different interpretations and with slightly different wording you could end up with varying results depending on which jurisdiction you end up in,” says Jeremy Jennings-Mares, a partner with law firm Morrison & Foerster’s capital markets group.

It is the kind of complexity that baffles some investors. Although the coco market has taken a knock, bankers believe that it is not completely closed to new issuance. “It is more of a repricing and recent events have created greater discrimination by investors between various banks,” says Sebastien Domanico, head of the financial institutions group, debt capital markets, at Société Générale. “I think that feature will persist once the market returns to normal.”

What's next?

It will certainly be a while before the market can again absorb ‘jumbo’ issues sized in the billions of euros. And though there might still be some appetite for solid bank names, they will have to pay for market access. “Execution risk could be quite high and an issuer may not want to set a precedent by issuing cocos with high coupons,” says Adrian Docherty, head of capital markets, advisory and solutions, at BNP Paribas. “It might send the wrong signal to the markets as regards their need for capital.”

But what if the market was shut to coco issuance for 12 to 18 months – say due to persistent volatility? Most bankers believe this unlikely but, if it happens, there are other options.

There are a range of opinions as to how much capital European banks need to raise between now and 2019 to fulfil TLAC requirements, which can be achieved via a variety of instruments such as subordinated bonds. A big chunk of the new issuance is to replace existing paper.

Estimates range from €100bn to €300bn, of which cocos would make up a small proportion of the issuance with the rest being subordinated debt. Others believe there could be another €100bn-worth of cocos alone in the pipeline, with new issuance expectations for this year down from €35bn to €40bn to just €10bn to €15bn.

However, these numbers are far less than the €1000bn estimate banded around in 2015 by some analysts. This is because greater regulatory clarity led to lower calculations. Also, according to Fitch Ratings, Germany will ensure TLAC eligibility of existing senior bank debt by subordinating it to all other senior liabilities from 2017. Italy is looking at full depositor preference from 2019, in which case senior bank debt can still be TLAC eligible if equally ranking excluded liabilities are small, the rating agency said.

With a few strokes of the pen, regulators have reduced estimated capital needs and if necessary they could probably find other tweaks and also extend TLAC deadlines.

Window of opportunity

“Common equity remains the foundation of a sound capital structure and is certainly an alternative to raising cocos,” says Dr Tom Huertas, the chairman of EY’s global regulatory network. “Deleveraging is also an alternative. Reducing asset levels, especially RWAs, is a way to improve capital ratios.”

Yet another way is to slash dividends, through which billions of euros pour out of banks every year. “A concern for coco investors is that some banks are increasing dividends, often as a sign of strength,” says Mr Struckmeier. “But that doesn’t make sense in a market like this. CEOs should keep capital on the balance sheet as you don’t know how long this volatility will last.”

Regulators can also support the coco market by better communicating their intentions to investors and by being crystal clear as to what would trigger events, such as coupon skips and conversions. Sources say those conversations are starting to happen more.

As markets oscillate between fear and relief, Mr Docherty advises issuers to take advantage of windows of opportunity to get their cocos away. “Frontloading gives you the ability to sit out tough markets even if it is not cheap,” he says. “People should act rather than hoping it might be cheaper next year, because next year the market might not be there.”

Meanwhile, to help its banks meet TLAC requirements, France is planning a new type of security, called non-preferred senior debt, to be subordinated to existing senior debt, which can be bailed in should a bank fail. More details should emerge towards the middle of 2016.

Market sources believe bond tenors will probably be about five years and predict issuance of up to €60bn to €70bn by 2019, with BNP Paribas likely to be the leading issuer. Providing yields are enticing, sources expect them to be popular with investors. Spain has cleared the way for Tier 3 senior debt, which would be subordinated to existing senior debt, but sits above Tier 2 paper.

Front-loading issuance when opportunities arise, particularly for cocos, might be sound advice given persistently high levels of uncertainty. In other words, the current environment makes the task of building up and maintaining regulatory capital more challenging for banks than it was during the past couple of years.