In an attempt to appease regulators, banks are issuing Tier 1 debt capital that converts into equity if a certain trigger point is reached. However, only the biggest names - and those least likely to need to convert debt to equity - will be able to attract investor support for such issuance. Writer Charlie Corbett

The Basel Committee's announcement last month that it would soften its stance towards future capital and liquidity requirements was met with a sigh of relief among banks.Fears that Tier 1 capital could be redefined in such a way that hybrid debt would no longer count have eased and the looming spectre of a rush to the equity market to beef up capital ratios has retreated into the background.

However, the committee's determination to put in place a structure that will mean the taxpayer is never again responsible for bailing out the financial system is as strong as ever. The new rules concerning capital ratios and Tier 1 capital have yet to be codified but what is abundantly clear is that it will be the industry and not the government that bails out the banks should another crisis occur.

Banks that wish to issue hybrid debt are being forced to be highly innovative in their approach and put in place so-called 'grandfathering' clauses in their deals that effectively reset the transaction should the rules change in the future. As expected, the hybrid debt market has been all but closed in 2010, save for a handful of deals. One of these was HSBC's $3.4bn Tier 1 hybrid bond, issued in June. Given that the European Commission's Capital Requirements Directive does not come into force until later this year, it was a bold move by HSBC to issue when it did.

However, the deal, targeted at yield-hungry US investors, found broad market support. The bank hopes that, even in the event of a rule change, the hybrid instrument will continue to be regarded by the regulator as Tier 1 capital since it can be flipped into non-cumulative preference shares at the bank's discretion. Investors can also redeem their investment at par.

Italian bank UniCredit is the only other bank to have issued hybrid debt so far this year when it tapped the market for €500m in July. Similar to the HSBC deal, it can be redeemed at par should the rules change. Interestingly, it also contains a 'loss absorption provision' that allows for interest payments to be suspended and the value of the instrument to be written down should the bank's capital fall below a certain level or a 'loss event' occur. This will appease the regulator but it raises a number of questions for investors. For example, how does one define a loss event and who decides when one has occurred? Also, why would anyone invest in a security that offers, ultimately, so little security? The answer: banks will have to pay.

A new instrument

Banks have also been attempting to get around the potential new rules concerning capital and liquidity by issuing contingent convertible instruments, or CoCos. These provide a little more clarity on the vague 'loss event' definition by converting into equity if a certain agreed trigger point is reached, for example, if a bank's core Tier 1 ratio falls below 5%. Lloyds issued a CoCo at the end of 2009 as part of its £13.5bn (€16.4bn) recapitalisation plan and Dutch Rabobank closed a €1.2bn CoCo in March. Both deals were met with some scepticism by market commentators.

It remains to be seen how popular such instruments will be longer term. Investors will demand high yields before they invest in a debt security that converts to equity just at the point when holding debt makes sense.

However, CoCos are also a good way to achieve high yields on quality names. The offering from UK bank Lloyds, for example, paid a whopping 10% coupon. This point also gets to the paradox at the heart of CoCos. It is only the highest quality names, and those banks least likely to need to convert bonds to equity, that will be able to issue a CoCo. Any bank that is ever likely to need to exercise a CoCo is highly unlikely to be able to issue one in the first place.

PLEASE ENTER YOUR DETAILS TO WATCH THIS VIDEO

All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker



For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Join our community

The Banker on Twitter