Regulators are desperate to find a capital instrument that provides a buffer for institutions, but also satisfies investors. Issuance, in a variety of forms, has already begun. But with so many questions still unanswered, have regulators and issuers moved too early?

Although additional Basel Committee on Banking Supervision guidance on contingent capital requirements for systemically important financial institutions is forthcoming, market participants believe that contingent capital will play a significant future role in bank capital. But with so many questions about contingent capital still unanswered, is post-financial crisis trauma causing the industry to move forward too quickly?

Contingent capital instruments (CoCos) have received enthusiastic endorsement from regulators, who usually refer to contingent capital as a hybrid debt instrument convertible into equity during a stress scenario or at the point of non-viability. This is just one formulation of contingent capital. The premise of a contingent capital instrument is that a financial institution will offer securities that constitute high-quality capital during good times, which will provide a buffer or enhanced loss absorbency during times of stress when the financial institution requires, but cannot raise additional capital. Although discussions focus on mandatorily convertible debt securities with regulatory triggers, one can envision other structures, such as a debt security with a principal write-down feature, or a 'contingent' committed funding facility, or even a collateralised insurance policy.

Market experience is limited. There have been examples of mandatorily convertible structures, such as those issued by Lloyds Banking Group and more recently Credit Suisse, and an example of a principal write-down instrument issued by Rabobank. These all feature a capital ratio trigger.

While these securities may provide an institution with high-quality capital at issuance, upon breach of the relevant trigger, the securities generally do not provide 'new' capital. In most formulations, the regulatory capital deck just gets reshuffled on a trigger breach. Yes, these securities provide loss absorbency. It also is true that by setting triggers at the outset and making these mandatory, the issuer does not have to make the painful deferral determination otherwise required had it issued a conventional hybrid, such as a trust-preferred security. Financial institutions have proven reluctant to defer payments given that this results in a loss of confidence – and confidence is everything for a financial institution. A mandatory trigger changes the discretionary aspect of this dynamic, but it does not address the confidence issue.

Defining the trigger

With a contingent capital instrument, there are a few new, and trickier, dynamics to consider. A lot rests on the trigger determination. Most likely, investors want precise, objective triggers, not triggers that permit regulatory discretion. Regulators want the opposite. But a discretionary trigger makes the securities near impossible to price. Then, there are timing questions. If a trigger is set to be tripped early – as a stress scenario is just emerging – so that the issuer receives the maximum benefit, will investors not view that negatively? For convertible instruments, it is difficult to strike the right balance to avoid having the security take on a 'death spiral' element.

Pricing is a challenge. For investors to be able to price these securities accurately, additional transparency will be required of financial institution issuers. Basel III already calls for enhanced transparency relating to capital. Even with more timely and detailed reporting by issuers, will investors have the information to predict the probability of a trigger breach? As an institution approaches the trigger, will speculative trading increase? And what about loss of confidence? One could envision adding caps or floors to the securities to minimise incentives to short, and there will be regulatory limitations on shorting that were not there during the financial crisis, but will this be enough? Or will it just add complexity that makes the securities more difficult to compare and value?

Challenging decisions

Regulators and rating agencies criticised hybrids for having become overly complex and difficult to compare. Will that not happen for these new securities? In Europe, debt investors already are finding it difficult to 'price in' the risk of a haircut for senior debt holders in connection with a bail-in or resolution scheme. It is not clear whether debt investors will buy contingent capital in amounts sufficient to make a difference from a systemic risk perspective. Just when an investor would want the full range of senior security holder creditors’ rights, the investor would be relegated to being an equity holder. Will these decisions be too challenging for retail investors or will these investors assume the possibility of a breach too remote?

If one assumes that all these structuring challenges can be addressed, it is important to remember that even if we seek harmonised approaches to regulatory capital and systemic risk issues, jurisdictional differences remain. In some jurisdictions, national law restricts the issuance of securities that may have a dilutive effect without obtaining shareholder approval. Securities exchanges also require shareholder approval for issuances of voting securities beyond certain thresholds.

In the US, there are important tax issues to address. Generally, in Europe, a financial institution issuer of a contingent capital instrument (whether of the convertible or the write-down variety) will likely be able to deduct interest payments on the security. By contrast, under existing laws, without new US Treasury guidance, a US issuer of a convertible or principal write-down instrument will likely not be able to achieve tax deductibility for these instruments in their current form. While other formulations may be possible, in the US we risk having issuers adopting byzantine structures to achieve what European issuers can achieve with one instrument. If contingent capital is required by US regulators, US financial institutions will be at a significant competitive disadvantage compared with European peers without tax guidance or relief.

The array of questions to be answered justifies more methodical and detailed consideration of these instruments and likewise of the jurisdictional issues that are as yet unreconciled. Unfortunately, there is no way to 'beta' test a new global super hybrid security before it is required of the world’s largest financial institutions.

Thomas Humphrey and Anna Pinedo are partners at law firm Morrison and Foerster.

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