In January 2011, the Basel Committee on Banking Supervision (the "Basel Committee") set out rules to supplement Basel III regulations on capital adequacy and liquidity. The Basel III reforms aim to improve the quality and level of capital within firms (further details of the Basel III reforms are set out below).
In July 2011, following a consultation period, the Basel Committee announced that global systemically important financial institutions ("G-SIFIs") would not be permitted to use contingent convertible bonds ("CoCos") to meet additional capital requirements introduced in the Basel III reforms. A CoCo is a fixed income security that automatically converts into equity capital when a pre-arranged trigger is met.
However, the Basel Committee supports the use of contingent capital to meet national loss absorbency requirements that supplement Basel requirements. An example of these supplementary national requirements is a proposal by the Swiss Financial Market Supervisory Authority ("FINMA"), referred to as the "Swiss Finish". The Swiss Finish will require Swiss banks to meet total capital ratio requirements of 19 per cent. Of this proposed 19 per cent. total capital ratio, large Swiss banks may use CoCos to meet 9 per cent. of their total capital ratio. The remaining 10 per cent. must be held in the form of common equity, comfortably covering the "Basel" element of the capital requirement.
It is expected that a number of large European and Asian banks may issue CoCos to meet national capital requirements set above the Basel III minimums. However, issuances of CoCos in the United States are not expected due to unfavourable tax treatment. CoCos are viewed as equity rather than debt in the US, meaning that interest payments would not be tax deductible.
Contingent Convertible Debt
The term CoCo is a broad term used to describe debt securities that automatically convert into equity on the occurrence of specified events, hence their description as 'contingent' instruments. If the contingency event does not occur, conversion will not be triggered and debt instruments will be redeemed at maturity, just as conventional debt instruments are redeemed. In general terms, the structure of these instruments is such that the occurrence of specific events, such as the equity capital ratio falling below 8 per cent, will trigger a mechanism activating conversion of the debt into equity at a predetermined rate. The price and ratio of shares resulting from the debt conversion is determined ex ante.
However, as the motivations of issuing entities varies from issuance to issuance, so too does the structure, including the trigger utilised. In general, CoCos will be issued by the subsidiary of a large financial institution and guaranteed by the parent entity. In some instances, issuances may be specifically structured to increase capital adequacy and meet obligations under the Capital Requirements Directive. In other instances, a well-capitalised institution may issue to improve and maintain its creditworthiness. An issuer's capital structure, national regulatory requirements and global regulatory requirements all have a bearing on the structure of a CoCo to be used and determine which conversion mechanism(s) will be used.
Debt Conversion Triggers
There are three different measurements on which triggers are generally based: (i) capital-based triggers that rely on accounting measures of capital adequacy; (ii) regulatory discretion-based triggers that allow regulators to mandate conversion of CoCos into common equity during a banking crisis; and (iii) market-based triggers that use declines in stock prices or increases in the premiums of credit default swaps.
There has been criticism of each of these mechanisms:
(i) in relation to capital triggers that rely on accounting measures, criticism has focused on their inherent delay in responding to a financial crisis. Financial reporting takes place on a quarterly basis, which means that the trigger will only be capable of occurring at the end of an accounting period and in some instances this may prove too late for a CoCo to perform its primary function, to act as an effective loss-absorber;
(ii) regulatory-based measures may lead to ad hoc decisions, thus creating uncertainty for investors. The fact that the discretion is exercised by regulatory authorities will make it difficult for investors and rating agencies to assess the probability of conversion taking place; and
(iii) market-based triggers, such as share price, would be subject to stock market volatility and stock price manipulation. In addition, a market based trigger may be affected by many market events unconnected to the financial health of the bank in question.
In relation to capital triggers the trigger level is of fundamental importance. A higher trigger level, for example a level set at the Basel III minimum capital ratio of 8 per cent, will enable the issuing bank to act promptly and in advance of the point of non-viability1 and when the bank is still perceived as solvent. A lower trigger level, for example, capital ratio falling below 5 per cent, will mean that conversion will only come into effect in circumstances of severe financial difficulty, closer to the point of non-viability for the institution concerned.
Many commentators suggest that a dual trigger mechanism is a suitable compromise, for example, one that relies on accounting measures coupled with regulatory discretion.
Overview of the Basel III reforms
Basel III requires a bank to hold Total Capital of 8 per cent. of its risk-weighted assets at all times. Total Capital consists of Tier 1 capital and Tier 2 capital. The Basel Committee describes Tier 1 capital as "going concern" capital, it is the issued capital that takes the first and proportionately greatest share of any losses as they occur. The objective of Tier 2 is to provide loss absorption on a "gone-concern" basis, prior to depositors losing any money.
(i) Tier 1 Capital - Common Equity Tier 1 Capital and Additional Tier 1 Capital
Tier 1 capital consists of Common Equity Tier 1 capital and Additional Tier 1 capital. Common Equity Tier 1 capital is the highest quality component of a bank's capital, which includes common shares and retained earnings. Under Basel III Common Equity Tier 1 must be at least 4.5 per cent. of risk weighted assets (up from 2 per cent. of risk weighted assets).
Additional Tier 1 capital consists principally of instruments issued by the bank which must meet strict criteria (and are not included in Common Equity Tier 1 capital).
Under Basel III the minimum total Tier 1 capital requirement will increase from 4 per cent. to 6 per cent. These new requirements will be phased from 1 January 2013 until 1 January 2015.
(ii) Capital Conservation Buffer
Basel III has introduced the capital conservation buffer, which is designed to ensure that banks build up capital buffers outside periods of stress which can be drawn down as losses are incurred, as described above. Basel III requires banks to hold an additional 2.5 per cent. of Common Equity Tier 1 capital above the regulatory minimum. Capital distribution constraints will be imposed on a bank when capital levels fall within this 2.5 per cent. range. The capital conservation buffer will be phased in progressively between 1 January 2016 and year end 2018 becoming fully effective on 1 January 2019.
(iii) Counter-cyclical buffer
A counter-cyclical buffer has been introduced to ensure that banking sector capital requirements take account of the macro-financial environment in which banks operate. National authorities will monitor credit growth and other indicators that may signal a build up of systemwide risk. Authorities will assess whether credit growth is excessive and based on this assessment they will put in place a countercyclical buffer requirement if circumstances warrant. The counter-cyclical buffer will vary between zero and 2.5 per cent. of risk weighted assets, depending on the extent of the build up of system-wide risk. This requirement will be released when system-wide risk crystallises or dissipates.
(iv) Global Systemically Important Financial Institutions
In addition to meeting the Basel III requirements, G-SIFIs must have higher loss absorbency capacity to reflect the greater risks that they pose to the financial system. The Basel Committee has developed a methodology that includes both quantitative and qualitative elements to identify G-SIFIs, resulting in 30 financial institutions being classified as such.
G-SIFIs will be required to meet this additional loss absorbency requirement using progressive Common Equity Tier 1 capital only and in amounts ranging from 1 per cent. to 2.5 per cent. depending on the bank's systemic importance. While G-SIFIs many not use CoCos to meet this additional requirement, the Basel Committee will continue to review their use, and as a general proposition, the Basel Committee supports the use of CoCos to meet national loss absorbency requirements set at higher levels than global requirements.
Contingent debt issuances
Since the first CoCo issuance by Lloyds Banking Group ("Lloyds") in late 2009, there have been few further issuances. In the few issuances that have occurred, all triggers have been capital ratio related, however, structure and returns in each issuance were tailored to the requirements of the issuing bank. A brief description of issuances by Lloyds, Rabobank, Credit Suisse and Bank of Cyprus is set out below:
Lloyds Banking Group
In November 2009, Lloyds offered Enhanced Capital Notes ("ECNs") in exchange for existing hybrid bonds. Holders of specified Tier 1 and Upper Tier 2 instruments were invited to exchange such instruments for ECNs or an amount payable in new and/or existing shares, or cash. The ECNs are capable of qualifying as Lower or Upper Tier 2 Capital and will convert into new and/or existing ordinary shares in Lloyds if the Lloyds Core Tier 1 ratio falls below 5 per cent. The conversion rate is predetermined, based on the observed share price and is to be adjusted in certain circumstances. The ECNs have maturities of between 10 to 15 years and the coupon is set between 1.5 per cent. and 2.5 per cent. As Lloyds had been partly nationalised at the time of the exchange offer, it could neither redeem bonds nor pay interest, as a result, the exchange was an attractive offer as the ECNs carried a higher coupon and could be sold upon conversion.
Rabobank
In March 2010, Coöperatieve Centrale Raiffeisen-Boerenleenbank B.A. (Rabobank Nederland) issued €1,250 billion of Senior Contingent Notes ("SCN"). The coupon was set at 6.875 per cent. These notes are contingent, but not convertible. If the Rabobank Group Equity Capital Ratio, defined as retained earnings and member certificates relative to risk weighted assets, falls below 7 per cent. before the notes mature, the par amount and unpaid coupons will be written down by 25 per cent. and investors will immediately be repaid at this redemption price. Unless previously redeemed or purchased and cancelled, the SCN will be redeemed at 100 per cent. of their principal amount on 19 March 2020. As the write down of Rabobank Nederland's notes does not meet the requirements of Basel III, the notes do not, therefore, count towards regulatory capital. This issuance was aimed at further enhancing triple A rated Rabobank's creditworthiness.
In November 2011, Rabobank Nederland issued US$2 billion Hybrid Tier 1 Notes. The notes have a perpetual maturity with a call after 5.5 years. The coupon was set at 8.4 per cent. and is fully discretionary, with no link between payments and dividends. If Rabobank's Equity Capital Ratio falls or is expected to fall below 8 per cent, the notes will absorb losses pro rata with equity capital and other loss absorbing instruments. The issuer or the regulator can also trigger the write down. The notes were designed to comply with Dutch and European capital requirements (CRD II) and incorporate provisions to address the guidelines issued to date for the upcoming CRD IV regulatory requirements and to strengthen Rabobank's capital base ahead of the upcoming Basel III implementation.
Rabobank also issued US$2 billion hybrid notes in January 2011. These notes were Hybrid Tier 1 Perpetual Notes, callable at 5.5 years, with a coupon set at 8.375 per cent. and a write down trigger if equity capital ratio falls below 8 per cent.
The Rabobank issuances are unusual for a number of reasons: (i) Rabobank is unlisted, making it the only private sector bank with a triple A credit rating; (ii) Rabobank is mutually owned and therefore cannot convert bonds into equity; and (iii) Rabobank's current Equity Capital Ratio2 is 14 per cent, providing a substantial capital buffer (approximately €12.3 billion) before its contingent debt can be written down.
Credit Suisse
In February 2011, Credit Suisse Group (Guernsey) I Limited issued U.S.$2 billion Tier 2 Buffer Capital Notes (the ''Tier 2 BCNs''). The coupon was set at an initial rate of 7.875 per cent. per annum, and thereafter at a rate, to be reset every five years, based on the mid market swap rate plus 5.22 per cent.
In this issuance, the conversion trigger was linked to the occurrence of either a contingency event or a viability event. In summary, a contingency event will occur if the Credit Suisse Group's ("Credit Suisse") Common Equity Tier 1 ratio falls below 7 per cent. and a viability event will occur if: (i) FINMA is of the opinion that Credit Suisse would reach the point of nonviability without conversion of the debt into equity, or (ii) if Credit Suisse receives a promise of State-aided support without which it would become non-viable. If either event should materialise, the Tier 2 BCNs will, subject to certain conditions, mandatorily convert into ordinary shares. Unless previously redeemed or purchased and cancelled, the Tier 2 BCNs will be redeemed at 100 per cent. of their principal amount on 24 February 2041.
Credit Suisse also issued SFr6 billion of Tier 1 Buffer Notes Capital Notes (the "Tier 1 BCNs"). Similar to the Tier 2 BCNs, a contingency event and viability event trigger applies to the notes, with the contingency event trigger threshold set at 7 per cent. Again, if the Credit Suisse Common Equity Tier 1 ratio falls below this threshold, the Tier 1 BCNs will convert into Credit Suisse ordinary shares.
Bank of Cyprus
In April 2011, the Bank of Cyprus offered €1,342,422.297 of perpetual Convertible Enhanced Capital Securities ("CECS") to existing shareholders in the ratio of €3 CECS for every 2 shares held. The coupon was set at an initial fixed rate of 6.5 per cent. until 30 June 2016 and thereafter, at a floating rate of Euribor plus 3 per cent. The CECS will be mandatorily converted into ordinary shares at a mandatory conversion price on the occurrence of a contingency event or a viability event. Similar to the Credit Suisse issuance, a contingency event will occur if the bank's Common Equity Tier 1 Ratio falls below 5 per cent. and a viability event will be deemed to occur if the Central Bank of Cyprus determines that either the conversion of CECS is necessary to ensure the bank's viability or the bank requires extraordinary public sector support to prevent non-viability.
Footnotes
1 The Basel Committee described the point of non-viability as the point at which a bank is unable to support itself in the private market.
2 As at June 2011.
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