Contingent Convertibles [Cocos]: A Potent Instrument For Financial Reform

A Potent Instrument for Financial Reform

George M von Furstenberg

• Publisher: WSPC
• Year: 2014
• eBook ISBN: 9789814619912
• Topic: Biological Sciences
• Subtopic: Science General
• Index: Biological Sciences

Contingent Convertibles (CoCos) represent debt that is subject to being converted automatically into common equity under pre-specified terms of conversion if the chosen regulatory capital ratio falls to a level triggering conversion. CoCos are that subspecies of contingent capital that references regulatory (Basel III) concepts in its triggers. From 2014, trigger points are set by common equity (Common Equity Tier 1 [CET1]) in percent of risk-weighted assets [RWA] or of more complicated measures of total exposure to a variety of risks, particularly credit risk. This is the first comprehensive book on CoCos, an innovative instrument that has attracted growing attention since it was first issued in 2009.

The book is mostly concerned with going-concern 'recovery-' rather than 'resolution-' CoCos, because avoiding failure and costly disruption of financial networks without government financing is the first order of business. CoCos hold a high promise of providing fully loss-absorbing equity capital when it is most needed and least available to financial institutions. Yet, having grown out of the 2007–2009 financial crisis, they are still an 'infant' reform instrument in many respects. Few of the instrument's design features (or even the rating, regulatory, and tax treatments) are entirely settled. This book seeks to move the discussion toward, and then past, the main decision points so that CoCos can prove their value for contingency planning and self-insurance all over the world. It is intended to increase the ability of issuers and investors to analyze and understand the different kinds of CoCos.

Contents:

• Foundations:
  • Introduction
  • Overview of Basel III Implementation Most Relevant for Cocos
  • Cocos and the Struggle to Preserve Going-Concern Value
  • The Treatment of TBTF Financial Institutions in the Last Crisis
  • Strategic Policy Objectives in Privatizing the TBTF Backstop
• Why Cocos?:
  • High-Trigger Cocos Compared with Other Bailinable Debt
  • Self-Insurance with Cocos Compared to Common Equity
  • Automatic Cocos Conversion vs. Voluntary Restructuring
  • Reasons for Having Cocos Liabilities on the Balance Sheet
• Varieties of Cocos Design and Rationales:
  • Determining Conversion Price and Risk Premium in Cocos
  • Write-Down-Only Cocos
  • Actual or Prospective Recovery Rates from Converting Cocos
  • Government Capital Injections and Bailout Cocos
  • Misuses of Cocos in Government-Led Recapitalizations of Banks
• Policy Choices and Essentials for Cocos' Success:
  • The Tax Treatment of the Interest Paid on Cocos
  • Major Credit Rating Agencies' Approaches to Rating Cocos
  • Regulatory Requirements at Cross-Purposes
  • Conclusions and Recommendations for Cocos Design and Evaluations

Readership: Researchers in Banking, Finance, and Financial Service, Finance Professionals, Law Firms, Accounting, and Financial-Consulting Firms; Portfolio and Wealth Management Specialists; Fixed-Income Investors and Fund Managers; Government Regulators of Financial Services; Libraries and Members of Research and Capital Markets Divisions at National and International Financial Institutions.

Part I

Foundations

1

Introduction

Reacting to the severe financial crisis of 2007–2009, contingent convertible debt securities, abbreviated CoCos or cocos, were introduced as a promising new instrument of financial reform. They were to reduce bank failures and thereby cushion the next financial crisis more reliably and automatically than existing subordinated debt. After a slow start in 2009 that almost stopped in 2010, their issuance has been growing progressively. However, a number of their design features and uses are still experimental. This makes it exciting to assist with their evaluation, development and acceptance in the public interest and from capital market perspectives.

Banks headquartered in Western Europe, most notably in the United Kingdom and Switzerland, have been the main issuers of cocos, but investor demand can be found for them wherever they may be offered: in North and South America and in Southeast Asia as well. Hurdles that must be jumped when issuing cocos into the US are described by Oakes and Milonakis (2013). BBVA Citi Research (2013, p. 5) , under the heading “lower total funding volumes but a clear preference for cocos” reported that cocos issuance by European Banks in 2013 had been running at 30% of their total subordinated funding and at about 4% of senior unsecured plus subordinated funding. If Citigroup estimates that European banks could raise as much as €65 billion ($88 billion at 1.35$/€) in 2014 should turn out to be correct, the latter percentage could rise to at least 15%.

The saving grace of cocos is that they get converted into common stock on pre-specified terms when a bank or investment bank becomes so thinly capitalized that a preset trigger level for a designated capital or leverage ratio is breached. For now it shall suffice to say that regulatory capital ratios typically have common equity in the numerator and risk-weighted assets in the denominator, while leverage ratios have a somewhat broader equity-like sum in the numerator and a much larger, not risk weighted, asset aggregate in the denominator. Hence it is not unusual for capital ratios to be twice as high as leverage ratios for the same firm, with both customarily reported in percentages. Indicative of the role that the loss of equity capital by many banks plays in bringing on and propagating a banking crisis, Caprio (2013) identifies a banking crisis by whether much or all of bank capital is being exhausted in a troubled country. He finds that, by this criterion, there were 117 episodes of systemic banking crises in 93 countries between 1970 and 2002. These episodes are thus a recurring phenomenon and ubiquitous.

Severe banking crises are marked by the breakdown of the intermediation system between financial and non-financial sectors and between agents frozen out of fraying financial networks. As risk aversion mounts and illiquidity rises, the price of the least liquid assets plummets, starting with the riskiest. Mutual trust in the ability of counterparties to honor their financial commitments breaks down. Consequently, banking crises almost invariably metastasize into pandemics of general financial and economic crises. These crises have an increasingly global reach. As operating and revaluation (mark-to-market) losses mount in the banking sector, losses many times higher than those inflicted on unsecured creditors and stockholders of the banks afflict the national and international economy as a whole and its nonbank participants.

Banking crises may not be entirely endemic or precipitated solely from within by the managerial, cultural, regulatory, and political environment in which banks operate. Several types of outside disturbances could also play a part in fomenting a crisis. However, human agency is paramount and analogies with acts of god or with volcanic eruptions, tsunamis, or black swans are a cheap excuse. For instance, if black swans are so extremely rare, why are financial crises so common? Indeed, financial crises share broadly similar patterns in the lead-up and aftermath of such crises. Here is just one quote from Reinhart and Rogoff (2009, p. 224) on their employment and output effects, leaving aside the asset price declines and surging government debt which they also identified as typically associated with such crises:

The aftermath of banking crises is associated with profound declines in output and employment. The unemployment rate rises an average [for severe systemic post-World War II financial crises that started prior to 2007] of 7 percentage points during the down phase of the cycle, which lasts on average more than four years. Output falls (from peak to trough) more than 9 percent on average, although the duration of the downturn, averaging roughly two years, is considerably shorter than that of unemployment.

For the US alone Atkinson, Luttrell, and Rosenblum (2013, p. 9) have since estimated that the total loss resulting from output remaining below trend from 2008 prospectively until 2020 would be equivalent to 65% to 165% of one-year’s output or $10 to $25 trillion.

Outcomes for individual crises may of course differ greatly from the average even within the same group of countries as Montiel’s (2014) case studies (which include 8 crises in emerging-market countries) vividly demonstrate. Two of these countries, Argentina and Turkey, appeared in 2014 to be lurching for somewhat different reasons toward crisis once again. Nevertheless the pathologies on the whole, in both emerging and advanced countries, are well known to crisis specialists and those who construct early warning indicators of approaching financial crises. Hence it is natural to wonder why banking regulators, supervisors, legislators, and international financial institutions which claim to know better cannot do something to break the pattern of recurring financial mayhem.

Here Reinhart and Rogoff (2009, p. 156) provide an important clue. They first cite evidence that inadequate regulation and lack of supervision at the time of liberalization may play a key role in explaining why deregulation and banking crises are so closely linked in developed countries and emerging markets alike. Then they conclude, “in the 2000s the United States, for all its this-time-is-different hubris, proved no exception, for financial innovation is a variant of the liberalization process” (emphasis added). Sharpening the point, it can be said that financial innovation is a process by which the financial system continually tries to deregulate itself so that, unmoored, it can get back to trolling in dangerous waters. Barth, Caprio, and Levine (2012, p. 231) also blame the Guardians of Finance and those who appoint and then hobble them, for forever dashing hopes of lasting improvement. They find serious and chronic defects in the institutional apparatus that selects, implements, and reforms financial policies and conclude, “Through acts of commission and omission, major financial regulatory agencies repeatedly designed and [knowingly] maintained policies that increased the fragility of the financial system and the inefficient allocation of capital.”

Just as financial crises are all too common, there are serial accommodations or outright bailouts of too-big-to-fail [TBTF] institutions caught up in them. Citibank (now Citigroup), for example, has had to be pulled back from the abyss many times in its over 200-year history. Counting back just a quarter century from the start of the 2007–2009 crisis, in 1982 Citibank almost failed because of bad loans made to Latin America, but of course it was TBTF for that to happen. In 1989–1991 it was in big trouble again largely on account of excessive lending on richly valued commercial real estate, not just in the United States. Then Citibank got drawn into the 1998 Long Term Capital Management disaster, falling victim to concentrated counterparty risk. This was followed by the residential mortgage credit, derivatives, and failure of risk management fiasco that led to a partial government takeover of up to 36% of Citigroup by early 2009. The average time between the onset of the institution’s crises in this quarter century was about eight years.

The Schumpeterian usage of the term creative destruction intends to draw attention to the invigorating effects of bankruptcy because “creative” is meant to apply to the destruction and its aftermath and not to its perpetrator. Applied to banking, the meaning is different: Those who wreak havoc in banking have found ever more creative ways to do so, but the results have not been particularly creative in making way for something new and better. The remnants of one operation that has been shattered and reduced by a loss of network relationships eventually get picked up by another without compensatory benefits to the system as a whole. When Nick Leeson’s outsized and unfortunate position taking in 1995 brought down Barings Bank, an institution 50 years older than Citibank, there was no indication that its business model was outmoded; still, it had obviously been ill-prepared to manage and appropriately limit some type of operational risk somewhere in its far-flung business. Such a whale of a loss has occurred in several TBTF banks since that time for exactly the same reasons, though so far not with quite such fatal consequences. Was there any healthy progress for investment banking hidden in the collapse of Lehman Brothers in the late summer of 2008? If so, it has yet to be pointed out.

Perhaps the main result of this collapse and its ugly consequences has been to make the implicit TBTF guarantee even firmer. This could help explain why maintaining a good reputation has become less relevant and dependable since TBTF became the norm. Unless supported by professional pride and a few grains of professional ethics, reputation becomes instrumentalized. It is then viewed as an institutional asset that is not to be piled up and treasured but used and abused in dealing with unwary loan, wealth-management, underwriting and consulting-business clients. Self-restraint by managers in the interest of preserving their institution’s—and their own—good name may be too much to hope for in the shadow of TBTF.

1.1The Operative Principles Applied in this Monograph

Five working principles for the choices made in this book follow from these considerations and polite reservations:

1.Financial innovations originally proposed from outside the financial industry are more likely to be beneficial than those developed entirely within that industry. However, the industry should not be forced to adopt any proposed instrument innovations, least of all if their optimal benefit-cost relations and the proper scale and scope of their application still need to be found out and pre-tested. Incentives to adopt that are commensurate with the expected public benefit may be justified by arguments similar to those used to justify infant-industry tariffs, but cocos mandates should be avoided.

2.Instrument innovations should focus on increasing bank capital and access to equity capital before an institution enters the acute stage of any crisis that has already reduced capital ratios to dangerously low levels. Going-concern cocos with triggers based on regulatory capital ratios provide such a service. True to their insurance rationale, cocos should be issued in good times to be available for providing capital support in bad times. There has been a worrisome tendency to do the opposite, particularly in Iberian bailouts, by attaching upside conversion or repurchase options to cocos that were sold to the government rather than to private parties.

3.Neither regulators nor bank managers should be allowed to interfere with the automaticity of high-trigger cocos conversion when triggered, provided that the trigger is set at or above the level at which the institution is regarded as adequately capitalized by its national regulator. In those cases, cocos trigger activation and conversion should not be subject to the dubious agency of government regulators or the managers of the banks that have issued cocos. The cost of issuing high-trigger cocos would needlessly be raised, and their credit rating would be reduced, by providing for discretionary override of a going-concern cocos trigger. Furthermore, if regulators can play fast and loose with trigger activation and the accounting measures and conditions surrounding conversion, they could prevent the legal system and civil law suits from safeguarding the accurate, timely and transparent application of the built-in conversion mechanism.

4.Apart from the definition of the trigger and the level at which it is set, the recovery or ‘replacement’ rate of cocos that is afforded by the common stock received in conversion is a crucial strategic variable. If that value is zero, as with write-down-only cocos, their holders are set to lose the entire principal invested when cocos are triggered while from debt write-off pre-existing shareholders gain what cocos holders lose. Since shareholders have the upper hand, this incentive structure is toxic and militates against the future issue of such cocos.

5.If cocos holders are direct or indirect loan clients of banks, for instance via hedge funds, their losses could spill back. Hence the replacement rate should be closer to 1 than to 0 to reduce prospective losses for cocos holders and to lower the yield they require. A second reason is that pre-existing shareholders and managers should not stand to gain more from conversion than would suffice to keep them interested in cocos being issued in the first place. A replacement rate of about 0.8 would provide for the appropriate apportionment of relatively small gains and losses to the two parties without undue spillovers to third parties.

1.2Orientation and Summary for Parts I–IV

Part I lays the foundations that are needed for the subject matter of this study by first outlining the regulatory environment into which cocos must fit in order to make a recognized contribution to some parts of regulatory capital. Because cocos convert into common equity outside of bankruptcy they are part of a long—though not unchallenged—tradition in Europe and the United States of trying to preserve going-concern value by offering struggling entrepreneurs occasional forbearance and a second chance to succeed. However, cocos are not the only currently available instrument that may be suitable for this purpose; reverse convertible securities and loss equity puts will be considered and contrasted with cocos as well. Because cocos came to be used in response to the financial crisis of 2007–2009, some knowledge of the muddled history of bailouts and rescue efforts mounted on behalf of individual institutions during this period is part of the background that will need to be laid out. Monetary and fiscal exposures and policy objectives in these rescue missions and their aftermath will be discussed as well, again mainly from a US perspective. Because banks headquartered in the United States have yet to issue cocos, the focus in the next two Parts will shift to what Europe has done with cocos.

Part II will try to make the case for cocos by taking on some of their challengers. First it will distinguish high-trigger from low-trigger cocos and then contrast them from non-viability contingent capital and other “bailinable” debt. It will then discuss what each of these hybrid securities, when converted, can do for the survival or prompt resolution of an institution compared with simply having a larger equity cushion in the first place. The third comparison will be with trying to negotiate a restructuring that meets with debt holders’ approval of a substantial write-down of their non-cocos claims. This will involve working through a recent actual restructuring with numbers that facilitate comparison with what might have been different had there been cocos to convert on the balance sheet. Hence the third paired comparison will pit cocos not against alternative financing instruments but against restructuring procedures which turned out to be very costly and time consuming without them.

Part III will deal with varieties of cocos design and their pricing and rationales. It will provide a baseline estimate of the conversion risk premium controlling for the level of the ‘riskless’ interest rate, the annualized probability of conversion, and the replacement rate. These estimates will be based on the assumption of risk neutrality, meaning that the conversion risk premium only has to cover the loss expected from the sale of stock obtained from conversion without requiring additional compensation on account of risk aversion. Actual yields required on write-downonly cocos with varying trigger levels and credit ratings will then be confronted with the baseline estimates and other model-based estimates such as of the annualized premium rate in percent of ‘nominal’ required on credit default swaps written on non-cocos bonds with otherwise similar characteristics. Attention will then shift to the somewhat perverse use of bailout cocos by governments wanting to help rescue their TBTF banks without ending up as the owners of all or substantial parts of them and having to take the acquisition costs on-budget. With interest rates set at 10% by the acquiring government agencies of Ireland, Portugal, and Spain, these cocos were meant to be repurchased within a few years, hopefully with the proceeds of new stock issues in the market, before their mandatory date of conversion by the government was reached. The government of Ireland instead managed to remarket these cocos and sell them to private holders with a small accounting gain. Two surviving Greek banks balked at going through with expensive cocos issues which they had already announced when they managed to meet the higher capital requirements imposed on them without cocos.

Part IV will emphasize that for cocos to be able to compete in the capital market they must satisfy three conditions which are not yet readily reconcilable in a number of national jurisdictions: They must (1) qualify to meet some part of regulatory capital requirements, (2) be rated investment-grade rather than high-yield debt by the major rating agencies of c...

Table of contents

• Cover Page
• Halftitle Page
• Title Page
• Copyright
• Acknowledgments
• Abstract
• Contents
• List of Tables
• About the Author
• Part I Foundations
• Part II Why Cocos?
• Part III Varieties of Cocos Design and Rationales
• Part IV Policy Choices and Essentials for Cocos’ Success
• References
• Index