Cetier the First: Convertible Capital Hurdles

For financial stability, along with Anat Admati, Martin Hellwig and others, I strongly advocate the simple idea of requiring banks and other financial firms to be financed by at least 50% equity on the liability side of their balance sheets.

… despite all of the efforts of bankers and the rest of the financial industry to obscure the issues, it all comes down to making sure banks are taking risks with their own money—that is, funds provided by stockholders—rather than with taxpayers’ or depositors’ money. For that purpose, there is no good substitute to requiring that a large share of the funds banks and other financial firms work with come from stockholders.

In particular, the basic problem with convertible capital, bail-ins, and so on is that they all require a decision–either drawn out an painful, or sudden and painful–to force those who have theoretically accepted a risk to actually take a loss. By contrast, equity holders take losses and make gains continually, without everything hingeing on a decision to make some group take the loss. The automatic nature of taking equity losses and getting equity gains is both an advantage in itself and tends to make these capital gains and losses more continuous and less sudden than for convertible capital and “debt” in bail-ins. The discretion that typically exists for convertible capital and bail-ins is much worse than monetary policy discretion, because the decision makers in those cases can’t help being highly conscious of which specific groups are losing money from their decision. By contrast, for monetary policy the decision makers have many other plausible ways they might be looking at things besides the distributional perspective.

For getting the flavor of the problems with convertible capital, in particular,  I liked this article on “Coco Hurdles” by Cetier the First on the Capital Issues website so much that I asked and received Cetier’s permission to reprint it here. (Note: The pen-name Cetier the First is from the Basel abbreviation for Common Equity Tier 1, or CETier 1–this is basically shares, not convertible capital.)

There is a vibrant debate going on regarding convertible capital or coco’s, see for example this recent paper from the U.S. treasury.

On first sight a coco looks great.  In going concern there is a tax advantage for the issuer. And when the issuer’s viability starts deteriorating, cocos may help lower the probability of default. Once a bank is in real trouble, a coco can be used to minimize the loss in default. Conversion should also dilute the owners, a punishment that should deter moral hazard behavior.

However, in practice, cocos are a mess. I will explain.

All discussions on cocos start out praising them for their virtuous properties: they are good for financial stability; they limit the probability of default and the loss given default. The general idea is that the coco converts when the bank hits some predetermined trigger, e.g. a BIS ratio of 9%.  When conversion takes place, the reckless owners are punished by way of dilution, and the bank does not have to access the market for new capital. The bank stays in business and can carry on as if nothing ever happened.

In practice there are hurdles that make cocos punitively unattractive. But before digging into these hurdles, let me first define a coco as any security that may be written off (partially or in full), in some cases combined with a form of compensation. This compensation can be in the form of shares or in the form of a claim on future reserves of the bank.

Coco hurdles:

  1. There is no such thing as an automatic trigger, even though a Tier 2 coco issued by Barclays end of 2012 says its trigger is automatic. Ignore that. Bank supervisors will always want discretion, for example for financial stability purposes. Offering discretion on pulling the trigger is opening Pandora ’s Box. If the supervisor can decide about the trigger, maybe another party can decide too, etc, etc.
  2. Conversion ends in tears, damaging the issuer’s reputation and increasing the cost of next coco issuances. Examples are Santander’s conversion of valores bonds, or the write down of SNS bonds. These cases show that conversion is the beginning of trouble, not the end.
  3. Rank deterioration: conversion of a coco entails writing down its value: if shares are not wiped out first, then the coco loses its seniority. It becomes junior to shares. Basel III requires a full write-off of securities that count as regulatory capital. Such a full write-off deprives the holder from any future upside potential, rendering the coco deeply junior to equity. The jump from senior to equity to junior to equity makes pricing the coco very difficult.
  4. Even if pricing were doable, the cost of a coco will be high: investors seek compensation for the threat of a write-down combined with the limited upside potential.  Consequently, the high servicing costs of cocos are a major drain on a bank’s cash flows. And, unlike dividends, the payments on cocos cannot be skipped easily.
  5. Some regulators, e.g. the European Banking Authority, allow a write-up after a write-down. That may look kind to the holder, but in practice the write-up is complicated: when, how fast, how much? Will prospective equity investors like it if coco-holders have their security written up before dividends be paid?
  6. Further, the quicker the write up, the less the coco absorbs losses, the less it contributes to financial stability. On the other hand, the slower the write-up, the less attractive the coco will be for investors. There is no optimal speed here.
  7. Orphans and widows. Cocos issued out of bank subsidiaries are tricky, as conversion turns coco holders into new co-owners, jointly with the parent bank. The parent bank may even lose its majority ownership of its subsidiary, in which case the latter becomes an orphan, and the former becomes a widow. Will the subsidiary be able to stand on its own feet?
  8. Mothers and daughters. A conversion may coincide with a take-over. Suppose the acquirer is a foreign bank, e.g. Fortis taking over ABN AMRO, and BNP Paribas taking over Fortis. Suppose ABN AMRO once issued cocos with terms specifying that it converts into shares of the parent. Would a domestic coco holder ever think of becoming co-owner of a foreign unknown bank? Would BNP Paribas like to deal with legacy bond-holders of a subsidiary becoming new owners?
  9. Conversion of cocos may dilute shareholders. However, there is nothing to prevent a bank from handing cocos to its executives, to complement holdings in shares. Conversion will turn existing owners into new owners, rendering the dilution effect partially void.

Despite the theoretical virtues of coco’s, in practice these virtues may be virtual.

Note: Anat Admati tweets

Re difficult pricing issues, see also http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2018478 … discontinuous tax treatment complicates too

and also agrees with my claim that bail-in-able debt has similar issues.

Update: John Aziz writes this addendum to his post “Obama Talks Bubble Avoidance”:

Miles Kimball on Twitter points me toward Anat Admati’s suggestion of implementing bank capital requirements to make bubbles less damaging. This is a very fair suggestion, because it is a stabiliser that does not lean on the idea of eliminating bubbles, but the idea of limiting their impact. Obviously, rules can be gamed, but if implemented properly it could systematically limit the size of bubbles, by cutting off the fuel of leverage.