Basel Committee moves closer to harmonizing contingent capital rules; will make investors pay for any bailout.
In a bank bailout investors should be the first source of funding, not taxpayers. That’s the conclusion of the Basel Committee, as it recently issued a consultative document on the rules regarding contingent capital. The main thrust is that contingent capital rules will now focus the costs on bondholders.
This means that before the government intervenes to rescue with taxpayer cash, the bank’s contingent capital would convert to equity or be written off. This basically makes the instrument better able to absorb losses if the company cannot fund itself. During the financial crisis, existing hybrid securities were not as loss absorbing for their issuers as everyone expected, often leaving taxpayers to foot the bill (while bondholders lost nothing).
The Basel proposal, Proposal to ensure the loss absorbency of regulatory capital at the point of non-viability, aims to “ensure all regulatory capital instruments are able to absorb losses in the event that a bank is unable to support itself in the private market, including situations when the public sector steps in to recapitalize a bank that would otherwise have failed.” The committee said it will welcome comments on the proposal until Oct. 1.
For banks this means the cost of issuing debt will likely rise as investors will want more compensation for the increased risk that they won’t be repaid. “The older sources of capital that may have been subject to public sector bailouts are no longer,” said an attorney who specializes in international finance. “So it will increase the costs of borrowing because investors will demand a higher interest rate.”
Is there a market?
While Lloyds Banking Group and Rabobank successfully issued contingent capital bonds — Lloyds late last year and Rabo in March — there is still a question as to whether there will be a market for the instruments.
In Lloyds’s case (a taxpayer-assisted bank), the bank issued around $13bn of enhanced capital notes (ECN) as part of a subordinated-debt exchange. The ECNs, or contingent convertible core Tier 1 securities (CoCos), would “trigger” or convert to equity if Lloyds’s core Tier 1 ratio fell below 5 percent. Struggling at the time, the bank brought the issues to market to shore up its balance sheet.
In a much smaller but very well received deal, Rabo issued $1.5bn benchmark 10-year fixed-rate senior contingent notes (SCN), which would convert to equity if Rabo’s Tier 1 ratio fell below 7 percent. Analysts saw the successful and oversubscribed Rabo deal, a healthy bank, as a good omen for things to come; that is, there will be buyers.
This will be welcome news as banks of every size and stripe will likely need more capital in the next few years, according to consultancy McKinsey, which earlier this year estimated that at least 25 banks needed as much as $600bn over the next five years. Also, new Basel III capital requirements will require banks to raise more Tier 1 cash, and contingent capital is exactly that — the type of capital regulators like.