EBA offers the – wicked – prospect of standard terms and conditions for CoCos.
Today the EBA published the final version of its updated report on the monitoring of Additional Tier 1 capital instruments. Regarding the most controversial issue, the use of contingent clauses, the report recommends disallowing them in the terms and conditions of EU issuances.
The output of EBA’s own funds subgroup invariantly meets the highest quality standards, thanks to all group members, and in particular thanks to group’s chair from Belgium, within the capital guild a valued, impressive contributor to regulatory capital standards. In this context, I found paragraph 14 kind of odd.* Despite the existence of the CRR, technical standards, and guidance, the EBA comes with this – almost self-deprecating – idea of standard contracts.
Seriously, it is not really hard to write contracts for regulatory capital. I mean, a copy and paste of a recent contract will work very well. The next step is to contact an investment bank that is at the forefront of writing these contracts and some good lawyers. Oh, yes, it helps to consult your prudential supervisor. In short, there is an infrastructure out there that should sort a bank out in no tome. And yes, it is okay if small banks cannot bear the cost of issuing hybrids, these instruments are efficient for large banks only, given their cost. Then again, where large banks may need haute couture contracts to meet their needs, small banks should be able to obtain cheaper Prêt-à–Porter contracts.
So, the idea of a standard contract, it is just wicked:
The idea that one can summarise the CRR, technical standards, and guidelines into standard contracts is a tad naive. The risk may be that an inapt contract enters the marketplace unsupervised. This is because a standard contract will lead to complacency: both issuer and supervisor rely on the standard contract thinking it is correct. More or less like the dual principal single agent model of Bengt Holmstrom, which leads to a lack of effort and low quality output. In regulatory capital land, low quality contracts get disqualified, which will end in tears.
A standard contract will likely be a one-size-fits all, with features that may not work properly. Suppose, for example that the contract specifies a temporary write down at a trigger level of 5.125%. Obviously, these instruments are hardly loss absorbing – the trigger will hit when the bank is in resolution. Consequently, the market gets inundated with these impotent instruments, and no, there is no Viagra equivalent in the world of regulatory capital, so, like many men over 50, that too will end in tears. (In the meanwhile, pointing to the large number of standard contract issuances, the EBA will claim that the idea of a standard contract is an éclatant success.)
Prudential supervisors will have a hard time in convincing banks to adopt more potent features. As Dan Davies demonstrates, the higher-ups at the bank will talk to the higher-ups of the supervisor, who supported the EBA standard contract. As a result, the front-line supervisor responsible for the issuance of the instrument will be second guessed.
Lastly, the public may be fooled into the idea that the standard contract is a safe option, which puts retail investors at risk.
It is great that the EBA offers solutions where markets fail, however, (quoting Friedrich August von Hayek) it is essential that we recognize that the desirability of a particular object is not sufficient justification for the use of coercion.
*”14. Furthermore, the EBA will develop standardised terms and conditions for AT1 issuances which will cover the prudential parts of the terms and conditions. This is believed to be helpful, in particular, for institutions of a smaller size and, more generally, for supervisors to assess the compliance of the instrument with the regulatory provisions. While these standardised terms and conditions would not be of a compulsory use for institutions, they would help to ensure the compliance of the instrument for an institution which would use these.”