Convertible Capital Hurdles
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.
- 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.
- 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.
- Rank deterioration: in case of a write-down and if shares are not wiped out first, then the coco loses its seniority. The write-down renders the coco 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.
- 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.
- 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?
- 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.
- 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?
- 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?
- 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.