Deutsche’s phase-out of old-style capital securities and the meaning of perpetual debt

On July 17, I posted on this blog about the difficulties that EU banks face when replacing pre-crises capital securities with Basel III compliant securities.

Today the WSJ illustrates these difficulties for Deutsche Bank. This bank struggles with capital securities that were issued before the financial crisis made us painfully aware of their abysmal prudential properties. Sold as perpetual securities, they were meant to absorb losses, loss absorption being a characteristic of equity. The perpetual securities were not meant to act like debt. However, the Deutsche case shows that they are debt: their market value jumped up when investors realized that Deutsche would redeem them soon: on September 19. Any losses once reflected through depressed trading prices of these securities will have to be ignored, as Deutsche will have to redeem their full value. These securities are not capable of absorbing losses.

The weird thing about these regulatory capital securities was pointedly highlighted by my son of 14. He asked me what ‘perpetual debt’ means if it can be redeemed after 10 years.

The answer: it depends on what investors expect. And what investors expect depends partly on where they live.

In fact, Basel III is very flexible and accommodating when it comes to defining the concept of perpetuity. For capital securities that are not ordinary shares, the Basel III rules mention on page 14 that they shall be … ‘perpetual, ie there is no maturity date and there are no step-ups or other incentives to redeem.’ However, the next page mentions that these securities ‘may be callable at the initiative of the issuer only after a minimum of five years.’

These two rules may look inconsistent, but they serve two distinct markets. European investors expect the security to be called at the first call date. For example, in 2008 the same Deutsche Bank shocked investors when it decided not to call a security. However, investors in the U.S. expect the security to be redeemed at the first call date. The rule on page 14 is for Europe, and the rule on page 15 may serve other jurisdictions.

Investors, banks, and regulators are aware of these differences in expectations. It is like measuring length in centimetres and inches, which almost never leads to problems. However, if you are not aware about the difference between them it can go spectacularly wrong.

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