Last week, the three European financial regulators warned financial institutions that they should tread carefully when it comes to marketing CoCos: capital securities that may convert or be written off when a bank gets into trouble. The warning may have been prompted by the failure of UK’s Co-operative bank or Dutch bank SNS. These failures bailed-in some subordinated debt securities, to the dismay of retail investors in particular.

I doubt whether the warning of the financial regulators will help: they warn the banks and insurance companies to be more careful. This is like telling R. J. Reynolds to be more careful in marketing cigarettes.

It is probably better to educate – or to suggest more potent measures, which this post does. It attempts to explain a bit more about the risks of investing in subordinated capital securities. As there are too many misunderstandings about them, I think generic warnings probably won’t cut it. Like the warnings printed on cigarette boxes, these won’t help some (vulnerable) members of the public. A better solution is to increase the amount an investor should pay-in to invest in these securities.

This post is a best effort, based on my limited experience with CoCos. Though incomplete, it should give you an idea about the features that make CoCos more risky than your garden variety savings account. Before digging into specific features of subordinated securities, let me start with a general warning for when you ponder about investing in subordinated capital securities:

You are pitted against those who protect the financial stability of your country.

You may not be aware of this, however, when it comes to CoCos, your interest and that of the bank supervisor may diverge. The bank supervisor is in charge of the financial stability of your country – the idea is to keep the financial system alive, even if some banks struggle to survive. CoCos may be sacrificed to safeguard the safety and soundness of the financial system. In other words, whenever you buy a subordinated capital note, a hybrid capital security, a Tier 1 or a Tier 2 instrument, you promise to save the issuing bank, and often with it, the financial system. This is laudable for sure. However, make sure you can afford to be that good a soldier.

Also, if you look at how the subordinated capital securities are created, then you should realize that it is you against some pretty powerful interests. Subordinated capital securities are not like ordinary shares. Each security is uniquely defined by an underlying contract. This contract is the result of negotiations between the bank, its platoon of expert advisers (lawyers, accountants, financial specialists) and the bank supervisor. Their joint interest is to make sure that the security that you buy absorbs losses in case a bank makes mistakes, i.e. when things go awry. It is not the bank supervisor’s interest to make sure you get a high return. In fact, the lower the return you get, the more there is to protect the bank and the financial system.

What capital securities, Tier 1, Tier 2 … ? Banks issue capital securities to meet solvency requirements, e.g. Basel III or EU’s CRR. Issuing subordinated capital securities is often cheaper than issuing ordinary shares. (For example because of the tax deductibility of the interest the bank pays on these securities; but there are more reasons why capital securities are cheaper for the issuing bank than ordinary shares.)

Solvency requirements, recognize two types of capital securities. Those that count towards Tier 1 capital, and those that count towards Tier 2 capital. Tier 1 capital bears losses when the bank is still viable, it is meant as a first line of defence. It may be sacrificed to minimize the probability of the bank getting into even deeper trouble.

Tier 2 capital is there to limit the damage to creditors and deposit holders when the bank has failed. As a second line of defence, Tier 2 capital should be less risky than Tier 1 capital. However, don’t count on it, banks can accumulate losses quickly, and there may be insufficient Tier 1 capital to bear all the losses.

Write down, write off, conversion, permanently, temporarily. Your capital security may be subject to a write down, a write off, or a conversion into equity; either temporarily, or permanently. Make sure you understand how and why a bank imposes losses on your investment. Banks that have their shares traded on an exchange may convert your security into shares. This is probably better than a full write down, where you lose your entire investment: Shares offer at least some upside potential.

Banks that have no ordinary shares, e.g. cooperative banks or mutuals, will likely write down your investment, either in part or in full. See for example, this Rabobank Tier 1 security.

Some banks, e.g. KBC, offer a temporary write down: Your investment bounces back to its original value once the bank returns to good health. This looks sympa, however, in practice, the process of a bank restoring to good health takes time and is full of uncertainties.

Things to look for when investing in a Tier 2 security. Tier 2 securities are meant to absorb losses when the bank is not a going concern any longer, i.e. when the bank fails. It is important to figure out how your security contract deals with bank failure. Some countries have special rules that deal with bank resolution. They may bail-in your investment, see for example Denmark, the United Kingdom, Switzerland and the United States. Other countries are developing these rules, e.g. Canada. European countries will implement the BRRD, a directive that deals with failing banks. This directive will enter into force in 2015, but important rules that put your investment at risk may kick in only from 2016. Another example is New Zealand: Its ASB bank will convert Tier 2 securities into shares of ASB’s parent: the Commonwealth Bank of Australia. However, if you read the terms, then this conversion is subject to requirements and risks.

Some banks do not mention much about imposing losses on Tier 2 securities. That does not mean the security is safe. Rabobank, for example, issued Tier 2 capital where the contract relies on the expected entry into force of the BRRD, a directive that requires banks to bail-in holders of capital securities, irrespective of contractual arrangements.

Also, a resolution regime should kick in when the bank fails. Fair enough, however, some regulators (e.g. RBNZ and APRA) keep the powers to impose losses on Tier 2 securities even if the bank is viable, see for example this issue of ANZ.

Things to look for when investing in a Tier 1 security. If you read the Basel III requirements for Tier 1 securities, then you should realize that the Basel Committee did not really want these securities to return to the market. Tier 1 securities have many features that shift risks to the investor; which is actually counter-productive: The riskier the security, the higher the return, the more attractive these securities look, in particular if you have no clue what this post is about.

For example, the interest (or coupon) on a Tier 1 security is subjected to the rule of “full flexibility of payments”. This means that the bank can stop paying interest at the drop of a hat, without explaining why. If you don’t receive your coupon, don’t even bother to call your bank: this is you against the interests of the bank.

Another feature of Tier 1 securities is that they should bear losses when the bank is still viable. This “loss absorption in going concern” entails writing down the security when the bank’s solvency reaches a pre-specified level. Some banks set this level relatively high. For example, Barclays issued a Tier 1 security with a write down trigger set at a solvency percentage of 7, i.e. when the Common Equity Tier 1 ratio hits the 7% mark.

Many bank regulators allow a lower trigger level. The minimum trigger level is 5.125%, which Basel members agreed upon after many months of deliberations. 5.125% is very low, at that point the bank is bust. For example, Banco Espírito Santo went into resolution with a 5% CET1 ratio. A contract that relies on the 5.125% trigger level for write-down has no teeth. Then again, a trigger set at 5.125% does not mean your investment is safe. It is still, like Tier 2 securities, subject to being written off when the bank is not viable. (Note also that some countries exempt some Tier 1 securities from going concern loss absorption. For example, Australia and New Zealand exempt Tier 1 securities that are accounted for as equity; Europe does not know this exemption.)

Perpetual securities? Yeah, sort of. Tier 1 securities are meant to be perpetual, they should be permanently available to bear losses. This is great, especially if the security offers a high coupon … forever. However, it is not that black and white. Banks are allowed to call capital securities once they reach the age of five. Most European banks will do so, they even upset some investors when they don’t do so, (Deutsche Bank has a bit of a reputation of not calling). A problem for you is that it is not easy to figure out if a bank will call or redeem your investment, because they are generally not allowed to raise any expectations about calling or redeeming capital securities.

In addition, banks may call the security when the relevant tax rules change, or when the solvency rules change. Therefore, before you invest, make sure you know what to expect when (or if) your investment celebrates its fifth birthday: is this a day to celebrate or not?

To conclude. Subordinated capital securities are complex. Therefore, I am not sure if they should be sold to retail investors. In my opinion it is too easy to rely on warnings, as financial literacy decreases with yield. The riskier the security, the higher the yield, the higher the likelihood that financially illiterate folks will buy these securities.

An effective way to mitigate this adverse selection problem is to sell capital securities at high denominations, e.g. $100,000 each. Someone willing to fork out such an amount should be able to hire someone who understands these securities and can value them correctly.