Five years after the first Basel III coco issuance, the Netherlands “gets” CoCos.

Uh oh, Jeroen Dijsselbloem form the Netherlands got into rough water this week: Dutch newspaper NRC had a nice scoop that showed how he relied on ING word smiths for writing a tax rule that renders bank capital instruments (CoCos) tax deductible, see full freedom of information documentation here.

How bad is this? End 2013, the Dutch government announced that it would make CoCos tax deductible. It is 2015, the tax deductibility rule is in force for some time … one should not be surprised. And by the way, hybrid bank and insurance capital instruments were tax deductible in Europe for many years, so basically nothing changed. And another by-the-way: if a hybrid coupon is deductible by the issuer, then the receiver generally pays tax.

What may have raised one or two eyebrows was that NRC obtained documents revealing the interactions between the Dutch ministry of finance and ING. This does not look good: a bank writing rules from which it benefits. But then again, how surprising is this: this week we learned that ECB top-brass regularly meets with banks.

At some point, the parties involved were worried that the tax deductibility rule for the capital instruments – if only available for banks – would be seen as State support. State support is out of bounds, of course. And ING, once at the receiving end of State support, would have known this. So some imaginative minds contributed to a solution that worked, well sort of worked (I will explain why).

Why banks only? NRC appears to be concerned that the parties involved in writing the rule wanted to avoid making references to banks only. This to avoid the impression of State support.

But why would the rule apply to banks only? Under Solvency II, insurance companies may have to issue CoCos too, and perhaps utility companies may have to issue them at some point in time, as these firms are also subjected to capital requirements.

In addition, eliminating a reference to banks makes sense for another reason:

A Coco trigger for Royal Dutch Shell? In practice, the CoCos that are at the heart of the controversy will be issued by banks and by insurance companies. These CoCos are defined by a trigger. The CoCo converts once the solvency ratio of the financial institution drops below a pre-dermined trigger level. Many triggers are set at very low levels: often at 7% of Common Equity Tier 1 capital over Risk Weighted Assets. In some cases they are set at 5.125%.

Non-banks are generally not subject to solvency requirements, so a trigger is irrelevant. In addition, I do not think a non-bank will survive with typical – low – bank capital levels.

Leaving the reference to banks out the rule would probably be wise, it opens the rule to all institutions that are subjected to capital requirements. The risk that corporates issue these CoCos is low: as the UBS note on this shows: “As corporates seek higher equity credit (100% from S&P / 75% from Moody’s) there is the need to incorporate mandatory deferral triggers, non-cum, non-step etc.. – however, there is still no requirement for write-down / conversion (unless very short maturities) and therefore it will not be in the same form as loss absorbing Bank AT1.”

Did Dutch banks issue lots of cocos after the ruling came into force? Over the last years, global CoCo issuances have soared. However, Dutch banks issue them in moderation. In fact, Rabobank issued a couple of path-breaking Cocos in 2011, but then its CoCo issuances dropped.

A person close to this matter informed me that this is because the tax rule is flawed. Yes, it allows the coupon to be deducted. However, it is unclear if the conversion is tax-deductible. The prospect of having to pay extra taxes in troubled times may put banks off from issuing CoCos.

Why change the tax rules in the first place?  Before Basel III entered into force, banks in the Netherlands relied on these three principles that determine whether an instrument counts as equity:

  1. The payment on the instrument is related to profit,
  2. The instrument is subordinated to claims of all other creditors, and
  3. The instrument has no maturity or has a maturity of at least 50 years.

If an instrument does not meet these three requirements, it will be treated as debt, its coupon will be tax deductible.

Most pre-Basel III hybrids did not meet these requirements, in particular the first. However, under Basel III rules, Additional Tier 1 CoCo’s are subordinated (req #2), permanent (req #3) and the bank has full discretion at all times to cancel the distributions on the instruments for an unlimited period and on a non-cumulative basis (req #1).

As a consequence of these three rules, the Dutch tax rules could potentially qualify AT1 CoCos as equity. To safeguard the tax deductibility, these rules may have had to change.

All in all, the issue raises a couple of questions:

  1. Why did the Dutch tax-law have to change, given that local tax-authorities used the true (short) maturity to determine the tax deductibility. Under Basel III that practice of redeeming instruments shortly after 5 years would not change.
  2. Who came up with this awkward idea that non-banks would issue AT1 instruments? Interestingly, the freedom of information documentation shows that the Dutch government relied on the Basel III rules text, ignoring the much harsher EU rules on hybrids. In addition, the Dutch ministry of finance shows that non-banks issued instruments that have features that are close to AT1 specifications. Close to is very vague, could mean anything.

How did the UK rule? I think the UK dealt with AT1 CoCos in a neat way by relying on the distinction between “truly perpetual” and “contingent perpetual” instruments. The Netherlands could have changed the rules along these lines.