Rabobank takes lead in bank capital revolution
(Refiles on October 19, 2010 to add disclaimer for author’s personal investment. Neil Unmack owned Lloyds CoCos when he wrote this article.)
Ever since the financial crisis struck, regulators have argued for an overhaul of bank capital. Contingent capital, which can absorb losses while the bank remains in business, sounds like the solution. But until last week it had only been used by a few distressed lenders.
So the decision by Rabobank — one of the world’s most highly-rated banks — to issue contingent capital securities is welcome. The Dutch mutual is the first healthy European lender to sell the securities to investors as a new issue. But investors and regulators will need persuading if the idea is to catch on.
Bankers hope contingent capital can replace other kinds of hybrid debt, which are being phased out by regulators.
Hybrids were popular during the boom years because they counted towards banks’ regulatory capital but did not dilute shareholders. But they proved of little use during the crisis because they could not absorb losses while the bank was still in business. Contingent capital solves this problem, by converting into core capital if the bank’s regulatory reserves fall below a predetermined trigger point.
Nevertheless, it’s still not clear how much of a market there is for this kind of debt. Lloyds Banking Group last year issued bonds that are convertible into shares. However, it did so as part of a debt exchange which gave investors a strong incentive to convert.
Rabobank’s securities are different because they don’t convert into equity if the trigger is reached. Instead, they are written down to 25 percent of their face value and then repaid. This reduces Rabobank’s liabilities, allowing it to book a profit which will boost its Tier 1 capital ratio.
Despite regulators’ enthusiasm for contingent capital, Rabobank’s offering won’t initially count towards its regulatory capital: the bank is using the securities to manage its own internal measure of capital.
Another issue is price. Because Rabobank’s securities are written down rather than being converted into shares, investors would suffer a loss with no prospect of future recovery. The fact that the bond is unrated will also deter some buyers. And investors may be less accommodating to weaker lenders.
Rabobank’s offering takes the market for contingent capital one step forward, but it won’t be the last word. It will still be some time before theory becomes reality.