BarCap may become CoCo bonus pioneer
Investment bankers don’t come up with a lot of financial innovations that today’s regulators and politicians like. But Barclays Capital is working on one that just might please everyone. The investment banking arm of Barclays, the London-based retail banking behemoth, is leaning towards issuing a healthy slug of contingent capital securities, or CoCos, to employees as part of their 2010 deferred compensation, according to people familiar with the firm’s plans.
These securities are bank bonds that turn into equity when things go awry, for instance when losses mount and the bank’s equity capital ratios fall, thereby boosting capital. So, in essence, adding CoCos to the bonus mix would be a novel way for BarCap to force bankers to contribute some of their loot to their employer’s capital cushion, thereby helping to minimize political opprobrium over pay.
The idea isn’t entirely new. The European Parliament gave the green light over the summer for banks to use these securities as compensation. Barclays would be the first major international bank to pull the trigger. Other banks in Britain and Switzerland, where regulators have generally shown the most interest in contingent capital, have also considered adding CoCos to their bonus pools.
It’s a good idea. First off, it’s a relatively defensible way to pay out healthy bonuses. And the backlash over bank pay is especially prominent in the UK, where BarCap — which acquired the U.S. operations of Lehman Brothers — is headquartered and where the government instituted a one-off tax targeting bonuses.
But CoCos would not merely constitute a compensation fig leaf. Throwing the securities into bankers’ stockings better aligns their interests with those of regulators hoping to avoid a repeat of the taxpayer bailouts of the last financial meltdown. That’s obviously true if CoCos replace cash compensation, but it’s also potentially the case versus plain old shares.
That’s because banks are highly leveraged, so share-based bonuses can give employees an incentive to take more risk in the hope of sending the share price skywards. Contingent capital works the other way around: it pays a fixed return, and falls in value if the bank suffers heavy losses. Employees holding these instruments should have more reason to worry about the risks as well as potential profits.
Moreover, BarCap bankers might be happy enough to receive CoCos if they pay around 8 percent annually and vest over three years, as bank executives examining the idea say they might. As it stands, a senior banker with 60 percent of compensation in deferred form receives most of that in restricted stock. Under the scenario being contemplated, that could now be split between stock and CoCos.
So what’s stopping Barclays or other banks from going cuckoo for CoCos right away? Well, there are some technical obstacles, such as tax implications and the absence of a liquid market for this form of securities. The more banks issue them, of course, the more liquid the market would become — but without institutional investors involved, banks might still have to cash out the securities held by their staff at the end of their vesting periods.
Still, the lack of a liquid market hasn’t prevented banks from going ahead with innovative forms of compensation in the past. Senior Credit Suisse investment bankers in 2009 received a portion of their deferred compensation in securities backed by around $5 billion of the firm’s illiquid assets. And these so-called Partner Asset Facility units, which held securities like commercial mortgage backed and leveraged loans that were deemed dodgy at the time, actually soared in value in the following year.
The biggest hurdle is actually the fact that regulators in Britain and global bank capital standard-setters in Basel, Switzerland, still haven’t issued clear guidelines on the treatment of contingent capital.
The risk is that banks aren’t certain that CoCos will count towards their regulatory capital when the bonus round closes in the next month or two. There could be ways around such a delay: for instance, a bank could issue a bond-like instrument, with a lower coupon, exchangeable for a higher-yielding CoCo later.
But even a willing pioneer like Barclays would almost certainly need a wink and a nod from regulators before going to all the trouble of paying its people in CoCos. It would be a pity if regulators’ slow deliberations prevented this particular innovation from proceeding.