A dark horse for financial innovation

August 27, 2009

Financial crises tend to spark innovation, and this one will be no different.  Today’s Times of London carries a story on a new security Lloyds Banking Group is devising to raise capital and reduce its participation in the British government’s asset protection scheme (GAPS).

The advantages for Lloyds of raising new capital are obvious: it would reduce the government’s stake in the bank taken as payment for GAPS, give it greater free rein and a more powerful negotiating stance with the European Commission over its restructuring plans.

The trouble is, the plan would require tens of billions of capital. A rights issue may help raise some of that, as would asset sales, but the other natural source of capital – the debt market – is still in turmoil.

Many investors are shunning hybrid securities after taking steep losses. While some banks have issued deals, the market is pretty much closed for any bank in which the government owns a large stake because of fears the European Commission will compel banks that have taken state-aid to defer coupons.

Lloyds may need to come up with something different.

It will be helped by the Financial Services Authority, which would like to see banks develop a capital instrument that absorbs losses in a more meaningful way than hybrid debt.

FSA director Thomas Huertas gave an example of a kind of new capital security in a speech in January, in which he outlined “contingent’’ or “top-up’’ capital — capital a bank can call on if it gets into dire straits before having to turn to the public sector for help.

One example would be a hybrid instrument that can be converted into core tier 1, such as common stock, at the supervisors’ request if the bank’s capital ratios fall. 

Alternatively, the bank could issue securities to investors through a special purpose vehicle, which sets the cash aside for a rainy day. The cash can be used to purchase ordinary shares if the bank’s capital position deteriorates.

Contingent capital sounds rather similar to Lloyds’ new instrument. Lloyds would convert the security into common stock automatically “if its balance sheet weakens’’ according to the Times.

The question is why Lloyds’ long-suffering shareholders would want to put more money into the stricken bank in the first place. There may be some appeal in the fact the new capital would offer a more stable return – more than can be said of its ordinary shares. There’s also the threat that their existing shares, which have staged a remarkable comeback in the past few months, will fall again if negotiations with the European Union go badly.

But they would need to be offered a juicy income to place themselves in the firing line for future losses. Lloyds existing tier 1 securities are yielding 11 percent or more. It’s hard to see new investors taking any less than that.

Lloyds might be ready to pay up now to help secure freedom, and it may be able to call the deal in a few years. By then there may be a broader and cheaper market for contingent bank capital that it can refinance into.

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