Financial Regulatory Forum

ANALYSIS-Big banks winners from new contingent capital move

By Reuters Staff
August 27, 2010

By Jane Merriman

LONDON, Aug 27 (Reuters) – Plans to make hybrid bond investors share the pain when banks run into trouble could polarise the financial sector into big firms that can afford to pay up for capital and smaller players that cannot.

Financial regulators want to ensure that taxpayers are not the only ones on the hook when banks fail by proposing that bonds that count towards a bank’s capital should be written down or converted to equity if it is close to collapse.

This form of contingent capital would mean bond investors as well as shareholders would take a hit if a bank had to be rescued.

But these plans from the Basel Committee on Banking Supervision could reinforce a pattern emerging in the aftermath of the crisis — a two-tier banking market with international banks that investors favour over smaller banks seen as riskier.

“It could polarise the market further in terms of issuer access and could shut out some smaller institutions and give larger firms a competitive advantage,” said one debt capital markets banker at a major international banking group.

During the crisis, some banks that had to be bailed out — such as the UK’s Northern Rock — continued to pay coupons on bonds that count towards capital known as Tier 2 because they were legally required to do so.

Tier 2 bonds typically have mandatory coupons, if the bank skipped a coupon it would trigger a technical default.

So bond investors not only benefited from a bank being bailed out but also continued to receive coupon payments. Shareholders, on the other hand, were wiped out and taxpayers footed the bill.

The Basel Committee has proposed a solution to this that requires banks’ Tier 2 bonds to be written down in a crisis and converted to equity.

POLARISED MARKET

“The latest proposals suggest that a bank’s capital base will be made up of expensive instruments because investors will look at the downside and want to be paid well for the risk,” said a credit analyst from a UK asset manager.

Bankers also think that the proposal will increase the costs for the sector as a whole, with one official at a U.S. firm saying that the additional spread investors will require could be between 200 and 300 basis points.

Investors have mixed views on contingent capital. They would have problems with more issues along the lines of bonds sold by British bank Lloyds, which are designed to convert to equity in the early stages of a bank running into difficulties.

“We don’t think there is a large market for them, certainly among institutional bond investors,” said Roger Doig, credit analyst at Schroders. Analysts say that such issues are difficult for credit rating agencies to evaluate and many institutional credit investors are not mandated to hold equity.

The Basel proposals have been unveiled as European banks face substantial hybrid debt redemptions in the coming years which they have to replace or shrink their balance sheets.

According to JP Morgan, nearly $29 billion is due in the final three months of this year and a further $85 billion matures in 2011.

Regulators are due next month to finalise what form new-style capital should take and how much more capital banks have to hold, with the new rules due to be implemented from the end of 2012. [ID:nLDE6440SN]

But Doig said he did not expect the latest Basel proposal on contingent capital to change investor appetite for Tier 2 bonds.

“What it may change at the margin, is the number of banks that can issue this sort of debt, as the proposed change in “going concern” threshold from breach of regulatory capital ratios to “non-viability” as determined by a regulator, slightly raises the bar,” he said.

The Basel proposal states that it could help even out differences between big and small banks.

But market participants say a possible side-effect of the proposals could work against regulatory efforts to tackle the problem of banks that are deemed too big to fail.

Daniel Bell, director of product development at Bank of America Merrill Lynch, said regulators would have to apply these provisions across the board.

“If not, investors might not be willing to look at non-systemically important banks because of concerns they will simply be allowed to fail.”

(Editing by Sitaraman Shankar)

((jane.merriman@thomsonreuters.com; +44 207 542 3121; Reuters Messaging:jane.merriman.reuters.com@reuters.net))

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