Financial Regulatory Forum

Regulators face battle to create market for CoCos

By Reuters Staff
October 18, 2010

By Jane Merriman

LONDON, Oct 18 (Reuters) – Financial regulators favour contingent capital — bonds that convert to equity — as a way to strengthen large banks, but they face a tough job convincing investors to buy these new-fangled instruments in bulk.

A Reuters survey of major corporate bond investors shows that some would be willing to buy the bonds under certain conditions, but they have a lot of questions they want answered.

(For survey results, please click here)

“As effectively a high-yield instrument, this will tend to limit the investor base because of (investor) mandates,” said John Hampton, lead manager of UK’s LV= Asset Management’s corporate bond fund.

“Whilst we are in a low rate environment, these sort of instruments will attract investors into the market — hedge funds, retail investors.”

But he said a big education programme was needed.

Regulators see contingent capital — known as CoCos — as a way to prevent taxpayers having to foot the bill in the future if large banks run into trouble.

During the credit crisis, governments had to rescue failing banks, which left taxpayers with a bail-out bill running into billions of euros.

But contingent capital would, in theory, give banks an equity injection when they needed it, potentially making government intervention less likely.

The Financial Stability Board will present recommendations on big banks, including CoCos, to the G20 summit next month.

Swiss financial regulators gave their backing to CoCos earlier this month when they said the bonds could bolster the capital base of Credit Suisse  and UBS.

The Swiss regulators’ move has shifted the debate up a gear, with analysts estimating the two banks would need to raise about 70 billion Swiss francs ($73 billion) in CoCos.

The Basel Committee on Banking Supervision has looked at them as an option for banks deemed “too big to fail”. UK regulators are also known to favour them.

PIONEERS

The bonds convert to equity or get written down under certain conditions, usually when a bank’s capital falls below a specific level or when a regulator decides a bank is shaky.

UK bank Lloyds  and Dutch bank Rabobank both issued contingent-style bonds in November 2009 and March this year.

These pioneering deals were successful, but were special cases. Lloyds’ investors were exchanging from impaired bonds that would not pay coupons, while Rabobank has an extremely strong balance sheet.

Rating agencies have been cautious about rating CoCos because of lack of clarity from regulators surrounding the conversion trigger. They rated Lloyds’ CoCos, but steered clear of rating Rabobank’s senior contingent bonds.

Some investors say the ratings issue is a big hurdle that needs to be overcome.

“We believe that our clients and the wider investment community will have far greater appetite for hybrid capital if these securities have clearly defined and measurable trigger thresholds, greater uniformity of structure, including fixed lifetime coupons and fixed maturity dates, and investment grade ratings,” said David Averre, head of credit analysis at Insight Investment.

Other European banks are looking at bonds with write-down and write-up features that do not convert to equity. Italian bank Intesa SanPaolo’s hybrid Tier 1 bond issue last month had some of these elements.

Barclays is working on a new bond with a write-down and write-up structure that has no equity conversion.

DEBT CHEAPER THAN EQUITY

Despite regulators’ desire for bank capital to be mostly equity in the future, some form of hybrid bonds will be needed because equity is expensive and relatively scarce.

Hybrids have provided banks with a cheaper alternative to equity in the past because interest payments on hybrid bonds are tax-deductible.

Analysts calculate, for example, that UK banks’ cost of equity works out on average at about 10.7 percent, which compares with the cost of hybrid debt of about 5 percent pre-tax.

Investors were cautious about hybrid bonds when they came on the scene in the late 1990s, but the market is now well established.

But investors might not forget in a hurry the volatility and lack of liquidity some bank hybrids suffered during the credit crisis. (Additional reporting by Tommy Wilkes; Editing by Will Waterman)

($1=.9539 Swiss Franc)

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

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