The term “contingent capital” is the generic name given to a group of long-term hybrid debt instruments. The distinguishing characteristic of all contingent capital instruments is an embedded equity mandatory conversion provision, triggered automatically after the issuer’s financial profile deteriorates below a defined threshold.1 These instruments are thus designed to provide more capital when needed so as to avoid formal resolution.
Contingent capital instruments incorporate long-term maturities that enhance the total loss-absorbing capital available to issuers, thus protecting all nonconvertible liabilities (including, indirectly, shorter term debt) against losses large enough to overwhelm common equity.2 Like bail-in proposals, examined next, contingent capital instruments
generally focus on the holding company level because generally only holding companies issue these instruments, not bank subsidiaries. Like bail-ins under the single point of entry (SPOE) approach, use of contingent capital at the holding company does not in and of itself recapitalize banking subsidiaries or other operating subsidiaries.
Since contingent capital is long-term debt,3 it is arguably more economical to issue than equity given tax regimes permitting the deduction of interest on debt but not dividends on equity. Further, since contingent capital instruments convert automatically, they can
absorb losses outside of a formal resolution process. In effect, they streamline loss
absorption and internalization of costs beyond the common equity layer. For this reason, and owing to its substantive similarity to creditor bail-ins, contingent capital may be viewed as a form of resolution procedure rather than simply as an exotic variant of capital.
Analogous instruments predate the financial crisis in concept and practice. Reinsurance companies use contingent capital to manage risk from large, discrete loss exposures.4 As one example, in 1997 LaSalle Re Holdings Ltd. issued $100 million of contingent capital structured as convertible preferred shares to cover “a major catastrophe or series of large catastrophes that cause[d] substantial losses” in the future.5 The adoption of contingent capital by the banking industry is a more recent development that remains at a more conceptual stage.6 Variations of contingent capital instruments customized for bank and nonbank financial institutions have, however, gained traction with some policy makers.
Between 2009 and February 2015, $288 billion of CoCos were issued.7 Significantly, $174 billion of these issuances occurred in 2014, demonstrating the growth of their popularity.8 Chinese banks accounted for approximately one-third of these 2014 issuances, while
European banks were responsible for slightly more than half of the amount.9 As of April 2015, there have not yet been any United States issuances.10
US regulators and the Basel Committee have not permitted CoCos to satisfy capital requirements. Thus, in July 2011, the Basel Committee announced that the capital buffer for systemically important banks would be composed only of tier I common equity,
rejecting the use of contingent capital to satisfy a SIFI surcharge.11 Similarly the Federal Reserve’s June 2013 final rules implementing Basel III in the United States require that the paid-in amount of any instrument be classified as equity under GAAP to qualify as tier I capital, which effectively prevents contingent convertible debt from qualifying prior to conversion.12 Regulators have, however, acknowledged certain potential benefits of CoCos: FSOC determined that contingent convertible instruments can help financial
institutions withstand losses at a cost cheaper than common equity13 and Federal Reserve Board Governor Tarullo has stated that requirements for long-term convertible debt
would “strengthen our domestic resolution mechanisms and be consistent with emerging international practice.”14
With the so-called Swiss finish, Swiss policy makers have offered the most significant endorsement of contingent capital. Under the new Swiss regime, in addition to the Basel III tier I common ratio of 4.5 percent, the two systemically important Swiss banks are required to maintain an 8.5 percent capital conservation buffer, up to 3 percent of which
may consist of contingent capital that converts to equity if tier I common falls below 7 percent of RWA (“high trigger CoCos”).15 The remaining 6 percent of RWA progressive surcharge may consist of contingent capital that converts when the tier I common ratio falls below 5 percent (“low trigger CoCos”).16
Contingent capital is an attractive complement to common equity and nonconvertible long-term debt and offers several benefits. It minimizes the public externalities and market disruption of putting a SIFI through conservatorship or receivership.17
Automating the restructuring motivates bondholders and equity holders to monitor risk- taking by issuers.18 The current yield on contingent capital instruments serves as an objective leading indicator of the market’s judgment of an issuer’s financial strength.
Contingent capital is cost-effective for issuers relative to permanent equity,19 but more expensive than nonconvertible debt, supplying an ex ante source of market discipline.20 The loss absorbency of contingent capital can shield short-term debt holders along with other creditors supplying credit not subject to conversion from impairment.21 Finally, contingent capital has an established record of performance in the insurance industry.
Nevertheless, two serious practical obstacles must be overcome before these potential benefits can be realized and before regulators will be willing to count these instruments as capital: (1) relative lack of investor demand and (2) design of an effective conversion trigger. In addition recent studies indicate that CoCo bonds may increase equity holders’
risk taking.22
16.1.1 Demand for CoCos
Strong demand for contingent capital is essential to realizing the cost savings that these instruments offer relative to equity. Recent contingent convertible issuances show that investor demand is heavily dependent on the particular structure of the contingent capital instruments, while the structure itself generally hinges on the constraints imposed by regulators and ratings agencies.23 Bert Bruggink, chief financial officer of Rabobank, reported ambivalence on the part of buyers about pricing the SCNs: “We met people who argued the pricing was completely wrong—overpriced—and others surprised we were even willing to pay a premium to our senior debt.”24 Similarly a disappointing UBS issuance in February 2012 shows that in some cases there is weak demand for the particular
contingent convertible structures that banks are able to offer.25
Weak demand for contingent convertibles is partially explained by the fact that many current institutional investors participating in the market for nonconvertible
subordinated debt instruments (classified as tier II debt under the existing Basel framework)26 face statutory restrictions on owning common stock or convertible
instruments.27 Other investors might be reluctant to manage the tail-risk associated with conversion as a matter of investment policy.28 Excluding these buyers from the
marketplace could narrow the prospective investor base for contingent capital to pure fixed income funds and hedge funds with investment mandates that extend affirmatively to hybrid, convertible debt, and equity instruments.29
16.1.2 Conversion Triggers
One model, favored by the Basel Committee, assigns this decision to the discretion of the issuer’s primary regulator. While the convertibility of the capital instruments is still
subject to contract, the conditions triggering the convertibility are determined under the contract by regulators upon a finding that the issuer’s financial condition is
unsatisfactory, for example due to a negative stress-test result.30 This flavor of a CoCo is really a bail-in, discussed below. A second model bases conversion on the adequacy of the issuer’s capital ratios.31 The Association for Financial Markets in Europe favors this
model, and both the Lloyds and Rabaobank securities are patterned on it.32 A third model employs market-based variables to determine when to convert,33 such as an issuer’s share price, credit spreads, or the CDS pricing on an issuer’s long-term subordinated debt.34 To ensure that a market-based trigger is activated only during a genuine market-wide
downturn, some have suggested pairing any of these market measures of an issuer’s
individual riskiness with a secondary variable measuring overall market risk, for instance the level of an index of financial firms. Using an index-based component theoretically would help ensure that conversion of contingent capital instruments occurs only during a financial crisis, when all firms are faring poorly for systemic reasons, while restricting convertibility and leaving scope for resolutions through normal bankruptcy channels otherwise.
The market trigger model, unlike the regulatory- or some capital-based alternatives, is independent of regulatory discretion and observable in real time. Critics of a market trigger worry that it will expose conversion to arbitrary market volatility and possible manipulation by speculators35 Risk of manipulation may be overstated, however. It is doubtful if even wide-scale manipulation by “speculators” or short-sellers could exercise enough influence on security prices to trigger a conversion event. This risk could easily be addressed, in any case, by adding an index-based conversion provision of the type
described above, which would require a downturn in the performance of all of the financial institutions in the financial system before mandating conversion of any individual issuer’s contingent capital.
Reliance on index-based triggering might, however, increase overall correlation risk among contingent capital issuers during a market-wide crisis. If a conversion event at one financial institution caused the securities prices of peer institutions to decline, for
example, because investors become fearful of a more generalized crisis, this could inadvertently prompt conversion of contingent capital securities issued by other institutions. By linking the behavior of individual convertible instruments to the
performance of financial institutions other than the issuer itself, an index trigger might introduce an additional source of correlation and connectedness, increasing systemic risk as a result.36 Additionally both the index-based and the single-issuer market triggers, either separately or in conjunction, should incorporate a type of market variable that is impervious to the effects of market noise. If CDS prices, credit spreads, or share prices prove to be too easily distorted during a crisis, then use of a market trigger will have to be reevaluated. Indeed an FRBNY study has found that “trade frequency in single-name
reference entities [is] relatively low.”37 This thin trading may suggest that CDS prices do not function as a high-quality proxy for the market’s perception of a reference entity’s likelihood of default and therefore might not provide a reliable conversion trigger.
Assuming these practical considerations may be resolved, contingent capital
instruments may improve the existing framework for internalizing the costs of financial distress and might lessen the probability of failure by adding to the amount of capital on which financial institutions may draw. In this sense automatic resolution operating at the holding company level, may protect short-term creditors of banks and other operating subsidiaries, making contagious runs less likely. However, a conversion event might well intensify contagion as existing creditors and new potential investors might interpret the signal transmitted by the conversion of contingent capital into equity in one institution as a sign of fatal distress for their own institutions or for the financial system more
generally.
Since contingent capital does not satisfy the systemic demand for liquidity created
during a run, it can never serve as a useful tool for rescuing financial institutions affected by contagion. Proponents of contingent capital instruments who appreciate this limitation acknowledge the necessity of interim liquidity facilities, organized privately or in all
likelihood by a public lender of last resort to steward issuers through a period of systemic crisis.38