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Hybrid capital securities

Contingent Capital Instruments: pricing behaviour

Contingent Capital Instruments (“CoCo”) have been issued by most of the Financial Institutions since January 2011 in order to address more stringent capital requirement initiated by the EU’s Capital Requirements Directive (CRD). This article examines CoCo design features and its pricing behaviour in the secondary market.

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L'auteur

  • Daubricourt
    • Risk Analyst
      UK Debt Management Office
    • Master spécialisé Finance, Alumna
      ESCP Europe

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Revue de l'article

Cet article est extrait de
Banque & Stratégie n°348

ESCP Europe Applied Research Papers 6

In the crisis aftermath, majority of analysis revealed and highlighted the high leverage level used by Financial Institutions in other words the lack of capital in the banking industry. This has quickly been presented as the prime lesson that Financial Institutions should hold much more capital in order to make banks safer in adverse situations. Consequently, policymakers such as the Basel Committee on Banking Supervision introduced new capital requirements which are supposed to prevent and ease resolution process in case of adverse situation would reoccur. Those new capital requirements for the banking industry are displayed through higher capital ratio requirements and higher capital cushion or buffer. Those requirements have been developed to prevent Governments having to intervene in Banks’ bailouts such as RBS, Lloyds and then uses of tax revenues to recapitalise banking industry.

Contingent Capital instruments are “hybrid capital securities that absorb losses when the capital of the issuing bank falls below a certain level” [1]. This hybrid product has been created in response to the stringent capital requirement by Banks in order to enable them to fund themselves to comply with Regulatory ratio namely Common Equity Tier one ratio (CET1>4,5%), Additional Tier 1 ratio (CET1+AT1>6%) and Tier 2 ratio (CET1+AT1+T2>8%). It has been designed to enable banks to recapitalise and so have a higher capacity to absorb those shocks.

The loss absorbing capacity is enabled by the conversion event which is based on capital ratio but can also be triggered by a discretionary decision made by regulators in certain cases explained in this paper. Thus, this unique design feature instrument implies specific risks associated. Contingent Convertible capital instruments first issues appeared in 2009 and then rapidly grew. Financial Institutions have issued $200 billion of CoCo since January 2011.

This article describes the quick development of this product among financial institutions with 239 contingent convertible issued since 2011 globally printed by 143 different issuers, this product has been used by most financial institutions such as Deutsche Bank, Credit Suisse, Barclays with an exception for US-based banks for tax-purposes. This article aims to examine the design feature of the issuance seen since 2011 and the related pricing done on the secondary market.

CoCo issuance prime determinant: Capital Requirement Regulation

If Financial Institutions have been massively issuing Contingent Capital instruments since 2012, the main determinant/driver of this trend was the stringent regulatory environment in term of capital requirement. In this part, the main changes in capital requirements will be discussed to understand the development of CoCo.

Basel III agreement is in Europe, carried out through the Capital Requirements Directive IV, which defines and implements capital requirements on the following criteria: “quality and quantity of capital, liquidity and leverage requirements, new rules for counterparty risk and new macro prudential standards such as countercyclical capital buffers for systematically important institutions” for banks, building societies and investment firms [2]. Looking into Contingent Capital instrument issuance for Financial Institutions means first understanding the regulatory environment in which financial institutions evolve.

The main measure which impacts Financial Institutions in term of Capital Requirement is the CRR [3], the introduction of a new definition of capital, minimum capital requirements and buffers which apply to the consolidated view of the institution. This aim to increase quality and quantity of regulatory capital for Financial Institutions. Those Financial Institutions had to enforce those rules from January 2014, with a phased-in approach that is up to 2019:

  • The Common Equity Tier 1 capital ratio of 4,5% of risk weighted assets at all times
  • A Tier 1 capital ratio of 6% of risk weighted assets at all times
  • A Total capital ratio of 8% of risk weighted assets at all times

In addition to the minimum capital requirements as explained in the previous section, another driver of Coco issuance are the different loss-absorbing capacity directives in place.

The Total Loss-Absorbing Capacity (TLAC) has been defined by the FSB (Financial Stability Board) in November 2014 and is required for Global Systematically Important Banks (G-SIBs, 30 banks), it will be implemented from 2019. The TLAC has been defined to prevent the “Too Big Too Fail” (TBTF) issue that Governments encountered in the aftermath of the crisis. It will require G-SIBs to hold a minimum amount of regulatory capital, this will set-up the level of loss-absorbing and recapitalisation capacity in case of adverse situations whereby banks would be too highly leveraged and facilitate recapitalisation thanks to “bail-in-able debt” of which Additional Tier 1 is the main instrument. The “bail-in-able” debt “refers to debt instruments or other creditor claims that are written down or converted into equity, in whole or in part, by a country’s resolution authority at the point a failing financial institution enters resolution” [4].

On the same month of November 2014, the European Banking Authority detailed in a paper the definition of the minimum funds and eligible liabilities (MREL) requirement for bail-in, this legislation does apply to any European credit institutions and investment firms. The objective is the same as the FSB legislation to prevent the taxpayer, so the Government, to have to recapitalise financial institutions in adverse situations. Contingent Capital instruments are most of the time issued with a bail-in feature i.e. regulator could discretionary activate the trigger. Loss absorbency would be trigger based on the Point Of Non Viability defined in the issuance prospectus.

In those two capital regulations, the common theme is to require an additional cushion or buffer from the financial institutions in order to ensure their capital capacity to resist financial shock without the help of Government.

Contingent Capital: Design and Features between equity-features and debt-features

On the basis of enhanced and stringent capital requirement regulation as explained in the previous section, contingent capital instruments have arisen from Financial Institutions issuance responding to the need of convertible debt in bank capital structure. This section will discussed the main features that define CoCo i.e. contingent clause and conversion trigger(s).

Contingent Capital Instrument criteria

Contingent Capital Instrument enables financial institutions to convert debt into equity under the event of a capital requirement ratio trigger(s) displayed in their prospectus. Issuance of CoCo by Financial Institutions covers Additional Tier 1 bond and Tier 2 bond. This results in the design/characteristics described in the below table 1.

Conversion trigger(s)

The main feature of Contingent Capital instrument is the choice of trigger and the trigger level which will define under which regulatory ratio event the CoCo would be activated. There are several triggers available (CET1 ratio, Tier 1 ratio, Total-Risk Based capital ratio). The instrument will have a capital requirement ratio trigger and a level associated to define at which level it will be activated. Capital ratio triggers are displayed as follow:

  • Common Equity Tier 1 capital ratio contains the core capital (Common shares & retained earnings) as defined by Basel III framework which is divided by the Risk-Weighted Assets.
  • Tier 1 capital ratio measures the core capital with the addition of preferred shares and CoCo with a “high” trigger defined. Additionally, Tier 1 capital includes discretionary CoCo i.e. bail-in-able on a regulatory decision (AT1). This is then divided by the Risk-Weighted Assets.
  • Total Risk-based capital ratio contains the sum of Tier 1 capital and Tier 2 capital which is divided by the Risk-Weighted Assets.

The main regulatory ratio used as trigger is the Common Equity Tier 1 capital ratio used in 90% [5] of Contingent Capital issuance since 2011. The other capital ratios are Tier 1 capital ratio and the total risk-based capital ratio for 8% and 2% respectively. This is set-up in accordance with the type of capital issued by the Financial Institutions i.e. when issuing Additional Tier 1 capital, banks will choose CET1 ratio as trigger and when issuing Tier 2 capital, Tier 1 capital ratio will be chosen as trigger (cf. Graph 1).

The level at which the CoCo will be activated can be set-up either on a “high” or “low” trigger. High triggers are set-up from 7% or above, they are designed to recapitalise the financial institution when there is concern around bank solvency but where insolvency is not yet close. Contrarily, CoCo issued with low trigger are set-up to recapitalise the financial institution only when it is close enough to enter in the resolution process as defined by the BRRD.

Whereas the main function of the CoCo is to recapitalise the financial institution when approaching insolvency, the CoCo issuance since 2011 has mainly been done through low trigger’s CoCo as described in the above graph in total without taking the capital ratio into account, 153 issues have been designed with low trigger (73% of the total) and 58 with high trigger.

Those trigger in theory as showed in the below graph [6] can be set-up on a book value or a market value trigger. The drawback of the primer is that conversion may be activated when financial distress is already too advanced to recapitalise the financial institution. The latter would prevent this, however this would give incentive for market manipulation and strategy to push the conversion.

In reality, since 2011, CoCos are issued using regulatory capital ratio based on balance sheet calculation i.e. Book-value trigger.

Additionally, when the issuer is part of the Global Systematically Important Banks and this CoCo is TLAC eligible, the conversion or write-down can also be discretionarily triggered by a regulatory decision. This is when Contingent convertible capital instruments have a “discretionary trigger which is also called point of non-viability (PONV) trigger, this is activated based on supervisors’ judgment about the issuing bank’s insolvency”.

Conversion clause: Loss Absorption mechanism

When the trigger is activated, the Loss Absorption Mechanism is called. This mechanism is what will enable the financial institution to recapitalise and doing so come back to appropriate capital ratio level. This mechanism at bank’s level should prevent systemic risk.

There are two different loss absorption mechanism features that an issuer can choose:

  • Equity Conversion: if the capital ratio level reaches the trigger defined then the CoCo will be converted to shares. The conversion price can be a pre-specified price or marked to market (usually floor/cap at a pre-defined level).
  • Write Down: if the capital ratio level is below the trigger defined then the CoCo will be first writing down to enable the financial institution to reach the required capital ratio level. The write-down can be full or partial and temporary or permanent. Full or partial means that the write-down can be done on either the total amount of the principal or only on a part of the principal. Temporary or permanent means that when the principal is written down, it could either be restored later if the financial institution returns to profitability or it cannot be restored.

Majority of issuance (over 87 issuances where Total Loss Absorption Mechanism is known) chooses the write-down feature in 63% (55 over the total). The main advantage is obviously to prevent shareholders dilution, however, it could create less appetite from investor. Even though, the majority of investors in debt instruments would not be keen to hold shares, in some cases, they are not eligible to hold equity (cf. graph 2).

CoCos Issuance

Issuance of Contingent convertible capital instrument since 2011 has reached an amount of USD 200 billion globally split into 239 different issues from 143 issuers.

The issuance really started in 2012 with 9 issues reaching USD 14 billion, this jumped to USD 89 billion in 2014 with 84 issues. The most important issuers in 2014 were Lloyds with 5 CoCos totalising an amount of 12 billion and then Deutsche Bank, Banco Santander and HSBC with 4 CoCos each reaching about 6 billion each. Since the beginning of 2015, issuance has jumped and then slowed down over the course of summer 2015 as per economic situation; Greece downstream effect on market and liquidity pressure to reach USD 54 billion with 95 issues. First quarter of 2016 confirmed this slow-down trend with only 15 issues totalising USD 6.7 billion. The case of Deutsche Bank in February that could be blocked from paying coupons to investors in its CoCos raised concerns among the investors. As a result, sell-off in CoCo markets have been observed, this made issuers more reluctant to use this type of hybrid debt (cf. Graph. 3).

Geographically, CoCo issuance is mainly performed by European based banks with the Nordics coming first. Local governing laws mainly drive country repartition. In the European Union, the issuance of CoCo is supervised and triggered by CRD IV and MREL but Nordics banks are particularly attracted by the instrument features of contingent capital given their capital structure and high capital ratio requirements.

Among the 143 issuers that used this instrument since 2011, there is no US-based bank such as JP Morgan, Goldman Sachs or Morgan Stanley and this product has only been issued by European based financial institutions. The reason is within the tax feature of this product, as European laws have applied to this instrument tax deductibility, as opposed to American laws whereby coupons paid for this contingent capital instruments are not deductible. Consequently, this instrument is not as attractive for American holding based company as this is as costly as equity for them.

Pricing Behaviour

Previous studies [7] on this instrument have first established how to value this instrument and then value the effect of issuing this instrument on banking funding cost. This article aims to look empirically onto this instrument pricing behaviour i.e. into conversion risk. This conversion feature is what set this instrument apart from other bond issuance used by financial institutions to fund them making this instrument hybrid. Thus, this main feature i.e. conversion risk should be priced on the secondary market and correlated to the design feature of the instrument which can be more or less risky.

Design features and its associated risk

Firstly, the analysis carried out was to establish if Yield-To-Maturity was higher or lower according to the higher or lower risk inherent to its contractual characteristics. Hence, the table presents the YTM mean by design features in order to analyse if contingent capital instrument is priced as per its related conversion risk.

This YTM analysis by design features validates the hypothesis that Contingent Capital instrument YTM is mainly driven by its design features when it comes to the trigger ratio and the trigger level contractual characteristics. However, this analysis rejects the hypothesis in the case when observing the capital type and the loss absorption mechanism.

CoCo’s equity component

In order to establish if Contingent Capital instrument behaviour on the secondary market is closer to equity or debt, study on the pairwise correlation coefficients between daily return of the Share and the Contingent Capital instrument has been carried out. This has been done on 41 issues from different 29 issuers, the minimum, maximum and median of the correlation have been sorted by design features.

This pairwise correlation analysis between the share daily return and the CoCo daily return partly rejects the hypothesis that Contingent Capital instruments have an equity component in their pricing. The analysis evidences a weak positive relation between the share and the CoCo. However, comparing correlation coefficient between different contractual characteristics set-up such as the trigger level and the loss absorption mechanism, this limited correlation coefficient proves an equity component in the pricing determinant of the low trigger CoCo and the CoCo instruments with a Write-Down loss absorbing mechanism.

Debt-instruments behaviour

In order to demonstrate whether Contingent Capital instruments do behave as debt instrument, a study of the pairwise correlation coefficient between the CDS spread and the Yield to Maturity has been carried out. CDS is the premium paid by protection buyer to the seller and so CDS spread reveals the default risk of the issuing bank. CoCo YTM is the total return anticipated on the bond if held until maturity i.e. it is the internal rate of return, it reveals the pricing done by secondary market of the instrument.

The correlation analysis has been carried out on 69 issues from 26 issuers whereby the CDS spread (5 year mid) and the Yield-To-Maturity (mid) on the 15/10/2015 were available (of the 239 total issues that have been extracted).

On the sample defined, the overall correlation coefficient (0,3953) indicates a weak positive relation between the CDS spread level and the Yield to Maturity which would indicate that other driver than default risk are predominant in CoCo’s Yield to Maturity determination (cf. Table 4).

This pairwise correlation analysis between the YTM and the CDS spread (5 year) partly corroborates the hypothesis that Contingent Capital instruments’ YTM is determined by the issuing bank default risk and so behave as debt-instruments. However, this hypothesis is only partly verified i.e. for certain design features, capital type and trigger ratio would confirm this relation. Although, correlation coefficient found per trigger level category rejects this hypothesis.

Conclusion

Contingent Capital instruments have been presented and developed to answer to the “too leveraged” capital structure issue experienced with the crisis. After having introduced and set forth this new instrument design features and the analysis carried out, we can conclude that Contingent Capital instruments, even though by its design feature is close to equity, have proved to behave as debt-like feature instrument. In fact, looking at its Yield to Maturity correlation to its CDS spread, CoCo does behave as a debt-instrument as CDS spread firstly matters when it comes to give a price to this CoCo. This conclusion is especially true when CoCos are discretionary triggered i.e. set-up on a Tier 1 capital ratio.

Additionally, looking at correlation between the share daily return and the CoCo daily return has shown no clear positive relation between both. Consequently, in that matter, the Contingent Capital instrument does not behave as equity even with design feature where we would have expected a higher correlation i.e. Additional Tier 1 with a high trigger CoCo.

Ultimately, establishing if Contingent Capital instruments are closer to its equity-like or debt-like features was also to validate that pricing matches with its related more or less risky features. Observation of Yield to Maturity mean demonstrates that YTM mean level matches with related risk level for trigger ratio and trigger level design features. But not for the capital type and loss absorption mechanism design features. This brings us to furtherly study the related risk by design features and its related pricing, CoCo Yield to Maturity is not driven by its design features risk when it comes to capital type (AT1 or Tier 2) and its Loss Absorption Mechanism (Equity Conversion or Principal Write-Down).

This can be explained given the novelty of this product and its limited scope (only issued by Financial Institutions with target to comply with the latest regulatory capital requirements), this product is not totally understood by investors. In fact, especially with the trigger level design feature, this criteria is defined as low when under 7% and high when equal or greater than 7%, the related conversion risk consequently differs but this has not been reflected in the YTM analysis. Thus, even if CoCos have been first developed to enable banks easily recapitalise in case of financial distress and avoid systemic risk, we could argue that this product got a complexity premium and then could bring financial distress to investors as mentioned in a communication statement by ESMA end of 2014.

 

[1] Avdjiev, Bogdanova, Kartasheva, “CoCos: a primer”, BIS Quarterly Review, September 2013.

[2] This can be found on the Bank Of England website, http://www.bankofengland.co.uk/pra/Pages/crdiv/default.aspx.

[3] Regulation, 575/2013.

[4] Frequently Asked Questions about Contingent Capital, http://media.mofo.com/files/Uploads/Images/FAQs-Contingent-Capital.pdf.

[5] Bloomberg, CoCo issuance extract.

[6] From the BIS Quarterly review, September 2013, « CoCo : A Primer ».

[7] Cf. References.

 

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ESCP Europe Applied Research Papers 6

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