When bank equity and hybrid debt markets went into a tailspin in February, HSBC was contacted by one of its regulators and asked to issue so-called coco bonds to help restore investor confidence in the instruments.
Put off by the prohibitively high price of issuing the hybrid securities in such volatile conditions, HSBC politely declined. But the move underlines the alarm among regulators about events in the market earlier this year.
Since then, top executives at several of Europe’s biggest banks have complained to supervisors about the byzantine rules around contingent convertible bonds, popularly known as “cocos”, which are a key pillar of the regime introduced to strengthen bank balance sheets after the financial crisis.
Cocos, of which the latest version are called additional tier 1 (AT1) bonds, force losses on investors when a bank’s capital falls below a “trigger” level through conversion into equity or a writedown.
Designed to restore the capital of a bank in a crisis, they are part of a broader push to transfer the cost of rescuing a failing lender from taxpayers to investors.
Some academics say cocos are an uncomfortable halfway house, proving to be more volatile than bonds but lacking the full loss-absorbing qualities of equity.
“Banks are very resistant to having more common equity capital — so they are attracted by AT1s — but ultimately equity is the best way to reduce the risk profile of a bank,” says Harald Benink, professor of banking and finance at Tilburg University in the Netherlands.
The sell-off in coco markets in February was partly triggered by investor fears that Deutsche Bank could be blocked from paying coupons to investors in its cocos because it made a multibillion-euro loss last year.
This stems from a German legal requirement for companies to calculate how much they can distribute to investors by working out their “available distributable items” — a complex formula based on a company’s earnings.
Deutsche insisted the fears were unfounded and launched a buyback of its own senior debt to prove it had more than enough resources to keep paying the coupons.
But there remain a number of concerns about the instruments. Firstly, there is widespread uncertainty over the circumstances in which a bank could be forced to suspend coupon payments.
The European Commission recently drew up proposals to clarify the “maximum distributable amount” rules that also govern when a bank can pay coco coupons. It looks likely to switch to the UK model, giving regulators more flexibility.
Secondly, as the volatility in February showed, cocos can add to investor anxiety around banks rather than making them seem more solid.
“If a bank misses a coupon payment, of course all hell would break loose,” warns Sam Theodore, director of financial institutions at Scope Ratings.
Finally, there is scepticism in many quarters that cocos will actually do what they are supposed to in a crisis. Most cocos are meant to convert into equity or be written down if a bank’s capital falls below a certain level — between 5.125 per cent and 7 per cent.
In reality, most big banks are required to have capital ratios above 10 per cent, so regulators are likely to take action long before the trigger level for cocos is reached.
“The trigger, frankly, at this stage is kind of a joke,” says Mr Theodore. “Even at 7 per cent, banks are way, way above it.”
Some bankers say cocos’ role in boosting capital on a going concern basis has been superseded by new rules requiring banks to hold a new type of debt called “total loss-absorbing capacity” that can be bailed in on a “gone concern” basis when a failed institution is put into resolution.
Under European rules, most large banks aim to raise a proportion of their total capital from AT1s by 2019 equivalent to 1.5 per cent of their risk-weighted assets.
Now that some bank executives, supervisors and investors are having second thoughts about cocos — and prices have dropped — it could make it harder for lenders to reach this target.
“Fundamentally, we think they should be giving near equity-like returns,” says Howard Cunningham, an investor at Newton Investment Management. “We will buy them with high single-digit yields but we don’t like them at mid single-digit yields.”
Some bankers say Europe could follow the US model, where no banks have issued cocos, partly because they do not have the same tax advantages.
As the debate intensifies, participants in the relatively young market are watching closely.
“It’s a very new market, people are having difficulties,” says Mr Theodore. “They say is it equity, is it debt, how do I price it? It’s not an easy market to understand.”