systematically important banks: BIS says “No, no!” to co-cos

the BIS and “too big to fail”

The Bank for International Settlements, the unofficial rule setter for the world’s commercial banks, is in the process of making new guidelines to govern the behavior of systematically important (read: really big, or “too big to fail”) banks.

extra capital needed…

A couple of days ago it aired new regulations that would force the biggest banks to hold more capital to back a given loan than a smaller bank would need.  The bigger the bank, the more capital necessary.  And if a jumbo bank tried to become jumbo-er by adding net new loans, it would need even a higher level capital to back those.

The thrust of the rules is to create economic incentives for banks not to get bigger, or even to break themselves up into pieces, so that the potential failure of  one massive bank would no longer threaten to bring down a country’s entire financial system.

…through co-cos?  No, thank you.

During the discussion, the question arose as to whether the BIS would allow this “extra” capital to be supplied, not just by equity, but by  convertible securities (co-cos) as well.  The BIS said no.

why not

It didn’t supply reasons, but I think it’s easy to see why (before I go any further, I should warn you that I’m not a fan of gimmicky securities like co-cos, as you can see from this older post.  I may have gotten a little carried away when I was writing it, but I still believe what I wrote then.):

bondholders and stockholders have different points of view about the issuers of the securities they own.  The former care mostly about collecting their coupon payments and getting their principal returned at the end of the bond’s life.  Shareholders want healthy growth of the enterprise, so that they get a higher stock price and greater dividend payments.  Shareholders tend to make waves; except in extreme situations, bondholders don’t.

If the idea of the extra capital is to have more people with a strong interest in preventing aggressive expansion of the loan book, you probably want to increase the number of professional equity investors with an interest in the bank, not replace them with bond fund managers.

no one knows how contingent convertibles will work in a crisis.  In particular, if the conversion provisions of a co-co are triggered and the security becomes an equity, bond managers who own it (and whose contracts with customers doubtless bar them from holding stocks) will be forced to sell.  Having lots of stock in a troubled company being dumped on the market and forcing the price down probably won’t make the bank’s situation any better.  If it prevents the firm from raising new equity, it could make things considerably worse.

a flaw in the terms of existing co-cos has been detected. Commercial banks and their investment bankers want the co-co conversion trigger to be based, as is the Lloyds TSB issue I wrote about in my original post, on the level of equity shown in the bank’s accounting statements.  We’re currently seeing in the EU financial crisis an example of the extreme unwillingness of governments and politically connected banks to write down the value of impaired assets (in this case, Greek government bonds).  But it’s the process of loan writedown that forces the co-co conversion into new equity.

In other words, in a future crisis, governments may not permit their banks to acknowledge that their capital is impaired.  So the conversion of co-cos may never be allowed to take place–meaning that the institutions will be seen to be even more leveraged than thought.

 

 

 

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