Is Contingent Capital the Answer to the Bank Capital Problem? November 23, 2009 Bob Eisenbeis, Chief Monetary Economist
Lloyds Bank has announced the successful exchange of some outstanding subordinated debt for a new debt instrument that would be converted to common equity if its capital ratio declined below a critical value. Specifically, in the Lloyds proposal, the security would convert when its Tier 1 capital ratio fell below 5%. The instrument is called contingent capital and has recently become the latest fad among regulators both in the US and abroad. It has even been incorporated into Senator Dodd’s recently introduced financial regulatory reform bill as a means to bolster bank capital positions. Sounds like a good idea, right? Especially if an institution can be recapitalized at no cost to the taxpayer. The instrument is billed as providing an additional buffer should an institution fall on hard times. But does it really and is it the panacea that regulators see?
First, we need to recognize that there are really only two types of bank liabilities: insured (or federally guaranteed liabilities) and uninsured liabilities that might have to absorb losses in the event of a failure, depending of course upon their priority in bankruptcy. Prior to the current crisis, it was relatively easy to identify de jure those liabilities that were federally guaranteed. Now it is not so easy, either for banks or for non-bank financial institutions, because many governments have stepped in and extended guarantees to all types of liabilities including transactions accounts, deposits , and virtually all debt – especially the debt of what are deemed to be systemically important institutions. Now, rational holders of the debt instruments issued by large institutions – including uninsured deposits, subordinated debt, and non-subordinated debt – can be reasonably assured that in the event of a crisis they will be covered, even if those instruments weren’t covered de jure. Unfortunately, what this does is to mute any incentives that uninsured creditors of large institutions might now have to exercise market discipline or to monitor the risk exposure of the institutions in which they have invested. It means that an unfortunate legacy of the policies now in place is that only tangible common equity and certain categories of preferred stock unambiguously stand to lose should an institution fail.
For large institutions, regulators historically had counted qualifying subordinated debt instruments as a limited form of capital when it came to establishing capital adequacy requirements. Debt, including subordinated debt, is a lower-cost way of getting additional loss protection into an institution, because of the tax deductibility of interest payments on that debt. Subordinated debt, like uninsured deposits and other non-deposit liabilities, would stand to share losses in the event the bank failed and was closed, thereby providing some residual protection to the insurer.
Under the Basel Capital Accords, Tier 1 capital consists, among other things, of common equity, retained earnings, and certain non-redeemable, non-cumulative preferred stock. The second level of capital, called Tier 2 capital, includes undisclosed reserves, revaluation reserves, provisions for loan losses, preferred stock not included in Tier 1 capital, and other hybrid instruments, as well as subordinated debt with a minimum maturity of five years.
Regulators, and economists, had hoped that expansion of subordinated debt might be one avenue for improving market discipline for large financial institutions. In the U.S. that has now changed because of the short-term policy decisions made by FDIC, the Fed, and Treasury during the crisis to insulate virtually all large bank creditors from losses. Enter contingent capital as the newest wrinkle.
In its current incarnation, contingent capital was developed by Professor Mark J. Flannery of the University of Florida. The basic idea is that banks should be required to issue a debt security that would automatically convert to common equity when a pre-specified trigger is reached. In his proposal, the conversion would be triggered when the market value of equity fell to a critical value, and the securities would convert to equity at a slight premium price to prevent short sellers from forcing conversion. The instrument is designed to provide a way to delever and recapitalize a large banking organization, thereby avoiding the costly negative externalities to depositors, borrowers, and counterparties that a bankruptcy might entail. At the same time the aim is to preserve market discipline and to internalize to shareholders the costs that might be associated with moral hazard and other risk-taking incentives.
Using a market-value trigger is especially important. It avoids reliance upon GAAP measures, which historically have lagged changes in market values and provided a poor indication of an institution’s current financial health. It also would limit the ability of management to engage in balance sheet manipulation. Finally, it would prevent regulators from pursuing forbearance because it eliminats regulatory discretion in deciding when the trigger should be invoked.
Flannery considers in depth many other important design issues that won’t be discussed here, but they are also critically important, especially since more recent contingent capital proposals like the Lloyds issue contain serious and even dangerous design defects. As is the case with most reform concepts, the devil is in the details, and the current contingent capital proposals are no exception. For example, Lloyd’s contingent capital would be triggered by a decline in its Tier 1 capital ratio, which is a lagging indicator of financial strength, but also is subject to accounting manipulation and all the other flaws that have been noted by critics of the Basel capital standards more generally. As the recent financial crisis has proved, institutions’ regulatory capital ratios can be positive even when they may be economically insolvent or have substantial unrecognized losses such that conversion might even wipe out the newly converted equity shares. In fact, Flannery maintains that “Contingent capital driven by a book-valued trigger is virtually worthless.”
Another variant of the contingent capital proposal would incorporate a dual trigger feature -- one that would not only rely upon an institution’s Tier 1 capital ratio but also would require a declaration by regulators that the financial system was experiencing a systemic crisis. An instrument with such features would be a double disaster, by introducing regulatory discretion and politics into both triggers to the potential detriment of equity holders, debt holders and taxpayers.
What needs to be recognized about contingent capital as it is currently being touted is that the conversion from debt to equity doesn’t bring new funds into an institution. No new securities have been issued (Flannery would require, however, that any converted contingent capital be replaced). Rather, all that happens is that holders of the contingent instruments are moved into a first-loss position along with current equity holders, whose interests have been diluted by the exchange. We might better term the conversion contingent bankruptcy rather than contingent capital for this reason. The conversion feature with the trigger is the way of orchestrating a reorganization of the capital structure of the firm without resorting to the traditional bankruptcy courts or standard resolution policies employed by banking regulators. However, as typically structured, it does keep the existing management in place, although management replacement could be incorporated as a feature of the instrument.
Before such an instrument could or should become an additional element in the regulators’ tool kit, much deeper consideration of the design issues should be pursued. For example, it is critical that the trigger not be a matter of regulatory discretion, and it should be market-based. How the trigger should be structured is a matter warranting considerable study. Neither of these features is incorporated in the Lloyds contingent capital securities. Additionally, no one has addressed the issue of what kinds of institutions – financial or otherwise – would be required to issue contingent capital. Then there is a matter of how a complex holding company would be treated. The security doesn’t address the issues raised in the case of large cross-border organizational structures with multiple subsidiaries chartered in many different national jurisdictions. Contingent capital in a parent company would not translate into capital in a separately chartered bank subsidiary, regardless of whether it was chartered in the US or another country. Conversely, contingent capital securities issued by a wholly owned bank subsidiary would only dilute the parent company’s ownership interest, and might even result in a de facto spin off should the diluted ownership fall to minority status. Since only legal entities and not the consolidated company can issue securities, where within the organization the contingent capital securities would be situated is important. In short, we should beware of incomplete or fragmentary solutions to complex problems without careful vetting and discussion.
How would we view such a security from an investor’s perspective? Again, it depends upon the price, instrument design, and where within the company’s structure the securities would be issued. But at present, the instrument’s features, especially those that rely upon book-value measures and/or regulatory discretion, are likely to contain significant uncertainty, will probably be expensive and likely be miss-priced.
While we don’t have experience with a debt security that has a regulatory trigger, there is a close parallel in the form of the non-cumulative preferred stock that was issued by Freddie and Fannie. As a specific example, Freddie Mac issued an 8.375% Non-cumulative Perpetual Preferred Stock, Series Z on Nov. 29th, 2007 at $25 per share. These securities were issued long after the accounting troubles experienced by the GSEs and long after the mortgage market had gone into decline. Trading was suspended on this issue when the government placed Freddie Mac into conservatorship. Dividends were suspended and because the securities were non-cumulative, should dividends be resumed, investors can not recoup past missed dividends. In effect, investors in that preferred stock issue have been de facto converted into quasi-equity holders and their shares are essentially worthless. The securities closed on Friday November 20th, 2009 at about $0.97. The losses in Freddie Mac keep rising, and the likelihood of it being able to restart paying dividends is close to zero. These securities did not nor will they contribute to rebuilding the capital structure of Freddie Mac.
Markets aren’t dumb nor are they likely to forget the recent Freddie and Fannie experience should contingent capital certificates with government triggers come onto the market. The securities are not likely to be liquid and, like the Lloyds’ issue, they contain significant regulatory and accounting risk. Like other convertible preferred stock and trust preferred securities, they will certainly require a risk premium; and if these other securities are any guide, that premium will be on the order of a several hundred basis points. I benefited from comments from Professor Mark Flannery and Larry Wall. Mark J. Flannery, “No Pain, No Gain? Effecting Market Discipline via ‘Reverse Convertible Debentures’”, in Hal S. Scott (ed.), Risk Based Capital Adequacy, Oxford University Press, 2005.
Mark J Flannery, “Market-Valued Triggers Will Work for Contingent Capital Instruments,” Solicited Submission to U.S. Treasury Working Group on Bank Capital, University of Florida, November 6, 2009
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