The popular quote about focusing on the journey rather than the destination could well have been written about current moves to create the next generation of bank capital instruments and determine the place of hybrid debt in bank capital structures.
Stakeholders – politicians, regulators, supervisors, issuers, intermediaries and investors – have spent an inordinate amount of time trying to come up with a formula that will offer affordable hybrid capital to banks that meets lawmakers’ demands for a robust safety net (and one that absolves taxpayers of responsibility) and at the same time suits investors’ return and risk metrics. Yet for all of the progress made so far, we are nowhere near a conclusion on rules and processes that will facilitate any of the above.
If one goal of the evolving regulatory and supervisory framework is maintaining some semblance of a level playing field, we are woefully short of achieving that. While national regulators retain primary responsibility for banks within their jurisdictions, they also need to pay heed to the fact that globalisation is firmly entrenched in the market for wholesale financial services. Unilateral moves can have dangerous, unintended consequences that undermine competitiveness and profitability.
At the supervisory level, the EU’s conceptual framework has been neatly laid out, but it looks far from a practical one. Think about it: at the micro-prudential level are a series of sub-committees and colleges focusing on banking, securities and insurance. While at the margin, they’re all financial services businesses, they’re also radically different business models.
Overlay on to that the fact that you have the machinery and institutional paraphernalia of 27 wrangling EU governments each with its national interests at heart. EU supervisory harmonisation depends on positive interaction between colleges and committees. The permutations for possible tension and disagreement are for all practical purposes endless. And that’s just the EU. The Basel Committee is having identical discussions and there is every possibility that the EU and Basel will come up with different or at best nuanced interpretations. The US hasn’t even got to Basel II.
Creating a market
The whole issue of bank capital needs to get down quickly to the brass tacks of productisation and marketability. The issue facing investment bank capital structurers and hybrid capital originators is simple: the kinds of capital instruments regulators would like to see banks issue are nowhere near the kinds of instruments current hybrid debt investors would like to buy.
The issue is a real one: banks are capital-deficient so need to raise capital, and would like to issue as much of it as they can in tax-deductible form. At the same time, investors have something like US$800bn of legacy hybrid securities on their books. As the regulatory mist starts to clear and rating agencies move into action, these may morph into something quite different, given talk of retroactive actions.
Fixed-income investors are (relatively) comfortable with the idea of burden-sharing, but they don’t really like the sound of bail-in debt, equity conversion triggers or permanent write-downs. They’re comfortable sitting in a deeply subordinated position in a bank’s capital structure only if subordination is strictly and formally respected. In short, common stockholders have to be the first to be wiped out in a liquidation. That’s not necessarily a given with some of the new features being discussed.
Contingent capital instruments alarm them because the last thing they want is equity. The fact that conversion triggers are regulatorily determined not only externalises the decision to convert but makes it very difficult to value.
And, of course, bond investors will only get equity and be forced to sell it when the stock price is likely to be in a death spiral because the decision to trigger conversion is predicated on deep distress. Indeed, equity-like features may breach the mandate of bond funds and put such capital instruments off limits to some fixed-income buyers altogether.
Investment bankers are confident – OK, they put on a confident facade – that once regulatory clarity enables them to build products with features that are well understood, an investor base will emerge. Equity-income funds could become buyers of a new generation of hybrid products, for example.
Debt market professionals naysay the ability of the equity capital markets to sell sufficient stock to meet bank capital requirements. That’s potentially a big call. They always also quote the fact that for issuers, common equity is expensive capital. But the reality is that the cost and complexity of adding capital-absorptive features into hybrid capital solutions to meet regulatory requirements is likely to push up the cost of issuing them. Common stock anyone?
Keith Mullin