The new Basel III guidelines require banks to hold more capital in order to prevent financial collapses. A recent report proposed that one way in which financial institutions can meet the requirements relating to Tier 1 and Tier 2 capital is by issuing contingent convertible bonds (so-called 'cocos'). Through such bonds, issued debt is converted into equity if the issuing bank's balance sheet becomes impaired and certain trigger conditions are met.
Various benchmarks may serve as trigger conditions. These can be either systemic triggers (eg, aggregated financial sector loss rates or cash capital ratios) or institution-specific triggers (eg, capital ratios or share prices). Depending on the implemented trigger condition, conversion will occur at different points in time, thus constituting on the one side so-called 'going-concern cocos', which serve to safeguard the institution from insolvency, and on the other so-called 'gone-concern cocos', which are triggered too late to prevent insolvency, but may prevent taxpayer losses and financial sector contagion.
The first Swiss financial institution to issue cocos has chosen a going-concern coco. In February 2011 Credit Suisse Group first made public that it had executed an agreement with two strategic investors from the Middle East to put in place Sfr6 billion of Tier 1 buffer capital notes. Shortly thereafter, Credit Suisse Group announced that it was further issuing, through an offshore finance vehicle, $2 billion of Tier 2 buffer capital notes, guaranteed on a subordinated basis by Credit Suisse Group. In both cases the conversion will be triggered by capital ratios. In the case of the Tier 1 buffer capital notes the Basel III common equity Tier 1 capital ratio will apply; in the case of the Tier 2 buffer capital notes the reported consolidated risk-based capital ratio. In both cases the threshold was set at the 7% mark (rather than the 5% mark). If the ratios fall below this threshold, the buffer capital notes will convert into Credit Suisse Group ordinary shares. Conversion will also be triggered if the Swiss Financial Market Supervisory Authority (FINMA) determines that Credit Suisse Group requires public sector support to prevent it from becoming insolvent, bankrupt or unable to pay a material amount of its debt, or in other similar circumstances. Credit Suisse Group had worked in close cooperation with FINMA in order to ensure that the buffer capital notes would qualify under the proposed Swiss capital rules as contingent capital. Credit Suisse Group expected that with the two issuances it would be able to satisfy an estimated 70% of the FINMA requirement for contingent convertible capital with a high trigger of 7%.
Besides Credit Suisse Group, only a small handful of financial institutions have issued cocos to date. Both Lloyds Banking Group (2009) and Rabobank (2010) have issued cocos as a means of capital injection. On the other hand, it is currently being debated whether cocos might also be issued for purposes other than financial purposes (eg, management remuneration and incentive programmes).
There appears to be a growing consensus in the finance community that cocos should form part of the future toolkit for financial institutions. However, in the face of such an increased supply of cocos, one of the main issues might be whether there is sufficient demand on the investor side. For Switzerland alone, hybrid capital instruments are expected to be raised to around Sfr60 billion (worldwide, the number is around $1 trillion). Since a regular market has not yet been established for these instruments, it remains to be seen how well institutions will be able to place them with a broad group of investors.
On the investor side, it is expected that demand for such hybrid instruments is to come mainly from alternative investors such as hedge funds, private equity and high-net-worth individuals. On the other hand, it might be that market conditions may develop in a way that only prime institutions will be able to place cocos among investors, while other institutions may face less investor demand. Moreover, concerns have been brought forward that a sudden increase of the supply of hybrid instruments might lead to a crowding-out of other forms of financing.
Further important developments with regard to cocos and regulatory capital requirements are thus to be expected in the future, considering the still-evolving regulatory architecture and the interconnected legal, economic and political issues at stake.
For further information on this topic please contact Mark-Oliver Baumgarten or Thiemo Sturny at Staiger, Schwald & Partner AG by telephone (+41 44 283 8686), fax (+41 44 283 8787) or email ([email protected] or [email protected]).