That 9% bank capital requirement may not be quite what it seems

From the FT this evening (26th October 2011):

Is the European bank recapitalisation a done deal? Not if you ask the Germans and Spanish. A broad agreement on raising the capital bar for banks has been announced this evening. But some technical details — that make a big difference to some banks – have been left open.

Berlin and Madrid are mounting a last-ditch bid to lower the bar by allowing a broader range of capital to be used as part of the “temporary buffer”. German and Spanish banks in particular will have a lot more work to do to reach the new, 9 per cent core tier one capital ratio if they are not allowed to count some hybrid forms of capital.

This is reopening a highly-charged (and tremendously technical) debate that overshadowed the European Banking Authority stress tests last summer. After a long fight, the EBA overruled the Germans and Spanish and imposed a relatively narrow definition of capital that excluded so-called convertible debt.

This time around, there is a chance there will be a little more leeway. European officials insist that the capital criteria will largely match that used in the summer stress test. But even some small tweaks could make a big difference. Some banks’ core tier one capital would rise by 1 or 2 per cent, if the hybrid capital were accepted. Morgan Stanley reckon that, under this scenario, the capital shortfall could be as low as €50bn-€90bn.

None of this was clarified in the European leaders’ statement this evening. But eventually the details will emerge. Will the market be impressed?

For those who don't know, so-called "hybrid instruments" are securities that have the characteristics of both debt and equity. Convertible instruments, probably the most common form, are debt securities (bonds) that have a provision in the terms of the contract that allow them to be converted into shares under certain circumstances, such as heavy losses or insolvency of the holder. This is important, because if a company or bank suffers serious losses shareholders' funds are first in line to take the hit after retained earnings. Bonds, which are in effect loans, have to be paid back if there are sufficient realisable assets. So if a company or bank fails, shareholders will lose their investment, whereas bondholders will expect to receive some or all of their money back.

Tier 1 capital, for banks, traditionally consists of shareholders' capital and retained earnings - so is the most loss-absorbent type of capital. The EU's definition of capital assigns convertibles to Tier 2, which is only called on if Tier 1 capital has been wiped out. This is what the debate is about. The 9% requirement is for Tier 1 capital only, but  Germany and Spain allow convertibles to count in Tier 1 capital.

It all depends to what extent these hybrid instruments can be relied on to convert to equity and therefore absorb losses. And that hangs on the terms of the contracts. I foresee a lot of work for corporate lawyers sorting this one out.


  1. So more using "assets" that may be worthless if you need to call on the Asset in an emergency. We seem to be going around in a circle.

  2. According to the EBA Q&A the hybrid capital allowed would be (qualifying) contingent convertibles, not convertible bonds in general. These "CoCos" include a provision to force conversion if the issuing bank's capital ratios deteriorate in some specified way. I see no harm in allowing them to be treated as Tier 1 capital, so long as the forced conversion is specified in terms of the Tier 1 ratio, or something that cannot be less protective than that.


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