Last week, the European Banking Authority (EBA) published a report on the monitoring of Additional Tier 1 (AT1) instruments of EU institutions.
AT1 instruments are the riskiest CoCos issued by banks under Basel III rules.
If you want to preserve your investment in European bank CoCos, hybrid securities, or subordinated bank debt, you may as well read the report, as well as the relevant regulation.*
The EBA report is interesting for its substance and for its timing. The substance is interesting because the EBA analyses nine AT1 instruments, and for these nine instruments alone, the EBA documents a surprising number of disturbing features.
These make the instruments more complex than they should be.
The features may not be well understood, which constitutes a risk if you invest in bank capital instruments.
The timing of the report is also interesting: this Sunday, the EBA and the ECB will publish results of the EU stress test and the Asset Quality Review.
With only a week to go, investors have become nervous. Spreads are widening, volatility is on the rise. Some banks may not make it, some CoCos are at risk of being written down.
Given its substance and timing, the EBA report is probably not so much a slap on the wrist of banks that issue overly complex capital instruments. To the contrary, the report reminds readers that investing in CoCos, capital hybrids, or Tier 2 subordinated debt is like cooking steak: Each of these instruments is unique and prone to getting burnt unexpectedly.
Lack of knowledge and a momentary lapse of attention can seriously affect your performance record and your bonus.
Therefore, please fork out some hours this week to take stock of your investments in bank hybrids and subordinated bank capital. This is time well spent.
Know your cuts of beef
Since 2011, EU banks started issuing capital instruments at an increasing rate, from €12 billion in 2010 to an estimated €66 billion this year. Each instrument is unique. However, important differences can be explained by instrument vintage, the nationality of the issuing bank, and - believe it or not - the flavour of the month.
Instrument vintages
The stock of capital instruments that is currently in issue may originate from various vintages. Some instruments were issued under the first Basel accord, other instruments under Basel II and Basel III.
Instruments that were issued before the end of 2010 generally reflect features that are investor friendly, with a moderate risk of losing coupon payments or principal. However, from 2011 onward, EU banks started issuing hybrids with more serious loss-absorbing features. For example, in January 2011, Rabobank issued a 8.375% Tier 1 capital security with a permanent write-down feature. This feature may lead to the loss of the instrument once Rabobank needs to top up its Common Equity Tier 1 capital.
The vintages reflect the requirements that the issuers knew and expected at the time of issuance. So, when in June 2012 the European Commission presented a proposal of the Bank Recovery and Resolution Directive (BRRD), issuers tuned their instruments to anticipated bail-in requirements - even though the BRRD bail-in requirements are not in force until 2016.
Instruments issued in the past may lose their capital eligibility, unless they are grandfathered. When they are grandfathered, it is for a limited time. Banks therefore may want to call or buy back any ‘old style’ instruments that you own, because they contribute to regulatory capital less and less as time progresses. Therefore, please check when and how your investment can be called or redeemed.
Instrument country of origin
Despite efforts to harmonise bank capital rules in Europe, hybrids are an exception. Each country has its own preferences.
For example, in Mediterranean countries, banks prefer issuing instruments with a temporary write-down feature. However, restoring the full value of the instrument after a write-down takes time. Therefore, the promise of a bank to restore the instrument to its full value is what it is: a promise. Seeing is believing.
Other countries may require capital instruments to be fully written down once the capital ratio of a bank drops below a trigger level. This may look scary, but these instruments compensate write-down risk with a high coupon, part of which should be set aside to insure against the loss of the instrument.
Other factors may explain why hybrids differ per country, one of which is taxation. In many countries, the coupon is tax-deductible. The obvious flip-side is that a change in tax rules may prompt the issuing bank to call your investment. Again, please check when and how your investment can be called.
Flavour of the month
Whatever EU regulation requires, hybrid capital instruments are subject to the whim of politicians.
A decision to bail out or bail in may depend on the investor base and if this overlaps with the voter base. For example, politicians dislike bailing in retail investors if it costs them their votes. This may explain why this year, Portugal decided to bail out failing Banco Espírito Santo (BES). This after Holland and Cyprus bailed in debt holders in 2013.
Investors without the power to vote for EU politicians should therefore pay extra attention. Many bank capital instruments were sold to retail investors in the Far East, some to retail investors in New Zealand. When it comes to writing down capital instruments, EU politicians may not always have your best interest at heart.
*Dig in!
It is always important to read the full terms and conditions of hybrid securities and subordinated bank debt instruments. Many banks sport them on their IR websites. (If not, then maybe you should consider selling.)
In addition, a look at EU regulation may help too. EU rules are complex, but accessible. Click here for a list of links to the most relevant rules: Capital Requirements Directives, Regulations, EBA Guidelines, and EBA Regulatory Technical Standards. It is a lot of reading, but it may help you decide to buy, hold, or sell a EU bank capital instrument.
Happy reading!
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*Dr Martien Lubberink is an Associate Professor in the School of Accounting and Commercial Law at Victoria University. He has worked the the central bank of the Netherlands where he contributed to the development of new regulatory capital standards and regulatory capital disclosure standards for banks worldwide and for banks in Europe (Basel III and CRD IV respectively).
3 Comments
Yes, I was offered Lloyds ECNs in exchange for existing debt with an extra 2% yield and no loss of income for 2 years (as forced by the EU ) The ECNs were compulsorily convertible into ordinary shares at 59p (dropped as low as 22p at one time) if cover went below 5%.
I took the haircut on a very small holding and invested in a lot more existing shares at a yield of potentially 14%. The result is a price nearly doubling and yield still nearly 8% on the current price.
Hence avoiding the extra offered 2% paid off in spades.
Let’s see. In just the eight year period leading up the crisis of 2012, the ECB’s balance sheet had exploded by 4X. And the the truth of the matter is that the subsequent shrinkage shown below is a dangerous pro forma illusion. The ECB’s bloated portfolio of discount loans to member banks which were collateralized by sovereign debt was not really liquidated; it has just slithered to an off-balance sheet parking lot for the interim.
What Draghi’s undeliverable pledge actually did was to incite the fast money crowd into frenetic peripheral bond buying on the usual front-running presumption that smart guys buy now what the central banks announce they will be buying later. Soon the prices of these sovereign junk credits were ripping higher, and the rest of the market piled on—- especially the very same Spanish and Italian banks which had previously retreated to the ECB discount window to fund their stranded books of own country bonds.
Stated differently, in return for three cheap words Mario Draghi was able to access a vast financial parking lot, which was quickly filled with the previously shunned peripheral nation bonds. Accordingly, European banks, especially in Italy and Spain, began to liquidate their LTRO borrowings and, presto, the ECB’s reported balance sheet shrunk drastically.
http://davidstockmanscontracorner.com/wall-street-is-one-sick-puppy-tha…
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