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CoCos May Be Endorsed in Capital Rules for Systemic Banks

International regulators will next week consider allowing contingent convertible bonds to count toward additional capital requirements for systemically important banks whose failure would roil the global economy.

The Basel Committee on Banking Supervision will discuss the potential for the securities -- nicknamed CoCo bonds -- to contribute to regulatory capital as an alternative to issuing shares or retaining more earnings, which banks say may stymie economic recovery by cutting their ability to lend.

The extra capital “has to be available to absorb losses before the bank fails, and obviously common equity meets fully that standard,” Stefan Walter, the Basel group’s secretary general, said in an interview ahead of the March 8-9 meeting of the committee. “We’re now also assessing CoCos and the possibility of this type of instrument fulfilling part of the loss-absorbency requirement.”

A global agreement by the Basel committee may expand the market for CoCos, following Credit Suisse Group AG’s sale of $2 billion worth of the securities last month. A Swiss government-appointed panel recommended last year that Zurich-based Credit Suisse and UBS AG should hold as much as 9 percent of their risk-weighted capital in CoCos by 2019.

“It looks like Basel is taking a leaf out of the Swiss book,” Monika Mars, a director at PricewaterhouseCoopers AG in Zurich, said in a telephone interview. “Not necessarily for how much extra capital” systemically important financial firms, or SIFIs, must hold, she said, “but at least with the structure of how the SIFI surcharge is going to work.”

Tougher Rules

The Group of 20 nations agreed in November that lenders whose collapse would threaten the wider financial system should face tougher capital rules than other banks, increasing their ability to take losses without failing. The Basel committee has been tasked by the Financial Stability Board with drafting the requirements.

Cocos are “a more focused instrument that should limit the need” for losses to be imposed on senior bondholders of distressed banks, said Jesper Berg, senior vice president at closely held Nykredit Realkredit A/S in Copenhagen. “The big issue, however, is developing a market for CoCos.”

Berg said banks and regulators would also “need to develop a special instrument” for mutually owned banks, “in order to have a level playing field.”

Minimum Criteria

Regulators are examining “possible concrete minimum criteria that CoCos would have to fulfil,” to form part of the extra reserves for SIFIs, Walter said. “We’re already reviewing some preliminary proposals” next week and “we will have much more concrete proposals for the committee and the FSB to review in June.”

Lloyds Banking Group Plc, which was bailed out by the U.K. taxpayer, swapped existing notes for CoCos in November 2009, Bloomberg data show.

CoCos alone may not be enough to provide the extra reserves systemically important banks need to guard against their failure, said Patricia Jackson, head of prudential advisory at Ernst & Young LLP. Holders of other bonds may also be required to suffer writedowns, known as bail-ins, at troubled lenders.

“Given the depth of market for CoCos it probably doesn’t provide the full solution,” said Jackson. “The indications have been that a combination of CoCos, bail-in and capital are being considered by the Basel Committee.”

Systemically Important

The possible use of CoCos only concerns additional rules for systemically important banks that go beyond capital and liquidity standards agreed on by the Basel group last year, Walter said.

The use of CoCos is “not being considered for the minimum Requirement,” or for an extra capital buffer agreed by the Basel group that would apply during credit booms, Walter said. “It’s really for the additional loss absorbency of SIFIs.”

Stephen Miller, a partner at law firm Allen & Overy LLP in London, said guidance would be needed “on criteria for setting the trigger and guidance on how to determine the number of shares per CoCo.”

Separately, the Basel committee will draw up standards requiring banks to disclose what instruments are included in their capital reserves, Walter said.

“All components of the capital base have to be fully transparent,” Walter said. Investors should be able to look at different banks’ “capital composition and compare them in terms of their capital structure, something that today is not possible.”

Banker Pay

Other transparency efforts will target the way banks pay their senior staff, Walter said.

The “focus here is not so much on levels of compensation from one year to the next but more on the incentives, and the governance process and the oversight,” he said.

Walter said the Basel committee also intends to examine ways to ensure so-called shadow banks face similar rules to traditional lenders when they carry out the same kinds of activities.

“What you don’t want is something which is bank-like and therefore could be susceptible to liquidity runs, deleveraging and contraction of credit, not being subject to any regulation,” he said.

Examples of shadow banks include structured investment vehicles, credit hedge funds and money market mutual funds, the Federal Reserve Bank of New York said in a report last year.

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