Basel Committee May Let Banks Use CoCos in Capital Surcharge

SEB AB CEO Annika Falkengren
Chief executive officer at Swedish lender SEB AB Annika Falkengren. Photographer: Alan Weller/Bloomberg

Global regulators may allow too-big-to-fail banks to use contingent convertible bonds to meet additional capital requirements designed to save them from collapse in a crisis.

So-called CoCo bonds, which convert into a bank’s ordinary shares if a specific trigger event occurs, are being considered for the capital surcharge by the Basel Committee on Banking Supervision, said Lars Frisell, chief economist of the Swedish Financial Supervisory Authority and a member of the Basel committee. There is some skepticism from regulators who question how well the instruments will work in practice, he said.

“It’s not set in stone whether it’s going to be common equity, CoCos, or if a combination will be allowed” in the surcharge, Frisell, 39, said in an interview in Stockholm yesterday. He expects that CoCos “will play a role.”

Regulators are exploring the use of CoCos to protect taxpayers from having to foot the bill of future bank rescues. Switzerland proposed that the country’s two largest banks, UBS AG and Credit Suisse Group AG, could use CoCos to satisfy part of a capital surcharge imposed at the national level.

“The big question is whether there is a market for CoCos,” Monika Mars, a PricewaterhouseCoopers AG director in Zurich, said in a phone interview. “Just because Credit Suisse managed to issue them does not mean everyone else can issue them. Credit Suisse is a very good bank and it didn’t need any money in the crisis.”

Basel Agreement

The details of the surcharge will be “hopefully settled” at the Basel committee’s next meeting in June, Frisell said. The committee would then submit a final proposal to the Financial Stability Board, which can amend the rules, he said.

“In the end, of course, it will be a political agreement what the surcharge should be for different banks,” Frisell said.

The FSB brings together finance ministries, regulators and central banks from the G-20 countries. The Basel committee brings authorities from 27 countries including the U.K., U.S. and China, to set regulatory standards for lenders.

CoCos automatically become equity when preset triggers are breached, supplying a buffer against losses in a crisis.

“It could only be a good thing” for regulators to give banks more options on how to meet any surcharge, Patricia Jackson, head of prudential advisory at Ernst & Young LLP in London, said in a phone interview.

Allowing lenders to use CoCos would “expand the market” for capital raising, enabling banks to “appeal to a wide variety of bondholders as well as equity holders,” Jackson said.

‘Very Expensive’

“Just relying on equity finance could get very expensive” for banks, Jackson said, as they will all be targeting the same group of institutional investors.

Most members of the Basel committee are “healthily skeptical” about CoCos, Frisell said, adding that he didn’t think this would prevent the securities from forming part of the surcharge plans.

“Overall, CoCos are actually a good thing,” said Annika Falkengren, chief executive officer at Swedish lender SEB AB, during a separate interview yesterday. “You buy something, you get interest on it, but if things go sour, you have to participate rather than getting paid back first.”

Regulators in the committee had shown more enthusiasm for CoCos than so-called bail-in debt, Frisell said. Bail-in debt involves imposing losses on banks bondholders to support a lender in difficulty.

‘Death Spiral’

An interim report published last month by the U.K. Independent Commission on Banking said that “a number of important questions remain to be answered” on using CoCos to build up banks’ capital, including whether there is a risk of a “death spiral” if a bank’s capital ratios approach the trigger point.

“Used in the right way,” a CoCo is “a good instrument,” Christian Clausen, CEO of Nordea Bank AB, the Nordic region’s largest lender, said in an interview on April 28. “But it has to be based on concrete criteria and contractual obligations.”

The alternative to CoCos would be a surcharge based on common equity, which includes mainly ordinary shares and retained earnings.

The Basel committee has discussed a surcharge of three percentage points of common equity for the most systemically important banks, people familiar with the talks have said. A surcharge of that size is “in the right ballpark,” Frisell said.

‘Translation Rule’

Some members of the committee are opposed to having a surcharge based purely on common equity, Frisell said.

Regulators will need to agree on a “translation rule” for how many CoCos banks would need to issue to compensate for holding less common equity in their surcharge, Frisell said.

Calculating such a translation rate would be “very difficult,” Mars said. “How do you quantify the relative quality of these instruments?”

Neither the Basel committee nor the FSB have released a list of the too-big-to-fail banks that will be required to hold additional capital.

“The usual suspects and a few more” will be on the list, said Frisell, who has been chief economist of the Swedish FSA since 2009.

Lenders would welcome the “flexibility” of being able to include CoCos in the surcharge, Rob McIvor, spokesman for the Association for Financial Markets in Europe, said in an e-mail.

“The key will be the framework for setting the rate of conversion to equity,” McIvor said. “It would need to be based on a set of principles that would enable banks to develop CoCos that the market will accept.”

Before it's here, it's on the Bloomberg Terminal. LEARN MORE