Danish CoCo Experiment Seen Flopping Before First Bond Sold

Denmark’s experiment with contingent convertible bonds risks falling flat even before the first sale, according to the nation’s biggest bank.

The Financial Supervisory Authority said this week it will let banks use such hybrid debt to meet individual capital requirements. The regulator is also looking into allowing too-big-to-fail banks to use the securities to build buffers beyond individual capital requirements. According to Danske Bank A/S, investors probably won’t be interested in the hybrids at a price that would make them feasible for Danish lenders to sell.

“It may be quite expensive, even too expensive,” Thomas Hovard, head of credit research at Danske Bank Markets in Copenhagen, said in an interview. “It may be cheaper for the banks to go for equity.”

The FSA argues stricter rules are needed to protect Denmark from a financial industry whose combined assets are four times the size of the $300 billion economy. For systemically important financial institutions, a government-appointed committee said in March that hybrid conversion triggers should fire once banks breach a capital threshold of 10.125 percent. Lawmakers have yet to approve the Sifi proposals.

“We have seen instruments in other countries that are designed to comply with Basel III and the triggers have been 5 and 7 percent,” Hovard said. “Debt investors don’t want equity in their hands with such a high trigger” as Denmark’s Sifi committee has proposed, he said.

Near ‘Impossible’

To make convertible bonds work for too-big-to-fail banks at the current trigger proposal is “close to impossible,” according to Hovard.

The FSA plans to provide more details in coming weeks on which hybrid instruments banks can use. The emphasis will be on capital that demonstrates an adequate loss-absorbing potential while the bank is still solvent, Director General Ulrik Noedgaard said in an interview last week.

Banks will be allowed to use the hybrids to fulfill individual solvency buffers above a minimum 8 percent equity requirement, Noedgaard said. The FSA has worked with international investment banks to design a security that is consistent with similar products in other countries, “so it should be also possible to issue for Danish banks,” he said.

Crisis Management

The FSA is still looking into the use of hybrids to fulfill proposed crisis-management buffers for too-big-to-fail banks, Noedgaard said.

Having an alternative to equity will in itself be positive for banks, said Torben Jensen, chief dealer in debt capital markets at Copenhagen-based Nykredit A/S.

“A number of European banks have issued CoCos, and I am sure Danish investors also will consider it if they find the terms sufficiently attractive,” he said in an e-mailed response to questions. Whether CoCos are cheaper will depend not only on the terms of the security, but also on how profitable a bank is and the probability of conversion to equity, he said.

Relying on hybrid debt also hides potential risks as rating companies redefine their assessments of the securities. The prospect of a change of rules at Standard & Poor’s is hampering Danske Bank’s ability to plan its capital structure.

S&P Review

S&P said in March it’s reviewing its criteria for risk-adjusted capital in a move that threatens to reduce the loss-absorbing potential of a $1 billion 2037 bond that Danske issued in September. Danske faces a Jan. 1 deadline to decide whether to call the bond, Steen Blaafalk, head of group treasury, said last week. No decision has been made yet, he said.

Danske won’t buy back the bond at par to avoid angering investors, Christian Hede, a senior analyst at Jyske Bank A/S, said. The bank needs to raise as much as 43 billion kroner in the capital markets to fill reserve requirements, he said.

Denmark’s FSA, which oversaw the European Union’s first senior bondholder losses within a bank resolution framework in 2011, eased its stance on closures this year after creditors balked at the prospect of writedowns. Instead of only allowing banks 48 hours to find capital before being closed down, the regulator is now giving insolvent lenders the time they need to get back on their feet, it said in May.

Buffer Options

Noedgaard said allowing banks the option of building their individual regulatory buffers with hybrids instead of only equity was also a move designed to accommodate the industry.

Yet given the likely costs associated with contingent convertible bonds in Denmark, Hovard says banks probably will stick with equity to meet additional capital requirements.

“It will be difficult for banks that aren’t Sifis to sell these instruments,” he said. “They could perhaps if they have good relations internationally, or even in Denmark, but in general it’s still a bit difficult for Danish banks to compete in the funding markets. Only a few of them will be able to issue CoCos with the current legislation.”

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