Danish CoCo Venture Risks Derailing Troubled Banks, S&P Says

Experimental capital instruments that Denmark is letting banks use to build regulatory buffers may inadvertently trigger a cycle of losses, Standard & Poor’s said.

The bonds convert to equity at a specified price when a capital threshold is breached. That conversion mechanism could spur a dangerous slide in a lender’s stock price and damage its ability to raise more capital, said Per Tornqvist, a Stockholm-based bank analyst at S&P.

“By creating clarity at what price an instrument converts, you don’t necessarily create the wanted outcome,” Tornqvist said yesterday in a phone interview. “There are always market participants that may act on the information with a different mind-set. Hence clarity on regulation is not always ensuring the wanted result.”

Denmark, whose the $320 billion economy stalled in the first quarter after shrinking 0.6 percent in the final months of 2012, is looking for ways to ease pressure on banks and help them lend more as they cope with tougher capital rules. The central bank said last month the industry isn’t making enough money as customers deleverage and writedowns from a 2008 burst property bubble remain high.

The Financial Supervisory Authority said in January banks would be allowed to use contingent convertible capital to meet individual solvency needs after tightening its methods for calculating requirements. Banks will be able to use CoCos in addition to equity and retained profits.

Loss Trigger

The regulator is also looking into letting Denmark’s systemically important financial institutions use CoCos to help them meet additional capital requirements. The instruments, which would fill a proposed crisis-management buffer, would convert to equity while a lender is still solvent.

Denmark is getting outside support for its experiment.

Bank of England Deputy Governor Paul Tucker said in a June 13 speech that new capital requirements don’t go far enough to ensuring financial stability, and regulators should consider requiring banks to issue CoCos, thereby incorporating equity-generating measures into their capital structures.

According to Tornqvist at S&P, investors in a bank that issues CoCos will drive down the share price until it reaches the conversion trigger.

“It won’t trade higher than the conversion rate,” he said. That could undermine efforts to raise new equity and ultimately deplete capital buffers, he said.

The warning from S&P comes as banks look for ways to reduce the cost of building capital as requirements mount. Yet debt instruments designed to contribute to regulatory buffers are proving hard to navigate.

Capital Review

Banks also face risks when using hybrid securities as rating companies probe the instruments’ loss-absorbing capacity. S&P said in March it’s reviewing criteria for risk-adjusted capital, with the prospect of a change of rules threatening to undermine the equity content of a $1 billion 2037 bond issued by Danske Bank A/S in September. Any change in the definition of hybrids won’t jeopardize Danske’s issuer rating, Tornqvist said.

“If we were to exclude it from Danske Bank’s risk-adjusted capital calculation, it would not change our opinion on the bank’s capital,” Tornqvist said. “The ratio would still be in the range of 7 percent to 10 percent, which we consider to be adequate.”

The FSA last month set triggers for banks planning to meet individual solvency requirements with CoCos. Banks will be able to choose between a threshold of 7 percent core equity Tier 1 and an individual solvency requirement, which includes Tier 2 capital, the FSA said June 12.

New Risks

That matches European standards and is well below the 10.125 percent a government-appointed committee in March recommended be applied to systemically important banks.

“Clarity can be good: you draw a line in the sand and say no further,” Tornqvist said. “But by doing so, you will risk creating other issues.”

The central bank urged lenders last month to continue to improve their earnings and capitalization. Return on equity “has been low in recent years,” the bank said in its annual review of the country’s financial industry.

The country’s six too-big-to-fail banks, led by Danske and mortgage lender Nykredit Realkredit A/S, reported last year an average return on equity of 3.6 percent after tax. The average for the rest of the industry was negative.

“Our expectation is that impairment losses will be reduced, and there will be cost savings in the industry,” Tornqvist said. “There are initiatives to boost the top line as much as can be done during a period of low interest rates.”