EU Warns of CoCo Risk as Banks Build Buffers on New Rules

European Union regulators alerted banks and insurers about the risks of selling complex debt and hybrid securities to retail clients as they seek ways to boost capital to pass stress tests and comply with new rules.

The EU’s banking, markets and insurance authorities reminded financial institutions they could face fines or other sanctions for selling products such as contingent-convertible debt, known as CoCo bonds, to customers without properly explaining risks.

Regulators “are concerned about the practices used by some financial institutions to comply with enhanced prudential requirements” under a range of new EU rules adopted in response to the 2008 financial crisis, according to a joint statement issued late yesterday. “Selling practices used in connection with such capital raising may put investors, depositors and policyholders at risk and could breach a number of requirements governing conduct of business.”

Global regulators have more than tripled capital requirements for banks in response to the financial crisis that toppled Lehman Brothers Holdings Inc. They are also developing rules that would force lenders to ensure that a minimum percentage of their liabilities consists of instruments, such as junior debt, that can be wiped out or converted to equity in the event the bank fails.

Euro-area banks are also seeking to boost their financial resilience in response to an asset-quality review and stress test being carried out by the European Central Bank. Non-euro lenders face a stress test by the European Banking Authority.

‘Multiple Reasons’

Financial institutions are spurred to raise capital from their own customers for “multiple reasons,” including that they “may consider existing banking customers to be more receptive and therefore a more suitable sales target,” the EBA, the European Securities and Markets Authority and the European Insurance and Occupational Pensions Authority said.

A probe by regulators revealed cases where “existing depositors have been proactively approached by credit institutions and given the impression that a recommended product is as safe as a deposit or is protected by a deposit guarantee scheme, neither of which has been true,” the agencies said. In other cases, “investors have received no, insufficient or misleading information about product characteristics.”

Such practices risk placing firms in breach of their obligations under EU legislation known as the Markets in Financial Instruments Directive, which foresees punishments such as fines, according to the statement.

Trigger Point

Spanish Economy Minister Luis De Guindos changed legislation after a misselling scandal at Bankia SA, which sold preference shares, a form of hybrid capital, to retail clients who then suffered losses when the bank failed.

Under EU laws that implement international bank capital rules, banks can use CoCo bonds -- debt that converts to equity at a specific trigger point -- to meet part of their requirements. The securities can also be used by banks to meet requirements for debt that can be written down by regulators in a crisis before senior creditors are hit.

“CoCo structures are highly complex and are non-homogeneous in terms of trigger levels, necessary capital buffer levels and loss absorption mechanisms,” ESMA said in a separate statement.

As “investing in CoCos requires a sophisticated level of financial literacy and a high risk appetite, these may not be appropriate for retail investors and ESMA recommends that investors take into account the relevant risks before investing,” according to the statement.

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