CoCo Holders May Get Protection as Europe Reviews Capital

  • European Commission looking to bring clarity to asset class
  • `Guidance' to raise capital doesn't bring automatic penalties

Holders of banks’ riskiest debt may gain some protection against the possibility of losing interest payments as the European Commission seeks to clarify the way investors in the securities could be penalized to help a troubled lender recover.

The Commission is seeking to address how European Union banking supervisors calibrate some capital levels that could determine whether or not banks can make payments on additional Tier 1 securities, according to a staff note to an expert working group. The executive arm of the EU also told regulators to differentiate between capital “guidance” they give individual banks and requirements they enforce.

Once banks miss a coupon on additional Tier 1 securities, known as AT1s or CoCos, it’s gone forever. Investors’ lack of certainty over what may trigger a missed payment has added to the volatility of CoCo prices this year, prompting regulators to address how to restore confidence in the securities.

“Investors in these AT1 instruments receive coupon payments and cannot, in contrast to shareholders or receivers of variable remuneration and discretionary pension benefits, be compensated for missed payments through higher distributions in subsequent more profitable years,” according to the document. “Accordingly, investors in AT1 instruments may deserve particular protection relative to the other stakeholders concerned.”

The document looks at how regulators treat so-called Pillar 2 capital requirements, which are designed to take account of the risks specific to that firm. Those go beyond the standardized Pillar 1 minimum capital requirements. The European Parliament last month demanded a review of the functioning of Pillar 2 requirements, as well as of the mechanism by which AT1 payouts can be suspended.

Slumping Market

“In essence, we believe that there might be a need to make a clearer distinction between the use of so-called Pillar 1 requirements, which are laid down in law and apply to all banks, and so-called Pillar 2 requirements that are institution-specific, decided on by the supervisor, and depend on the level of additional risks of a particular bank,” Vanessa Mock, spokeswoman for the Commission, said in an e-mailed statement.

Regulators created additional Tier 1 notes in the wake of the financial crisis to preserve capital in a stressed lender and avoid government bailouts. They are undated and interest payments on them are optional. The $102 billion market has slumped this year on concerns about bank capital levels and confusion about what could trigger losses for holders of the debt.

The latest moves are “another token of the remarkable initiative of transparency by European regulators towards the newly-born AT1 asset class,” said Gildas Surry, an analyst at Axiom Alternative Investments in London. “We expect that it will allay investor concerns and should instill back confidence in the sector.”

Different approaches that various authorities take in determining banks’ Pillar 2 requirements are also a concern in terms of maintaining a level playing field, the commission said in the document, which was also provided to the European Parliament and obtained by Bloomberg. Supervisors should differentiate between Pillar 2 “capital requirements,” which must be met at all times, and “capital guidance,” which wouldn’t be sanctioned until transformed into a requirement, according to the document.

‘Hypothetical’ Guidance

“An institution is subject to automatic restrictions on earnings distribution when its total capital falls below the sum of Pillar 1 capital requirements, Pillar 2 capital requirements and the combined buffer capital requirements,” according to the document. “If an institution meets the sum of those requirements, but does not meet the capital guidance, it shall not be subject to the automatic restrictions.”

Pillar 2 requirements shouldn’t be imposed to address “hypothetical situations” such as a firm failing to meet its requirements under the adverse scenario of a stress test, the Commission said. That should be handled by guidance and only become a requirement if a bank “consistently fails to comply,” according to the document.

“Guidance” on capital may imply a request for a “credible capital plan, the imposition of other supervisory measures or a stepping-up of supervisory monitoring,” the Commission said. The measure implies “an expectation that the institution will have additional capital but should not imply a formal capital requirement,” the commission said. Guidance doesn’t have “automatic and immediate consequences for an institution operating below the guidance level but still above the combined buffer capital requirement,” according to the note.

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