CoCo Turmoil Forces Europe to Act on Surprise Coupon Loss

Updated on
  • Commission may split Pillar 2 into `guidance,' `requirements'
  • Volatility sparked concern over investor certainty, fairness

The volatility that roiled banks’ riskiest debt and raised questions about the future viability of the $102 billion market is forcing the European Commission to review the way the securities work to reduce the likelihood of investors facing a surprise loss of interest payments.

Different approaches that European supervisors have adopted in setting capital requirements “are a concern both in terms of investor certainty and maintaining a level playing field,” the commission said in a note to an expert working group that was obtained by Bloomberg News. “Such concerns were recently reflected in significant volatility in the price of certain capital instruments.”

The commission’s note reacts to calls by the European Banking Authority, the European Central Bank and European Parliament to clarify the limits for discretionary payments, including on capital securities such as additional Tier 1 bonds, or CoCos. Highlighting the level of attention the problem got, ECB President Mario Draghi volunteered a reference to the commission’s note when he reached the end of his press conference on Thursday.

“It’s quite important, and I want to point your attention to a communication by the Commission that was distributed this morning,” Draghi said. “This communication opens the way for a clarification by supervisors of the implementation of the measures that determine the so-called MDA, the maximum distributable amount.”

MDA Changes

Banks can make discretionary payments, which also include stock dividends and bonuses, if they have sufficient regulatory capital to do so. The MDA limits the payout once capital drops below certain levels. The commission is considering changing the way some of those levels are defined to increase banks’ flexibility about making the payouts, a move that amounts to a softening of standards.

“Once again, the ECB and the commission are undermining the principles of the market economy for the banking industry,” said Sven Giegold, a Green member of the European Parliament’s Committee on Economic and Monetary Affairs. “Instead of softening the existing rules, the commission should legislate clearly to ensure that nothing can be paid out if the regulatory capital levels aren’t met.”

Concern that some banks might have insufficient capital to be allowed to pay coupons on their CoCos rocked the market this year, pushing the mean price of bonds on Bank of America Merrill Lynch’s CoCo Index to as low as 88.8 cents on the euro from an 2015 high of 104.6 cents. The turmoil has shut the market down, with issuance sliding to 2.4 billion euros ($2.67 billion) this year, from 11.4 billion euros in the same period in 2015, and with the latest sales -- by Credit Agricole SA and Intesa Sanpaolo SpA -- taking place two months ago.

Banks’ capital requirements fall into two basic categories plus a series of buffers under the framework set by the Basel Committee on Banking Supervision. Pillar 1 requirements are one-size-fits-all and set out the minimum levels all lenders must meet to be considered solvent. Pillar 2 requirements are defined by supervisors for each bank individually, to cover risks that may not be covered by Pillar 1. The European Central Bank determines them in its Supervisory Review and Evaluation Process, or SREP, and until now encouraged banks to not disclose them.

“We know that there are differences in how these rules are applied by supervisors and that’s why we have now started the process of reflecting on this,” the commission’s financial services chief Jonathan Hill told European Parliament on Thursday. “There needs to be a clearer difference between the goals of Pillar 1 requirements that apply to all banks, and Pillar 2 requirements,” he said. His spokeswoman Vanessa Mock confirmed the review without commenting on the paper.

The commission suggests splitting the Pillar 2 capital into two elements. One of these would be a binding requirement and would count toward triggering a reduction or suspension of optional payouts. Supervisors would have less discretion in imposing it and banks would be able to appeal against it. “Hypothetical situations,” such as failing to meet minimum capital levels in the adverse scenario of a stress test, can’t be the basis of this requirement.

‘Capital Guidance’

Beside the Pillar 2 requirement and separate from it, is “guidance,” which has an “informal nature,” and allows supervisors to exercise discretion, according to the note. Supervisors would be allowed to consider the results of a stress test, demand a “credible” capital plan and step up monitoring in setting guidance, which would become a requirement only if “consistently” breached. That capital guidance would not be relevant for the triggers that could restrict optional payouts.

“By removing an element of Pillar 2, the level at which coupon risk occurs would clearly drop,” Morgan Stanley analysts Greg Case and Jackie Ineke said in a note to clients. “We’re yet to see by how much, and we might not know until SREP decisions are taken for 2017, likely after the results of the stress tests are published in October.”

The commission wants to ensure that the AT1 market, which regulators created, remains a viable source of funding for lenders. CoCos, which are taxed as debt and are designed to retain cash in a struggling lender, are undated and interest payments are optional, meaning an issuer can’t default on them.

Unlike suspended dividends or bonuses, interest payments on CoCos that are lost can’t be made up for by higher payments later. That element indicates that holders of the securities “may deserve special protection,” according to the note.