Banks’ CoCo Bond Payouts Gain More Protection in EU Proposal

  • Commission suggests privileging coupons over dividends, bonus
  • Part of EU’s push to soften ‘Pillar 2’ capital requirements

The European Union is considering adding to protections for banks’ riskiest debt securities by requiring lenders to pay coupons before stock dividends and staff bonuses.

Coupons on additional Tier 1 securities, such as contingent convertibles, or CoCos, “should be given priority” if capital levels are breached that trigger limits on payouts, according to an undated European Commission discussion paper prepared for a meeting of national experts. Banks would only be able to pay stock dividends if such coupons are paid in full, according to the proposed rules from the EU’s executive body.

Regulators introduced CoCo bonds -- undated securities with optional interest payments that are gone forever if missed -- to replace forms of debt that didn’t absorb losses in the 2008 financial crisis. EU law currently forbids tying AT1 coupons to the payment or non-payment of dividends with so-called dividend pushers and stoppers.

“This could foreshadow a wider reversal of EU policy on dividend stoppers,” said Steven McEwan, a partner at Hogan Lovells International LLP in London. “It makes sense as a policy because it would allow a bank in distress to recapitalize by selling CoCos, which wouldn’t be possible if investors were afraid coupons would be turned off immediately so that dividends can be paid to ordinary shareholders.”

Payout Limits

The CoCo proposal is part of a rule overhaul in which the commission is reining in supervisors’ powers to impose capital requirements exceeding the legal minimum and giving the banks more leeway to set those capital levels themselves. That move to curb so-called Pillar 2 requirements, a crucial factor for payout limits, started with a March paper that also raised the option of protecting CoCo coupons.

Under current EU law, a lender could skip a coupon rather than a share dividend, a feature that helped roil markets earlier this year and prompted some investors to dub the securities “junior equity.”

The ban on dividend stoppers, whereby the failure to pay an AT1 coupon would automatically halt discretionary payments on some other classes of securities including CET1, was designed to support investor demand if a bank got into trouble and needed to raise equity, McEwan said.

Equity Definition

“The change probably reflects the recognition that a bank is more likely to recapitalize through issuing additional Tier 1 securities rather than new shares,” he said.

The commission’s latest discussion paper, obtained by Bloomberg, refines the definition of common equity Tier 1 capital, allowing equity to qualify only “if distributions for this instrument are paid after all legal and contractual obligations have been met, including payments on non-CET1 own funds instruments,” according to the document.

Concern that some banks might have insufficient capital to be allowed to pay coupons on their CoCos rocked the market in the first quarter of 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 a 2015 high of 104.6 cents. The price has now rallied to 99.13 cents, just below par value.

“Many banks already make a statement in their AT1 marketing materials that they currently intend to take into account the relative ranking of the AT1s in their capital structure when declaring dividends,” said Tom Grant, a capital-markets partner at Allen & Overy. “This proposal means that AT1 holders would no longer need to rely on trusting that the issuing bank will continue to have that intention in the future.”

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, set by the European Central Bank in the euro area, are defined for each bank individually.

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In response to the turmoil in the first quarter, the ECB has decided to adopt the commission’s plan to divide Pillar 2 into a part that’s binding and another part that’s “guidance.” In calculating whether they have the funds to make a payout, lenders don’t need to consider the ECB’s capital guidance, in effect giving them more room to make discretionary payments.

While the ECB is currently applying that split of the Pillar 2 capital voluntarily, the commission’s proposal would enshrine it in EU banking law. The authority to give capital “guidance” would even be purged from the legal text, according to the proposal, to avoid even the impression that it is binding.

The commission also proposes clarifying current rules to underscore that “setting a target level of capital is in the first place up to the bank.” Under existing law, financial firms are already required to assess their capital needs.

Under the proposal, supervisors would “regularly review” the capital levels set by banks based on stress tests and regular evaluations of the risks to which lenders are exposed and which they pose to the financial system.

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