CoCo Investors May Lose Payout Priority as EU Revamps Laws

  • Many member states oppose putting AT1 coupons before dividends
  • EU presidency also proposes tougher market-risk rule phase-in

Holders of banks’ riskiest debt securities were given priority for payouts in a draft revamp of European Union banking law. Now they may lose their spot at the front of the line.

Back in November, the European Commission proposed that when a struggling bank is required to rebuild its capital buffers, it must restrict bonuses and dividends before stopping payment due on additional Tier 1 bonds. Most EU member states want to abandon that plan, according to a working paper prepared by Malta, which holds the bloc’s rotating presidency.

Member states are pushing for a number of changes to the commission’s proposed revamp of the rules on bank-specific capital requirements, which are imposed by supervisors in addition to the legal minimum. In the main, the changes would give supervisors greater autonomy in dealing with banks than was foreseen by the commission.

“It does seem to be just the Europeans who have issues with giving CoCo coupons priority,” said Roger Francis, a credit analyst at Mizuho International Plc in London. “Regulators in Europe had all sorts of problems with complicated conditions on bonds, so it looks like they’ve just thrown up their hands and said ‘No.”’

Additional Tier 1 securities, such as contingent convertible bonds, or CoCos, are designed to ensure lenders that are heading for trouble have a way to retain cash while they try to turn things around. They have no stated maturity, and coupon payments are optional. And if the issuer’s capital ratio drops below a pre-set threshold, they convert to equity or are written down to absorb losses.

Discretionary Payments

The Brussels-based commission, the EU’s executive arm, proposed giving AT1 coupons priority over other discretionary payments after the market was thrown into turmoil in the first quarter of last year by the threat that some issuers would miss payments. Once an AT1 coupon payment is missed, it’s gone forever, in contrast to dividends and bonuses, which can be recouped through higher payments when the institution returns to health.

The commission also proposed to divide bank-specific capital demands, known as Pillar 2, into binding requirements and non-binding guidance. The European Central Bank has already adopted this two-pronged approach, which decreases the likelihood of a missed CoCo coupon payment because the guidance portion isn’t relevant for imposing distribution restrictions.

The majority view set out in the May 24 working paper seen by Bloomberg is in line with the position of the European Banking Authority, which has objected to prioritizing CoCo payouts because it wants to ensure supervisors have the flexibility needed to head off a banking collapse.

A spokeswoman for the Council of the European Union, which represents the governments of member states, declined to comment on the document. A spokeswoman for the EU presidency didn’t immediately respond to requests for comment.

Capital Demands

Other changes envisioned in the Maltese paper include removing restrictions planned by the commission on supervisors’ power to impose firm-specific capital requirements and to require additional disclosure and reporting. The member states also want to give supervisors the power to require a higher percentage of high-quality Tier 1 and common equity Tier 1 capital.

Such changes would allay concerns of the ECB’s supervisory chief, Daniele Nouy, who said in April that the EU’s draft law would “put a frame around supervisory actions that is much too tight.” She called for the right to impose stricter capital add-ons.

The paper also proposes stiffening the commission’s proposals for implementing global market-risk rules known as the Fundamental Review of the Trading Book. At issue are rules that cover how much capital banks use to fund the stocks, bonds, derivatives and other assets they have in their trading businesses. 

Market Risk

The commission sought to phase in the new rules over three years, during which banks’ market risk-weighted assets would be reduced to 65 percent of the amount calculated under the new rules. Member states are considering gradually decreasing the reduction during the transition, and removing a provision for the commission to prolong the phase-in period.

On this point, the member states are in also sync with the ECB, which also wants to toughen up the commission’s plan. Yet the Maltese paper makes clear that no consensus has been reached.

“While delegations generally agreed with the aim and the principles underpinning the presidency proposals, there was no agreement among delegations on the details, and hence a concrete redraft of these provisions requires further discussion,” according to the paper.

The working paper was prepared for a May 30 meeting of national officials on the commission’s package of risk-reduction measures. EU member states are still debating their stance on the bills. When they settle on a position, talks can begin with the European Parliament on a final version of the legislation.

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