The Basel Committee on Banking Supervision is proposing that debt counted as bank capital should be converted to stock or written off in a crisis, forcing bond investors to bear some of the cost of future bailouts.
All regulatory capital instruments sold by banks should be capable of absorbing losses if the company can’t fund itself, the committee said in a consultative paper today. Before taxpayers’ cash is used to rescue a lender, so-called contingent capital should be converted to equity or written off.
The committee, which sets international banking rules, wants to avoid a repeat of the financial crisis when government assistance to failing banks helped holders of some subordinated bonds dodge losses. Banks’ cost of capital may rise as investors demand compensation for the increased risk they won’t be repaid.
“It looks like the banks are going to be paying more for regulatory capital,” said John Raymond, an analyst at credit research firm CreditSights Inc. in London. “They’ll also have to look for a different investor base.”
The proposals will reduce moral hazard and excessive risk- taking by discouraging investors from buying securities with the assumption they will avoid losses if a bank fails, the committee said. It would also make private investors the first source of new equity to rescue a bank when it nears collapse, cutting down on the need for government bailouts.
Open to Comments
“A public sector injection of capital needed to avoid the failure of a bank should not protect investors in regulatory capital instruments,” the committee said in the report, published today on its website. The committee said it will welcome comments on the proposals until Oct. 1.
Lloyds Banking Group Plc, Britain’s second-biggest taxpayer-assisted bank, issued about $13 billion of enhanced capital notes last year as part of a subordinated-debt exchange. The ECNs, also known as contingent convertible core Tier 1 securities, or CoCos, become equity should Lloyds’s core Tier 1 ratio fall below 5 percent.
The Basel committee, which represents central banks and regulators in 27 nations and sets capital standards for banks worldwide, was asked by Group of 20 leaders to draft rules after the worst financial crisis since the 1930s. The committee is planning to present a final package of reforms to the G-20 leaders meeting in Seoul in November.
Liquid Market Needed
Regulators are proposing an “instrument that’s very different from what we have now and there’s no standard investor base to buy it,” said Oliver Judd, an analyst at Aviva Investors, the investment unit of the U.K.’s second-biggest insurer. “There needs to be some form of liquid market out there for investors to be willing to buy and that simply doesn’t exist.”
Bonds that have some of the features of contingent capital such as HSBC Holdings Plc’s undated 8 percent notes issued at $25 each in June were little changed at $26.79, according to data compiled by Bloomberg. The Markit iTraxx Financial Index of credit-default swaps of subordinated debt of 25 European banks and insurers rose 10 basis points to 197, according to JPMorgan Chase & Co.
The proposal “will clearly raise the bar even further for bond funds to invest in bank capital instruments,” said Georg Grodzki, the head of credit research at Legal & General Investment Management in London. “The ratings on future subordinated notes should be adjusted down and possibly below some investors’ and indices’ threshold levels.”
Risk Taking
Don Quigley, who helps oversee about $5 billion of assets as co-portfolio manager in New York of Artio Global Management LLC’s Artio Total Return Bond Fund, said that “you’re getting paid to take risk. There should be a penalty.”
Deborah Kilroe, a spokeswoman for the Federal Reserve Bank of New York, Thomas Schlueter, a spokesman for the Berlin-based Association of German Banks, and Ben Fischer, a spokesman for German financial regulator BaFin, declined to comment.
The British Bankers’ Association is “broadly in support of measures that ensure that regulatory capital instruments are loss absorbent,” Executive Director Simon Hills said. “We recognize that where a bank has been bailed out it would be wrong for holders of regulatory capital instruments to garner any benefit.”
The Association for Financial Markets in Europe, an industry group representing banks, said last week that failing financial companies should reduce the risk to taxpayers by using contingent capital and by converting debt into equity to fund their own rescue.
In what it termed a “bail-in,” AFME said bank bondholders should see their securities convert into common shares in the event an institution’s capital ratios fall below a preset level, the group said in a discussion paper on Aug. 12.
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