Swiss finish rests on big assumption about CoCos


Peter Lee
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When the Basle Committee on banking supervision proposed new minimum capital requirements in September of 7% total common equity against bank assets and 10.5% total capital, they left open the possibility of imposing higher surcharges on systemically significant or so-called too-big-to-fail banks.

It remains to be seen whether or not these will be commonly agreed international standards or instead be shaped by individual country regulators.

On October 4, the Swiss Federal Council published the recommendations of its commission of experts on what these surcharges should be for the country’s two biggest banks. Switzerland intends to require 19% of total capital against risk-weighted assets; 10% must comprise common equity; the other 9% must be in the form of contingent capital notes that would convert into common equity if either bank’s common equity ratio falls to 5%.

These are eye-watering amounts of capital, although both UBS and Credit Suisse had been bracing themselves for even worse from the so-called ‘Swiss finish’ that their national regulators were always going to impose. Credit Suisse analysts say: “We had been expecting a 12% minimum equity tier 1.” So the 10% requirement may come as some relief.

But there’s another wild card at play here. The Swiss regulators seem to expect that UBS will be able to raise Sfr27 billion ($28 billion) of contingent capital notes against its Sfr300 billion of risk-weighted assets in the next five years, while Credit Suisse will sell SFr36 billion of CoCos against its SFr400 billion of risk-weighted assets. For its part, the bank declares: “Credit Suisse believes it will be an attractive issuer of contingent convertible bonds”.

This sanguine view overlooks one crucial aspect of the CoCo market: to date, new issues of such bonds amount to a big fat zero. Lloyds Bank Group has such instruments outstanding following a distressed exchange of liabilities executed in November 2009. Four months later Rabobank issued senior secured 10-year bonds that the Dutch co-operative bank will write down to just 25% of face value if its equity capital ratio falls to 7% from the 12.5% at time of issue. These bonds will not convert into equity. Rabobank is not publicly listed.

The problem with the CoCos market, then, is that it doesn’t exist. The ratings agencies can’t rate them and no obvious natural buyer base presents itself. Buying bank debt has traditionally been a binary decision. If the bank is sound, or guaranteed by a highly rated sovereign, investors will buy. If there’s any risk of capital loss, they won’t. “There’s a lot of talk about debt investors who will be prepared to take losses at higher levels in the capital structure,” Douglas Flint, soon to be chairman of HSBC, told Euromoney in September. “I would be very interested to meet one.”

Other bank issuers have looked closely at CoCos and decided not to issue. The strong banks see that such bonds would pay a high spread to investors for no good reason. Triple-A rated Rabobank paid a coupon of 6.875% on its 10-year deal, a spread of 351bp to mid-swaps.
Gary Jenkins, fixed income analyst at Evolution, mischievously wonders if central banks implementing quantitative easing might be the bedrock investors in CoCos. If not, he wonders what concession bank issuers will need to make. “From an investor’s point of view, if the Swiss proposals become the European-wide standard, you know that the banks have to issue a certain amount of CoCos. That combination of necessity issuance and no natural buyer suggests that they will have to be as cheap as chips to become a significant part of the bond market.”

Credit Suisse analysts kindly ran the maths for such issues by UBS, assuming it might put out SFr12 billion of CoCos, some of which would presumably substitute for the existing SFr7 billion of hybrid tier 1 capital. “UBS currently has approximately SFr1.2 billion of expense on hybrid tier 1 (taken through the minorities line); assuming that CoCos might cost as much as 10% more than the existing hybrid would suggest that this could increase to SFr2.2 billion; in our opinion this extra expense would be manageable.”
That’s a lot of assumptions.

One bank treasurer recalls sounding out investors about such a deal and being told that it would be read as a warning signal of balance sheet problems that might prompt investors exposed across the bank’s capital structure to reduce equity holdings or even short the bank’s stock: not the desired outcome.

It may be that the Swiss commission of experts is on to something with its high requirements for capital buffers for too-big-to-fail banks. But the assumption that a contingent capital market exists to provide a big chunk of it is highly questionable.

Another European bank CFO worries about different country regulators each imposing uncoordinated capital surcharges for too big to fail banks. “There’s terrible nationalism at the moment,” he says. Large international banks must worry what will happen if the after the Swiss finish, they find themselves operating under a new Dutch cap, waiting for a French polish. As Euromoney went to press, rumours that the Brazilian regulators would demand a more painful yet much less substantial environment could not be confirmed.