Contingent capital: Europeans want to sell CoCos to Asia

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By:
Lawrence White
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European banks are looking to their counterparts in Asia to help them with their capital-raising problems, according to sources in Hong Kong familiar with the deals, but are struggling to sell more paper as the news out of Europe worsens.

Contingent capital bonds are notes that transform into loss-absorbing equity under certain triggers, usually an emergency that threatens the issuer’s capital adequacy. The notes offer much higher yields than comparable straight bonds in exchange for this risk. Banks are interested in issuing them because they need to increase their capital bases to meet the forthcoming Basle III regulations.

CoCos, as contingent capital deals have been dubbed, enable a bank to keep its cost of capital down on a relative basis by classifying the funds as debt, while providing a capital buffer that switches into loss-absorbing equity if disaster strikes.

"Asian investors are not necessarily familiar with the structure and regulators are not all comfortable with them"

Issuers including Lloyds Bank, Rabobank and Credit Suisse have already sold contingent capital transactions, and debt bankers in Asia say other European issuers are sounding out investors.

"Increasingly, the relative importance of the Asian private bank investor base has come to the fore," says Benedict Nielsen, head of syndication and debt origination EMEA at Nomura. "Institutional investors are still very much present but we have continued to make regular sales within our private bank network despite the volatile market conditions."

Asian private banks have a track record of investing in more complex capital-raising deals from the financials sector, having bought into tier 1 capital deals from European issuers when they were the favoured structure. However, Nomura’s Mark Leahy, head of debt syndicate, acknowledges that CoCos are "an evolution in complexity".

The main challenge banks face in selling these notes, apart from investors’ unwillingness to buy debt from any European issuers at the moment, is the complexity of the pricing methodology for contingent capital. According to Nomura’s investor survey, even more sophisticated investors have not used a fundamental approach when evaluating CoCos.

The Japanese bank describes in its research a valuation model that aims to calculate a price for the contingent option embedded in these bonds. However, the model relies on a number of assumptions about simulated cashflows, volatility and correlations that might make investors nervous even if markets were calmer than they are.

"The CoCo market seems to have shut down in the past few weeks," says the head of debt capital markets at a global bank in Hong Kong. "Asian investors are not necessarily familiar with the structure and regulators are not all comfortable with them. However, you might see the market return if things settle down somewhat."