The BBA is now integrated into UK Finance. Please go to www.ukfinance.org.uk for new content and updates from UK Finance.
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From 1 July 2017, the finance and banking industry operating in the UK will be represented by a new trade association, UK Finance. It will represent around 300 firms in the UK providing credit, banking, markets and payment-related services. The new organisation will take on most of the activities previously carried out by the Asset Based Finance Association, the British Bankers’ Association, the Council of Mortgage Lenders, Financial Fraud Action UK, Payments UK and the UK Cards Association.x
Current market volatility has led to interest in CoCos – or Contingent Convertibles – and their role in the capital structure of banks. What are they and what do you need to know?
Banks issue bonds to fund their operations, just like other businesses. However, regulators impose prudential regulation on banks – such as Basel III – to ensure that they have the capacity to withstand future losses. Basel III therefore effectively places minimum requirements on how banks structure the liabilities used to fund their activities, such as lending. The standards require banks to maintain a minimum ‘Tier 1 capital ratio’ of 6% of their risk weighted assets (RWA). Of this, 4.5% must be in the form of common equity – shares – and 1.5% may be in the form of Additional Tier 1 (AT1) subordinated debt (AKA CoCos).
The key purpose of Tier 1 capital is to ensure banks can absorb losses during a time of stress whilst remaining a going-concern – or open for business. AT1 bonds are therefore convertible as the value can be partly or wholly written-down (reduced) or converted to equity on a mandatory basis in certain circumstances. This helps to boost the capital position of banks in a stress but means that the investor (owner of the bond) may suffer losses.
Regulation imposes strict conditions which must be met for a bond to count as AT1. First, the bond must be perpetual (i.e. have no final maturity date). Second, banks must have the power to suspend coupon (interest) payments. Under European law, banks can only pay dividends on shares or coupons on bonds if they have sufficient capital to meet both their Tier 1 capital and other combined capital buffer requirements which sit on top. Third, CoCos must have contractual terms to govern the circumstances under which they convert or write-down.
The contractual triggers for conversation are linked to the bank’s capital ratio. European law requires AT1 to trigger at a capital ratio of 5.125% but certain instruments can have higher triggers – in the UK the Bank of England is requiring a 7% trigger if AT1 is used to meet some of its requirements. Regulators also have the statutory power to convert AT1 if a bank fails – in the jargon it reaches the point of non-viability.
AT1 is now an important source of funding for banks. Bank of England data shows that the main UK banks issued almost £4.5bn during the second and third quarters of 2015. According to some estimates as much as €40bn was issued by European banks in 2015.
The current market volatility has led to investor focus on both the risk that banks may be prevented by regulation from making coupon payments on their bonds, due to uncertainty over how the new rules will work, and also by the potential risk of CoCos reaching their trigger points. Further clarification and insight from the regulators about how this would work in practice would be helpful as investors and fund managers are analysing the risks these instruments may pose.