Reuters: Bankruptcy News: BoE warns of contingent capital risks

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BoE warns of contingent capital risks Jun 1st 2012, 15:56 By Owen Sanderson Fri Jun 1, 2012 11:56am EDT LONDON, June 1 (IFR) - Policymakers designing a regulatory regime for contingent convertible capital instruments should consider their potential risks when constructing them, a paper published by the Bank of England warned on Thursday. The Bank highlights risks such as holders of contingent capital instruments trying to sell out ahead of a conversion, and bank management or equity holders manipulating ratios to avoid triggers, underlining the likelihood that market participants in a competitive system will respond to economic incentives. The paper's authors marshaled evidence from nearly 60 academic and policymaker sources to consider the case for and against CoCos. It also examined existing issues from Credit Suisse, three Irish banks, Lloyds TSB Bank, Newcastle Building Society, and Rabobank - all of which have triggers related to some measure of core capital. It said "the key considerations when deciding which capital measure to use in the numerator are the timeliness of conversion and the risk of investors manipulating the trigger." It added: "If the trigger metric depends on a bank's ratio of capital to assets or risk-weighted assets, incumbent equity holders or managers could try to reduce assets to push the ratio up and away from the trigger value." The paper seemed slightly more positive on market-based triggers. It said "in the period up to the crisis there is some evidence suggesting that conversion would have occurred earlier if the trigger was based on a capital ratio with market capitalisation as the numerator." It did caution that a crude market capitalisation measure could be vulnerable to manipulation by investors, but suggested options to deal with this risk, including a moving average of market capitalisation, restrictions on long/short investors holding CoCos, and multiple triggers. The Bank's paper also examined alternatives to CoCos that might fulfill the same aims. It mentioned mandatory rights issues, capital insurance, debt to equity conversion, and straight debt writedowns. Contrary to reports elsewhere, the Bank's paper comes to no definite conclusion, and should not be read as a straight rejection or acceptance of Cocos as a part of regulatory capital. The report acknowledged that "issuing precautionary contingent capital instead of equity might also reduce risk-shifting incentives as long as holders of contingent capital face a credible threat of suffering losses. Market prices of precautionary contingent capital could provide useful information about the riskiness of banks to supervisors if investors have private information about banks' assets." The bulk of the report is concerned with how an instrument that achieves these benefits could be designed. However, the Bank's preference for large cushions of common equity in the banking system has been well documented, and there is little here to contradict that view. (Reporting By Owen Sanderson, Editing by Helene Durand) Link this Share this Digg this Email Reprints

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