There are only two ways to finance a company: with equity and with debt. You sell pieces of what you do in return for a piece of the profit. Or you borrow money, hoping you do what you do well enough to pay the money back and have enough left over for profit. One is fish, the other fowl. There is no in-between. Anyone who tells you different is trying to sell you Chicken of the Sea.
Barclays (BCS), a large British bank, yesterday sold $1 billion of what’s called “contingent capital,” or what investors call “CoCo.” A CoCo is a bond. It’s borrowing. But if something happens—a contingency—the CoCo turns into something else. What Barclays sold yesterday turns into nothing. It loses its value entirely if the bank’s core Tier 1 capital ratio drops below 7 percent. If you don’t know what a core Tier 1 capital ratio is, that’s OK. No one does, precisely. Each bank has some ability to define it for itself, subject to constant parrying with regulators. So what Barclays sold is not quite debt that, depending on how the bank decides to look at its own books, will at some point turn into something that’s not quite equity.
Everything’s going to be fine.
Banks prefer debt to equity—they like to borrow money rather than sell pieces of themselves and share the profit. This is so for two reasons: The U.K. doesn’t tax the interest paid on loans (neither does the U.S.), and the less equity you sell of your company, the more profit you make when things go well. But the more a bank finances itself with equity, the more its owners stand to lose if things go poorly. Equity loses its value before bankruptcy as investors watch what’s happening. Debt loses its value after bankruptcy when there’s no money left. A drop in the value of equity leaves rich people less rich. An inability to pay back debt is what causes systemic crises. This is why regulators, at least since 2007, have been pushing ever so hesitantly for banks to hold more equity.
A core Tier 1 capital ratio is the amount of equity a bank holds compared with its assets—that is, with its outstanding loans. But banks perform what they call “risk weighting” on their own assets. If you don’t understand what risk weighting is, again, that’s kind of the point. Each bank performs it a little differently, and regulations are open to interpretation, which means Barclays has retained some discretion to figure out when its core Tier 1 capital ratio reaches 7 percent. The Basel Committee of international bank supervisors and the European Banking Authority have set up working groups to figure this out. In the meantime, Barclays is selling something in a can. It says it’s tuna. They’ll let you know when it turns to chicken.
We’ve seen this magic trick before. In 1996 the U.S. allowed what it called “trust-preferred securities,” a kind of low-class debt, to count as Tier 1 capital. If a bank became insolvent, this debt would be the first to become worthless. During testimony to Congress in 2011, Sheila Bair, then chairwoman of the Federal Deposit Insurance Corp., explained that “our experience with these instruments during the crisis is that they impeded recapitalizations [she means that banks that used these securities failed to get more equity when they needed it] and that institutions relying on them were generally weaker and more likely to be engaged in high-risk activities.”
The appeal of kind-of debt, kind-of equity—then and now—is that it can be different things to different people. To investors now, Barclays is offering a more than 7 percent yield—more than 7 percent!—with no risk. How could Barclays ever drop below its mandated core Tier 1 capital ratio? Regulators would never allow it, right? Because regulators always win. To shareholders, suddenly there’s more money to invest without having to dilute their shares. To regulators, there’s a new cushion of kind-of equity to keep the bank safe. So Barclays is offering a high return to investors and telling them there’s no risk. To regulators, Barclays is saying of course there’s risk; our new CoCos are there to absorb it. To its shareholders the bank is saying CoCos are the best! Let’s go buy some assets.
What did Barclays sell yesterday? It sold something that came in a can. Label’s a little hard to read. In a couple of years we can open it up. See what it smells like.