Bloomberg News

Regulators’ Decision on Contingent Capital Backs U.S. Stance

June 27, 2011

(Updates with Swiss regulator comment in fifth paragraph.)

June 27 (Bloomberg) -- The decision to make too-big-to-fail banks primarily use retained earnings and ordinary shares to meet heightened capital requirements was a victory for U.S. regulators over their European counterparts.

The Basel Committee on Banking Supervision largely rejected requests from European countries to use some forms of contingent instruments to satisfy the new capital buffers. Regulators have yet to prove that so-called CoCo bonds, which convert into ordinary shares if a trigger event occurs, can absorb a bank’s losses, a person familiar with the negotiations said.

“Europeans were pushing for a mix of common equity and contingent capital and they lost at a global level,” said Karen Shaw Petrou, managing partner of Washington-based Federal Financial Analytics Inc., a bank consulting firm.

The decision was part of the Basel Committee’s overhaul this weekend of rules on how much capital the world’s largest and most systemically important banks must hold to ensure they don’t collapse during a financial crisis. The group of regulators said June 25 that lenders deemed too big to fail would need to set aside from 1 percentage point to 2.5 percentage points in additional capital.

Banks will have to meet the Basel surcharges using core Tier 1 capital, also known as common equity, the group said in its statement. The extra measures for as many as 30 of the largest banks will be imposed in addition to Basel rules announced last year. The 2010 accord, known as Basel III, require lenders to hold core capital equivalent to at least 7 percent of their risk-weighted assets.

Capital Surcharges

The outcome of the latest talks indicates that a “consensus” among regulators is “getting hardened around 10 percent common equity core tier 1,” Tobias Lux, a spokesman for Swiss financial regulator Finma, said in a telephone interview.

The committee said it would continue to study the issue and that banks could use CoCos to meet national capital rules that are even stricter than the Basel rules.

The agreement will help make “key financial institutions even more solid than already foreseen” under Basel III, Chantal Hughes, a spokeswoman for Michel Barnier, the EU’s financial- services commissioner, said in an e-mailed statement.

(For a related story on the Basel Committee’s surcharges, click here. To read a story about deadlines to phase in the rules, click here. To read about bank reaction, click here.)

Regulators Split

Regulators have been split over how far banks should be pushed to bolster their core reserves, which consist mainly of a bank’s ordinary shares and retained earnings, with lenders also warning that forcing them to plough more profits back into their capital could impede credit lines and ultimately harm the economic recovery.

Central bankers ultimately rejected allowing the buffer to include contingent capital for now because there wasn’t enough experience with the securities to see how they would serve as a buffer in a time of crisis, said one person involved in the discussions, who declined to be identified because the meetings were private. The group acceded to a request by several nations to keep the securities under study, and decided to validate a Swiss plan to use them on top of the systemic buffer.

“The credit markets were eagerly awaiting some sort of Basel sponsorship of the CoCo instrument as contributing to any SIFI buffer, and thus taking us one step closer to the proper launch of such a market, outside of the Swiss banks,” Morgan Stanley analysts said in a note yesterday.

‘Entirely Disappointing’

“For those hoping for a 200 billion euro plus CoCo market (like us) over time, the release was entirely disappointing,” the analysts said.

Bertrand Benoit, a spokesman for the German finance ministry, declined to immediately comment on the discussions. Ben Fischer, a spokesman for Germany’s financial regulator, Bafin, declined to comment.

“It is still too early to tell” whether CoCos will be accepted by the markets, Ewald Nowotny, Austria’s central bank governor who isn’t a member of the Basel committee, said in a telephone interview. “Up to now we have seen quite positive signs, it is still a bit mixed,” he said.

Not all European countries supported the use of CoCos. The U.K. Independent Commission on Banking in April said in an interim report that important questions remain to be answered” about the use of the instruments to build up capital.

Federal Deposit Insurance Corp. Chairman Sheila Bair has supported international efforts to impose tougher capital rules on systemically important financial institutions to avoid a repeat of the market turmoil that followed the 2008 bankruptcy of Lehman Brothers Holdings Inc., and that those rules should be based on banks having to build their common equity.

‘Feed a Crisis’

“Conversion to equity in a stressed situation could trigger a run on the institution, downstream losses to the holders of the debt, and potentially feed a crisis,” Bair said in a hearing last week.

With national regulators allowed to go their own way in any additional requirements they impose, American banks may face more restrictive choices than their European counterparts in how they bolster their capital.

“This will create disparities in the international market if you have some countries using it and some not,” said Scott Talbott, senior vice president of government affairs at the Washington-based Financial Services Roundtable, a group representing large banks such as Bank of America Corp. “There is a need for international harmonization for all aspects of capital whether types, quality or amount of capital levels.”

Contingent Capital

Global regulators “will continue to review contingent capital,” the Basel committee said in its June 25 statement. The group supports the use of such instruments to meet higher national loss absorbency requirements than the global minimum, the group said “as high-trigger contingent capital could help absorb losses on a going concern basis.”

Swiss regulators have already called for the country’s two largest lenders, Credit Suisse Group AG and UBS AG, to issue CoCos in addition to meeting a three percentage-point surcharge.

“We took note that Basel also mentions CoCos as a way for national authorities to impose additional surcharges,” Lux said. On the use of core Tier 1 capital, “what was suggested is really close to the proposition now being discussed before parliament in Switzerland,” Lux said.

CoCos are “quite an important element” for the two Swiss Banks, Nowotny said.

The success or failure of CoCos as an instrument “is nothing regulators can decide in the end,” Nowotny said. Regulators can make it possible for banks to issue them but whether they are accepted “is up to the markets to decide,” he said.

--With assistance from Craig Torres in Washington, Jim Brunsden in Basel, Ben Moshinsky in London. Editors: Anthony Aarons, Paul Armstrong

To contact the reporter on this story: Meera Louis in Washington at mlouis1@bloomberg.net

To contact the editor responsible for this story: Anthony Aarons at aaarons@bloomberg.net.


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