Contingent Convertible Bonds, Corporate Hybrid Securities and Preferred Shares: Instruments, Regulation, Management [1st ed.] 978-3-319-92500-4;978-3-319-92501-1

Table of contents :
Front Matter ....Pages i-xix
Contingent Convertibles Issued by EEA Banks (Marcin Liberadzki, Kamil Liberadzki)....Pages 1-82
CoCo Bonds and Bail-in Mechanism (Marcin Liberadzki, Kamil Liberadzki)....Pages 83-121
The Contingent Convertibles Pricing Models: CoCos Credit Spread Analysis (Marcin Liberadzki, Kamil Liberadzki)....Pages 123-148
Non-EEA Banks’ and Insurers’ CoCos (Marcin Liberadzki, Kamil Liberadzki)....Pages 149-165
Corporate Hybrid Securities and Preferred Shares (Marcin Liberadzki, Kamil Liberadzki)....Pages 167-210
Back Matter ....Pages 211-229

Citation preview

MARCIN LIBERADZKI AND KAMIL LIBERADZKI

Instruments, Regulation, Management

Contingent Convertible Bonds, Corporate Hybrid Securities and Preferred Shares

Marcin Liberadzki • Kamil Liberadzki

Contingent Convertible Bonds, Corporate Hybrid Securities and Preferred Shares Instruments, Regulation, Management

Marcin Liberadzki Department of Finance Warsaw School of Economics Warszawa, Poland

Kamil Liberadzki Department of Finance Warsaw School of Economics Warszawa, Poland

ISBN 978-3-319-92500-4    ISBN 978-3-319-92501-1 (eBook) https://doi.org/10.1007/978-3-319-92501-1 © The Editor(s) (if applicable) and The Author(s) 2019 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, express or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. Cover image © bowie15, istock / Getty Images Cover design by Tjaša Krivec This Palgrave Macmillan imprint is published by the registered company Springer Nature Switzerland AG The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland

Preface

This book is a comprehensive monograph devoted to the new generation of hybrid securities: contingent convertibles (CoCos) issued by banks and insurers, banks’ subordinated bail-in bonds, insurers’ subordinated bonds, hybrid securities issued by non-financial entities (so-called corporate hybrids) and US banks’ preferred stock that form a new class (tier) of Basel III regulatory capital: Additional Tier 1 (AT1). The ‘new-generation’ hybrids mean fixed income securities that possess characteristic of both debt and equity, being neither of them. They are placed in the ‘debt-equity continuum’ as credit rating agencies name it. The idea of hybrid securities alone is not new. However, the last one and a half decades saw a significant development it this assets’ class in terms of new-style hybrid instruments having come up that merger into one single instrument the whole bundle of already present clauses elsewhere such as: (1) subordination to all issuer’s other debt, (2) very long tenors or no maturity date at all (albeit with issuer’s call option typically not exercisable until 5 to 10 years after the date of issuance), (3) coupon reset mechanism (usually fix-to-float with a step-up or fixed-to-reset) and (4) coupon deferral. The first new-generation corporate hybrids were issued around 2003. At first glance, they are coupon-paying, normal subordinated debt securities to retire at maturity (unless they are perpetual bonds). However, they become less debt-like when issuer falls into financial distress. Their loss-absorption capacity occurs in terms of ranking below all other debt but above equity in case of liquidation or winding-up of the issuer. The deep subordination along with ability not to pay a coupon or notional brings them closer to equity instruments. In contrast, with the pure debt coupon must be paid regardless of the issuer’s financial condition, and the same holds true regarding the repayment of debt face value when the debt v

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reaches maturity. In other words, in times of financial stress hybrids offer flexibility of equity instruments without diluting voting rights of existing shareholders. Another, this time totally new dimension of hybrids occurred with the advent of worldwide recognized Basel III Capital Accord in 2011. It is a conversion to a more deeply subordinated instrument (contingent conversion) or write-down of the principal value of the hybrid bond upon the occurrence of a stress event. These force the hybrid security to absorb loss while the bank remains a going concern, without undergoing a bankruptcy or restructuring. The global financial crisis of 2007–2009 showed that banks relied too much on debt financing and a capital buffer was highly needed to absorb losses in a manner that would not force regulators to bail out banks with public money. That is why the Basel III set new prudential capital requirements for banks increasing level of banks’ equity. Apart from genuine equity (i.e. shares, retained profits and reserves), the present regime allows for other instruments, in the form of the contingent capital notes, to be included as bank capital. These are called contingent convertibles (CoCos). CoCos are hybrid securities with an automatic conversion provision which enables banks to exchange bonds for common stock, subject to a breach of a conversion trigger set forth at the inception of the issuance of the bonds. Unlike with regular convertibles, a conversion is not an option at the discretion of a bondholder but is forced when regulatory capital fails to meet a predetermined level. Despite their name, CoCos may present a more extreme construction of loss absorption imprinted in a write-down mechanism, where the occurrence of a predetermined stress-event automatically triggers a write-down of a bond’s value without diluting shareholders. The burden of an institution’s failure is imposed on the bondholders, but the institution may continue to operate, averting disruption of the financial system. Chapter 1 offers an insight into CoCos issued by European Economic Area (EEA) banks. With only few exceptions, European CoCos date no earlier than 2014. This analysis is combined with basic analysis of EEA banks’ capital data, as it is crucial to assess risk of trigger event and coupon cancellation. In addition to automatic trigger mechanism based on regulatory capital ratio level, European Union’s (EU) competent resolution authorities are granted discretionary power to start write-down or conversion and determine its exact scope on reaching the point of non-viability (PONV) that marks an institution is ‘failing or likely to fail’. Unlike with automatic CoCo trigger, the determination that a bank is no longer viable has not been well defined in a way that it could explicitly be translated into a strict quantitative measure, say a level of capital adequacy ratio. Notably, the main controversy is that PONV

 Preface 

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may occur before a bank’s capital ratio falls to the trigger level. These two trigger mechanisms are effective parallelly and their interrelation is the subject of detailed study in Chap. 2. Distinctively, the PONV power goes beyond AT1 CoCos and refers to virtually all classes of bonds including the senior ones. The PONV loss-absorption mechanism that came with the new EU’s resolution regime in 2014 is a determinant for the whole ‘bail-in’ bonds class. In Chap. 2 we examine the subordinated bail-in bonds in the form of Tier 2 and new class of non-preferred senior instruments. The general concept of bail-in bonds led to the introduction of total loss-absorption capacity (TLAC) for globally systemically important banks and minimum requirement for own funds and eligible liabilities (MREL) for all EU banks in 2014, which is referred to in Chap. 2. Investors in contingent capital facilities prefer consistent and high coupon payments to equity stakes. As a rule, they anticipate that the triggers will never be reached and therefore enjoy a relatively high coupon that embodies the option to convert the bond into equity (i.e. spread plus premium of the option). The AT1 CoCos credit spread calculation is a challenging task considering numerous clauses embedded in this security. Apart from risk of trigger event occurrence, holders of AT1 CoCos are exposed to risks of coupon cancellation and call extension. The complexity of CoCos is amplified by the fact that the triggering may be caused not only by the occurrence of contractually determined trigger events, but also by the behaviour of the supervision or resolution authority. Their pricing models have been classified into market and structural models. The most prominent among the market models are credit derivatives and equity derivatives model. Chapter 3 presents these models together with the implied CET1 volatility model in more detail as an example of structural approach. Further sections present our empirical analysis using a dozen of regressors for explaining ‘spread to Tier 2’ observable values. In Chap. 4 we present CoCos issued by selected non-EEA countries’ banks for the same purposes of fulfilling Basel III regulatory capital requirements. The focus is on underlining main differences between EEA banks’ and non-­ EEA banks’ CoCos. We then look into insurers’ Tier 1 Solvency II regulatory package compliant CoCo bonds. Like banks, insurers are part of regulated industry. Banks’ and insurers’ CoCos present very similar debt characteristics under Solvency II and Basel III. Most notably, they both have a loss-absorbency mechanism on a going-concern basis, which is based on a regulatory capital ratio trigger event. We then compare Tier 2 bonds issued by insurers to those issued by banks. Tier 2 bonds are plain vanilla bonds similar to those issued by European banks. Both of them are subordinated to senior unsecured debt. This chapter concludes with presenting main features of insurers’ Tier 3 bonds.

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The final chapter of this book is on corporate hybrid securities, namely hybrids issued by non-financials, that is, other than banks and insurers. Unlike CoCos, they lack the contingent conversion or write-down loss-absorbing feature. We concentrate on the market performance of hybrids issued by Volkswagen in the scenario of a corporate governance scandal that broke out in September 2015. As the corporate hybrids market is relatively young and dominated by ‘blue chip’ issuers, the VW ‘dieselgate’ offered the rare opportunity to observe the real-world behaviour of such instruments class when an issuer is likely to defer scheduled coupon payments. Finally, we take broader look at the non-voting preference shares. Although nominally considered to be full-fledged equity, they are in fact placed in debt-­ equity continuum only slightly closer to common equity than bond-based corporate hybrids. Remarkably, preferreds carry debt-like features as they are stripped of the voting rights and, in particular as with US preferreds, they pay dividend on a regular basis. As such, they are deemed ‘fixed income’. The newest class are preferreds issued by US banks to fulfil the Basel III regulatory AT1 capital requirements. The US Dodd-Frank rules differ in this respect from the EU regulatory framework. In particular, US banks’ AT1s do not have a ‘going-concern’ loss-absorption mechanism embedded in the form of contingent conversion into shares of common stock or write-down. What makes this book distinctive is, in our opinion, its comprehensive and in-depth approach to all the modern types of hybrids throughout the world. Although concentrated on EU rules, in no way does this analysis constrain to Europe; it refers to other various jurisdictions as US or selected countries of Asia-Pacific region. This is our second book on hybrid securities issued worldwide. Those readers familiar with our previous Hybrid Securities. Structuring, Pricing and Risk Assessment monograph of 2016 (also with Palgrave Macmillan) will find this book complementary to the 2016 publication. It is not only in a sense that this book is a continuation and, what obvious, an update of the previous one, but it offers improved and more in-depth analysis especially in terms of EEA AT1 CoCos as well as PONV parameterization. Besides, it adds study on Asia-Pacific CoCos and US AT1 preferreds. Warszawa, Poland 

Marcin Liberadzki Kamil Liberadzki

Contents

1 Contingent Convertibles Issued by EEA Banks  1 2 CoCo Bonds and Bail-in Mechanism 83 3 The Contingent Convertibles Pricing Models: CoCos Credit Spread Analysis123 4 Non-EEA Banks’ and Insurers’ CoCos149 5 Corporate Hybrid Securities and Preferred Shares167 Bibliography211 Index223

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Abbreviations

ADI AGM APRA AT1 BaFin (Bundesanstalt für Finanzdienstleistungsaufsicht) BCBS BIS BRRD CAB CAR(1) CB CBR CBRC CCAR CCB CDS CE CoCos CET1 CoCo CRD IV CRR DB DECS DFAST DI

Available distributable items Annual general meeting of shareholders Australia Prudential Regulation Authority Additional Tier 1 Federal Financial Supervisory Authority Basel Committee on Banking Supervision Bank of International Settlements EU Bank Recovery and Resolution Directive Capital access bonds (Tier 1) Capital Adequacy Ratio Convertible bond Combined buffer requirement China Banking Regulatory Commission Comprehensive Capital Analysis Review or CET1 Capital Adequacy Ratio Capital conservation buffer Credit default swap Conversion to equity contingent convertibles Common Equity Tier 1 Contingent convertibles The fourth Capital Requirements Directive Capital Requirements Regulation Deutsche Bank Debt Exchangeable for Common Stock or Dividend Enhanced Convertible Securities The Dodd-Frank Act Stress Test Distributable items xi

xii Abbreviations

DoJ D-SIB DsT EBA EC ECB ECL ECN EEA EIOPA

US Department of Justice Domestic Systemically Important Bank Distance to trigger European Banking Authority European Commission European Central Bank Expected credit loss Lloyds’ Enhanced Capital Notes European Economic Area European Insurance and Occupational Pensions Authority ERN Equity Recourse Notes ESMA European Securities and Markets Authority ESRB European Systemic Risk Board FCA Financial Conduct Authority FINMA Swiss Financial Market Supervisory Authority FSB Financial Stability Board G-SIB Global Systemically Important Bank HKMA Hong Kong Monetary Authority HoldCo Holding Company HT High-trigger (CoCos) IAS International Accounting Standards IASB International Accounting Standards Board IFRS 9 International Financial Reporting Standard ‘Financial Instruments’ IRB Internal ratings based LAA Loss-absorbing amount LCR Liquidity coverage ratio LGD Loss given default LT Low-trigger (CoCos) LT2 Lower Tier 2 LTD Long-term debt requirement MCR Solvency II Minimum Capital Requirement MD Modified duration MDA Maximum distributable amount MIPS Monthly Income Preferred Stock MPE Multiple point of entry MPS Banca Monte dei Paschi di Siena MREL Minimum requirement for own funds and eligible liabilities NC Non-call NCWO No creditor worse off NPL Non-performing loans

 Abbreviations 

NSFR Net stable funding ratio OCR Overall capital requirement OpCo Operating Company O-SII Other Systemically Important Institution P2G Pillar 2 guidance P2R Pillar 2 requirement PD Probability of default PEPS Premium Equity Participating Securities PERCS Preferred Equity Redemption Cumulative Stock PONV Point of non-viability PRA Prudential Regulation Authority PWD CoCos Principal write-down contingent convertibles RA Recapitalization amount RC Reverse convertible bond RT1 Restricted Tier 1 RTS Regulatory Technical Standards RWA Risk-weighted assets SCB Stress capital buffer SCR Solvency Capital Requirement SIFIs Systemically Important Financial Institutions SLR Supplementary leverage ratio SPE Single point of entry SPV Special purpose vehicle SRB Single Resolution Board SREP Supervisory Review and Evaluation Process SRF Single Resolution Fund SRM Single Resolution Mechanism T1 Tier 1 T2 Tier 2 T3 Tier 3 TCR Total capital ratio TLAC Total loss-absorbing capacity TPS Trust Preferred Stock TSCR Total SREP capital requirement UT2 Upper Tier 2 VIF Value in force VW Volkswagen YTC Yield to call YTM Yield to maturity

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List of Figures

Fig. 1.1 Fig. 1.2 Fig. 1.3 Fig. 1.4 Fig. 1.5 Fig. 1.6

Fig. 1.7

Fig. 1.8

CET1 cushion above MDA restrictions of the major European banks in €mn and as a percentage of RWAs, at end-2017. Source: CreditSights 31 Distributable items of the major European banks in €mn and as a percentage of AT1s outstanding, at end-2017. Source: CreditSights 33 Reaction of selected bonds’ prices to DB 7.125% (GBP) and 6% (EUR) perpetuals’ price slump. Source: Cbonds 34 Major European banks’ end-2015 DIs as multiple of their annual AT1s coupon payments. Source: CreditSights 35 Prices of selected AT1 CoCos and regulatory amendments throughout 2016. Source: Assenagon Asset Management, 2016 37 AT1 capital fulfilment of major European banks 1Q2018. Calculation for UK Banks is following: 1.5% RWAs + AT1 Pillar 2. For Swiss CS and UBS: high-trigger, 1.5% leverage exposure (see Sect. 4.2.1 of Chap. 4 for details on Swiss capital adequacy rules). Source: CreditSights 56 Distance to trigger of the major European banks at end-2017. Calculations based on transitional CET1 levels. UK, Norwegian and Swedish banks operate on fully loaded CET1 levels. Source: CreditSights57 EBA 2016 EU-wide stress test*: Transitional CET1 ratio: (1) in 2015 beginning and (2) under adverse scenario in 2018. *Banco Comercial Português and CaixaBank were not included in the stress test but published their own results separately. Source: Own study59

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Fig. 1.9 Fig. 1.10 Fig. 1.11 Fig. 1.12 Fig. 1.13 Fig. 1.14 Fig. 1.15

Fig. 1.16

Fig. 1.17 Fig. 1.18 Fig. 1.19

Fig. 1.20 Fig. 2.1 Fig. 2.2

Fig. 3.1

Fig. 3.2

List of Figures

EBA 2018 EU-wide stress test: Fully loaded CET1 ratio: (1) under baseline scenario in 2020 and (2) under adverse scenario in 2020. Source: Own study 59 Major European banks’ RWAs/total assets (%) at end-2017. Source: CreditSights 60 CET1 ratio in EU countries at end-2017. Source: EBA 63 CET1 ratio developments (numerator and denominator) from 2015 to 2017. Source: EBA 64 RWAs developments by type of risks (in EUR Tn). Source: EBA 64 NPL ratio developments. Source: EBA 65 Yields* of Banco Bilbao (BBVA) euro-denominated international bonds as on 17 May 2016. *Yields quoted according to yield to maturity (YTM) convention. In case of bonds embedding call option, yield to first call date was used. Source: own analysis based on Cbonds data 66 Yields* of Danske Bank euro-denominated international bonds as on 17 May 2016. *Yields quoted according to yield to maturity (YTM) convention. In case of bonds embedding call option, yield to first call date was used. Source: own analysis based on Cbonds data66 Spreads (bp) of major eurozone banks’ selected bonds Aug 2012—Mar 2018. Source: EBA 67 Banks’ RoE (weighted average by country) at end-2017. Source: EBA69 Cost of capital assessment. European banks’ long-term sustainable profitability targets (left panel—July 2018 EBA questionnaire). ROE targets large euro area banks (right panel—2018–2021 horizon). Notes: left panel: The results are taken from the EBA’s Risk Assessment Questionnaire, which reports the responses from banks and market analysis. Right panel: Based on 21 large euro area banks. The targets have been collected from banks’ business and strategic plans. Source: EBA, individual bank disclosures and ECB calculations following the ECB (2018) 69 AT1 index (mid-yield in %). Source: EBA 70 Levels of regulatory capital triggering CoCo-specific events 101 PONV trigger level* and resolution trigger level*** in CET1 capital only versus contractual CoCo trigger levels for 41 major EEA banks at the end of 1Q2018. *base CET1 + P2R + 1.5%; **base CET1 + P2R 102 Theoretical value (prior to maturity) of a convertible bond and of a contingent convertible (CoCo) versus the price of the underlying share. Source: Liberadzki and Liberadzki and Liberadzki (2016) 124 CoCo spread decomposition. Source: Credit Suisse 138

  List of Figures 

Fig. 3.3 Fig. 3.4 Fig. 4.1 Fig. 4.2 Fig. 5.1 Fig. 5.2 Fig. 5.3 Fig. 5.4 Fig. 5.5 Fig. 5.6 Fig. 5.7 Fig. 5.8 Fig. 5.9 Fig. 5.10 Fig. 5.11 Fig. 5.12 Fig. 5.13

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The empirical dependent variable (vertical axis) versus model variable (horizontal axis) as on 13 March, 5 April and 19 April 2018. (Model #1). Source: Jaworski et al. (2019) 143 The empirical dependent variable (vertical axis) versus model variable (horizontal axis) as on 13 March, 5 April and 19 April 2018. (Model #2). Source: Jaworski et al. (2019) 148 Swiss banks’ capital and leverage requirements. LT low trigger, HT high trigger151 Solvency II regulatory capital composition. Source: Liberadzki and Liberadzki (2016) 159 Prices of selected VW hybrids in Mar 2014–Dec 2017. Source: Jaworski and Liberadzki (2018) 180 Prices of selected VW issued senior notes Mar 2014–Dec 2017. Source: Jaworski and Liberadzki (2018) 180 Prices of VW 5.375% 22 May 2018 senior note versus VW 3.875% perpetual (first call date 04 Sep 2018) in Mar 2014–Dec 2017. Source: Jaworski and Liberadzki (2018) 181 Prices of VW 2% 26 Mar 2021 senior note versus VW 3.75% perpetual (first call date 24 Mar 2021) in Mar 2014–Dec 2017. Source: Jaworski and Liberadzki (2018) 181 Prices of VW 3.3% 26 Mar 2033 senior note versus VW 3.5% perpetual (first call date 20 Mar 2030) in Mar 2014–Dec 2017. Source: Jaworski and Liberadzki (2018) 182 YTC of selected VW notes in period Mar 2014–Dec 2017. Source: Jaworski and Liberadzki (2018) 184 YTM of selected VW senior notes in period Mar 2014–Dec 2017. Source: Jaworski and Liberadzki (2018) 185 YTM of VW 5.375% 22 May 2018 senior note versus YTC of VW 3.875% perpetual (first call date 4 Sep 2018) in period Mar 2014–Dec 2017. Source: Jaworski and Liberadzki (2018) 186 YTM of VW 2% 26 Mar 2021 senior note versus YTC of VW 3.75% perpetual (first call date 24 Mar 2021) in period Mar 2014–Dec 2017. Source: Jaworski and Liberadzki (2018) 186 YTM of VW 3.3% 22 Mar 2033 senior note versus YTC of VW 3.5% perpetual (first call date 20 Mar 2030) in period Mar 2014–Dec 2017. Source: Jaworski and Liberadzki (2018) 187 Quotients hybrid/Proxy in period Mar 2014–Dec 2017. Source: Jaworski and Liberadzki (2018) 189 Hybrids: mean local intensity in period Mar 2014–Dec 2017. Source: Jaworski and Liberadzki (2018) 190 Senior notes: mean local intensity in period Mar 2014–Dec 2017. Source: Jaworski and Liberadzki (2018) 191

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List of Figures

Fig. 5.14 Spreads for different time to maturity in period Mar 2014–Dec 2017. Source: Jaworski and Liberadzki (2018) 192 Fig. 5.15 Spreads as on 10 September 2015, 8 December 2015 and 2 August 2016. Source: Jaworski and Liberadzki (2018) 192 Fig. 5.16 Slope versus free term. Source: Jaworski and Liberadzki (2018) 193 Fig. 5.17 Major US Banks CET1 ratio surplus as of end-2Q2018. Source: CreditSights208 Fig. 5.18 US Banks CET1 ratio (as of end-2Q2018) versus requirement (including stress capital buffer (SCB)). Source: CreditSights 208 Fig. 5.19 US major banks supplementary leverage ratios. Source: CreditSights 210

List of Tables

Table 1.1 Selected AT1 perpetuals with a first call date in 2019–2020. Price quotations and implied coupon on 10 Jul 2018 24 Table 1.2 AT1 and Tier 2 CoCos redemptions by 31 Aug 2018 26 Table 1.3 Contagion index for selected CoCos and straight bonds, 1Q2016 36 Table 1.4 Selected AT1 CoCos outstanding 47 Table 1.5 Outstanding Tier 2 CoCos at 05 Apr 2018 76 Table 2.1 Interpretation of the overall SREP score 99 Table 2.2 Individual bank minimum capital conservation standards 104 Table 2.3 Regulatory capital of Banco Popular at end-1Q2017 107 Table 2.4 The best and worst capitalized major EEA banks at end-1Q2017 107 Table 3.1 Rating valuation method (the rating agencies’ grades are associated with the relevant ‘weights’) 140 Table 3.2 Regressors and structural parameters (Model #1) 142 Table 3.3 Regressors and structural parameters (Model#2) 147 Table 4.1 Chinese banks’ minimum capital requirement under 2012 Trial Measures153 Table 4.2 Selected Asia-Pacific AT1s outstanding 155 Table 4.3 RT1 CoCos outstanding 162 Table 4.4 Insurers’ Tier 3 subordinated bonds outstanding 164 Table 5.1 Comparison of VW perpetuals further analysed in Sects. 5.2.3–5.2.5 178 Table 5.2 Change of VW long-term senior notes, perpetual corporate hybrid callable in 2018, Vorzugsaktien and common (voting) stock179 Table 5.3 Selected characteristics of VW 3% 01 Jul 2039 senior note 184 Table 5.4 Selected characteristics of VW NC5 3.875% perpetual 184 Table 5.5 Selected US Bank old-style legacy Tier1 preferreds 205 Table 5.6 Selected US Bank new-style AT1 non-cumulative preferreds 207

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1 Contingent Convertibles Issued by EEA Banks

1.1 Definition of Contingent Convertibles Contingent convertibles (CoCos) are subordinated hybrid securities with a fixed coupon and an automatic conversion provision. This provision enables banks to exchange bonds for common stock, subject to a breach of a conversion trigger set forth at the inception of the issuance of the bonds. In the event the conversion trigger is not breached, CoCo bonds remain as coupon-­paying, normal subordinated debt securities to retire at maturity (unless they are perpetual bonds). A conversion is not an option at the discretion of a bondholder but is forced when regulatory capital fails to meet a predetermined level. This unique feature provides to the CoCo bonds the loss-absorption capacity on a going-concern basis, a regulatory goal that seems not to have been effectively implemented under the pre-crisis legal framework of tier-based capital structures. Thus, CoCo bonds provide buffer capital to a bank at a time of distress but before potential insolvency (i.e. on a going-concern basis). A more extreme construction of loss absorption is designed in a write-down mechanism, where the occurrence of a predetermined event (stress-related) automatically triggers a write-down of a bond’s value. Such an automatic ‘bail-in’ executed in times of distress may rescue a bank from failure without a (heavily criticized) injection of taxpayer money into large financial institutions (bail-out). The burden of an institution’s failure is imposed on the bondholders, but the institution may continue to operate, averting disruption of the financial system. One may say that this write-down mechanism is somehow similar to that embedded in so-called catastrophe bonds (or simply ‘CAT bonds’), which were

© The Author(s) 2019 M. Liberadzki, K. Liberadzki, Contingent Convertible Bonds, Corporate Hybrid Securities and Preferred Shares, https://doi.org/10.1007/978-3-319-92501-1_1

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o­ riginally designed by US reinsurers and were used to transfer to the i­ nsurance industry the risk of losses caused by natural disasters (Liberadzki and Liberadzki, 2016). The most recent developments in the structuring of CoCo bonds aim to reduce the severity of an automatic write-down of the bonds’ principal value, facilitating the discretionary write-up of the bonds once the financial situation of the issuing bank is no longer distressed. The contingent convertibles play an important role in the tier-based capital structure imposed by the Basel III Capital Accord package, which will be examined in detail below. Their most eminent virtue of contingent conversion (or write-down) allows them to be assigned to the category of the bank’s Additional Tier 1 (AT1) regulatory capital. The internationally accepted principles of Basel III are translated into law worldwide. Each country has implemented Basel 3 in its own way, resulting in some material differences, some permanent and some temporary due to different timelines for implementation. This makes it hard to compare regulatory capital ratios across systems. The European Union prudent capital requirements are set out in the CRD IV package—the fourth Capital Requirements Directive (CRD IV)1 and Capital Requirements Regulation (CRR)2 forming a single rulebook for all EU member countries.

1.2 The Way to CoCos: From Basel I to Basel III 1.2.1 Basel I Tier 1 and Tier 2 Capital In this section, we discuss various types of hybrid securities borne out of the First and the Second Basel Capital Accords (Basel I and Basel II) and trace an evolution of the most controversial capacity of the CoCo: contingent conversion or contingent write-down. We offer some suggestions concerning the very origins of such mechanisms, and discuss how their evolution finally brought CoCos into existence. Basel regulation of banks on a global basis started with the publication of Basel I (or Basel Capital Accord) in 1988 to be implemented from January 1992. Basel I dealt with minimum capital requirements against credit risk. It  Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC. 2  Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012. 1

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introduced the concept of risk-weighted assets (RWAs), against which banks were required to hold at least 8% capital. The purpose of capital requirement was to prevent internationally active banks from excessive risk exposure. Under Basel I, banks had to hold regulatory capital in the amount of 8% of their risk-weighted assets. A risk-weighting scheme has also been provided. Basel I also introduced the concept of Tier 1, 2 and 3 of capital, where only Tier 1 fits the classical, strict definition of equity. Tier 1 capital (also referred to as ‘core capital’) consisted of common equity, reserves and non-cumulative preferred shares.3 Hybrid capital instruments and subordinated dated debt instruments may be eligible for Tier 2 (supplementary capital) purposes on the condition that the total of Tier 2 (supplementary) elements4 were limited to a maximum of 100% of the total of Tier 1 elements and subordinated term debt will be limited to a maximum of 50% of Tier 1 elements (BCBS, 1988). In the category of hybrid capital instruments ‘fall a number of capital instruments which combine certain characteristics of equity and certain characteristics of debt. Each of these has particular features which can be considered to affect its quality as capital. It has been agreed that, where these instruments have close similarities to equity, in particular when they are able to support losses on an on-going basis without triggering liquidation’. Therefore, the main characteristic of hybrid instruments is that ‘they are available to participate in losses without the bank being obliged to cease trading (unlike conventional subordinated debt)’. Another distinguishing feature is that ‘although the capital instrument may carry an obligation to pay interest that cannot permanently be reduced or waived (unlike dividends on ordinary shareholders’ equity), it should allow service obligations to be deferred (as with cumulative preference shares) where the profitability of the bank would not support payment’.5 Another element of supplementary Tier 2 capital could be formed out of subordinated term debt that did not meet all hybrid capital eligibility criteria. This category included conventional unsecured subordinated debt capital instruments with a minimum original fixed term to maturity of over five years and limited life redeemable preference shares. During the last five years to maturity, a cumulative discount (or amortization) factor of 20% per year was to be applied to reflect the diminishing value of these instruments as a ­continuing source of strength. What must be stressed is that unlike hybrid  Tier 1 capital does not include cumulative preferred stock as it can’t be deemed ‘permanent shareholders’ equity’ according to Annex 1.D. BCBS (1988). More on preferred stock see Sect. 5.3 of Chap. 5. 4  Apart from hybrid capital instruments and subordinated debt, the Tier 2 capital consisted of undisclosed reserves, asset revaluation reserves and general provisions/general loan loss reserves. See Annex 1.A. p. 17 of BCBS (1988). 5  see BCBS (1988) p. 6 and 19. 3

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capital, subordinated term debt was to absorb losses only on gone-concern basis (that is, only when a bank declared bankruptcy). The Basel Committee on Banking Supervision (BCBS) categorization was not reflected in the banks’ balance sheets: Tier 2 items were still reported as liabilities. It is at this point that the notions of ‘equity’ and ‘bank capital’ have split off.

1.2.2 Tier 3 Capital In January 1996, the Basel Committee published the document titled ‘Amendment to the Capital Accord to Incorporate Market Risk’ where it introduced a third tier of capital (Tier 3) consisting of short-term subordinated debt defined as follows (BCBS, 1996): 1 . is unsecured, subordinated and fully paid up; 2. has an original maturity of at least two years; 3. cannot be repayable before the agreed repayment date unless the supervisory authority agrees; 4. must be subject to a lock-in clause which stipulates that neither interest nor principal may be paid (even at maturity) if such payment means that the bank falls below or remains below its minimum capital requirement. These instruments possessed only gone-concern loss-absorption capacity.

1.2.3 Innovative Tier 1 Instruments On 27 October 1998, BCBS published a press release with an aim to regulate the new Tier 1 regulatory capital subcategory of so-called innovative Tier 1 instruments. It was a Basel Committee’s reaction to banks issuing a range of innovative and cost-efficient Tier 1 capital instruments via special purpose vehicles (SPVs) and denominated in other than local currency. BCBS allowed for 15% of the Tier 1 capital layer to be filled with hybrid securities meeting the supplementary Tier 2 eligibility criteria plus the following criteria: 1 . deferred dividend payment is non-cumulative; 2. are junior to depositors, general creditors, and subordinated debt of the bank (deep subordination); 3. are perpetual; 4. can neither be secured nor covered by a guarantee of the issuer or related entity or other arrangement that legally or economically enhances the seniority of the claim vis-à-vis bank creditors;

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5. are callable at the initiative of the issuer only after a minimum of five years with supervisory approval and under the condition that it will be replaced with capital of same or better quality unless the supervisor determines that the bank has capital that is more than adequate to its risks; 6. the main features of such instruments must be easily understood and publicly disclosed; 7. proceeds must be immediately available without limitation to the issuing bank, or if proceeds are immediately and fully available only to the issuing SPV, they must be made available to the bank (e.g. through conversion into a direct issuance of the bank that is of higher quality or of the same quality at the same terms) at a predetermined trigger point, well before serious deterioration in the bank’s financial position; 8. the bank must have discretion over the amount and timing of distributions, subject only to prior waiver of distributions on the bank’s common stock and banks must have full access to waived payments; and 9. distributions can only be paid out of distributable items; where distributions are pre-set, they may not be reset based on the credit standing of the issuer. Besides, the innovative Tier 1 instruments were also fitted with coupon step-up clause in case an issuer did not exempt his call option. However, only a ‘moderate’ step-up was allowed at a minimum of ten years after the issue date.

1.2.4 The Basel II Hybrid Capital Instruments The Basel II Accord followed Basel I and was released by the Basel Committee in June 2004. The Basel Committee expressly stated that ‘Upper’ Tier 2 (UT2) may consist of hybrid debt capital instruments—that is, ‘a number of capital instruments which combine certain characteristics of equity and certain characteristics of debt. (…) where these instruments have close similarities to equity, in particular when they are able to support losses on an on-going basis without triggering liquidation, they may be included in supplementary capital (…)’. What is more, certain categories of instruments were named as constituting ‘hybrid’ capital: perpetual preference shares carrying a cumulative fixed charge (a most obvious example of a hybrid), long-term preferred shares (Canada), titres participatifs and titres subordonnés à durée indéterminée (France), Genussscheine (Germany), perpetual debt instruments (UK) and finally, the US mandatory convertible debt instruments (Paragraph 49[xi] of

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the Basel II Accord). One may conclude that UT2 capital was formed from undated (perpetual) subordinated hybrids. Qualifying criteria for UT2 capital instruments also were provided in Annex 1a of the Basel II Accord. The essential requirements for hybrid capital instruments are as follows: (1) unsecured, subordinated and fully paid up; (2) non-call option for bondholder or no call for issuer except where supervisory authority agrees; (3) loss absorbing without bank being obliged to cease trading (unlike conventional subordinated debt), and finally (4) ‘although the capital instrument may carry an obligation to pay interest that cannot permanently be reduced or waived (unlike dividends on ordinary shareholders’ equity), it should allow service obligations to be deferred (as with cumulative preference shares) where the profitability of the bank would not support payment’. The last requirement on distribution required citation in extenso, as it will be shown that such an approach to coupon deferral finally resulted in severe consequences. Deferral of coupon payments was allowed only in a situation of financial stress that calls into question the bank’s ability to remain profitable. In fact, distributions on hybrid UT2 instruments were left to the discretion of the financial institutions. When designing Lower Tier 2 (LT2), the Basel Committee gave special attention to perpetual maturity of instruments and to their loss-absorbing ability. As a result, dated subordinated debt instruments, with maturity of over five years at issuance (or five years to the first call date) were allowed as supplementary elements of capital, but only subject to adequate amortization agreements (Paragraph 49(xii) Basel II Accord). Moreover, the amount of this dated Lower Tier 2 instruments was capped at 50% of the company’s common equity items. LT2 instruments were not designed to absorb losses, so coupons were paid on a mandatory basis, provided that the institution had announced an annual profit. Basel II also left it for decision of national regulators if a Tier 3 instruments are to be allowed. The sole purpose of such short-term subordinated debt was to allow a financial institution to meet a proportion of the capital requirements for market risk (Paragraph 49(xiii) Basel II Accord). Such instruments had to meet certain minimal conditions: (1) be unsecured, subordinated and fully paid up, (2) have an original maturity of at least two years, (3) no call except where supervisory authority agrees and (4) lock-up clause prohibits any distribution (even repayment on maturity) which would result in breaching of minimum capital requirements by the institution (Paragraph 49(xiv) Basel II Accord).

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1.2.5 Basel III Capital Instruments The financial crisis of 2008–2009 has exposed the insufficiency of the Basel II capital structure, which was not able to preserve banks from bankruptcy. In practice, before the great financial crisis classical equity amounted to 1–3% only of RWAs in many banks. In the aftermath of the crisis, regulators set out to strengthen capital regulation. The Basel III capital requirements call for a minimum of 4.5% of RWA as core Tier 1. Basel III requires also a backstop 3% leverage ratio, defined as common equity to total assets, or more precisely total exposure taking into account off-balance sheet derivatives. Most of the Basel II hybrid Tier 2 capital has been phased out now6 as it became too bond-like and was proven by the credit crunch to not be truly loss absorbing. It ranked senior to the Core Tier 1 instruments and had an entitlement to a fixed coupon. Coupons were discretionary but had to be paid if the bank made a profit or paid any ordinary dividend. Most coupons were paid throughout the credit crisis unless there was some form of state involvement in the bank. In fact, lack of banks’ willingness to defer coupons on UT2 hybrids (that would ruin their credit history) and lack of ability to defer coupons on LT2 subordinated debt led to necessity of bail-outs. One may say that restrictive provisions on deferral applicable for Basel III new layer of Additional Tier 1 capital financial hybrids were forged to avoid repeat of this situation. Financial institutions which strongly relied on Lower Tier 2 instruments had no tool to convert these instruments to more loss-absorbing ones. This observation is a cornerstone for the contingent conversion into common equity that forms the footprint of Basel III. All the instruments eligible for Additional Tier 1 purposes (that has to a large extent replaced the Basel II UT2) must be subject to such contingent conversion. Under Basel III, Tier 2 capital is no longer divided into ‘Upper’ and ‘Lower’. Finally, Tier 3 instruments were abandoned and currently national regulators may not introduce them. However, it will be demonstrated that the very concept of Tier 3 instruments has not been totally abandoned. There is strong market demand to mitigate the uncertainty introduced by the discretionary contingent conversion trigger event, or ‘regulatory trigger’, defined in Bank Recovery and Resolution Directive (BRRD). The idea of Tier 3 regulatory capital is to identify the debt instruments that may be subject to the resolution mechanism provided by Tier 3 instruments and simultaneously identify the debt instruments that are beyond the scope of the mechanism.7  See Sect. 1.3.3.4.  See Sect. 2.9 of Chap. 2.

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In terms of the magnitude of capital, Basel III calls for banks to have the following minimums: Tier 1 common capital of 4.5% RWAs, Tier 1 capital of 6.0% and total risk based capital of 8.0% RWAs. In addition to these minimum levels, banks would be required to maintain a ‘capital conservation’ buffer of up to 2.5% RWAs, phased in over four years beginning in the fourth quarter of 2015. Global systemically important banks (G-SIBs) were to maintain an incremental capital buffer of up to 250 bps. BCBS guidelines for Basel III call for higher capital requirements to be phased in over seven years (through 2019). The post-crisis tighter restrictions and greater capital regulation stringency can be translated into peculiar metrics: Back in 1988, the document Basel I contained just 30 pages. The Capital Requirements Regulation and Directive that comprise CRD IV—the EU version of Basel III—runs to over 1600 pages (not including associated European Banking Authority (EBA) regulatory standards). In the US, the Dodd Frank Act, a mere 848 pages, has grown into almost 9000 pages of associated rules and regulations.

1.2.6 Origins of CoCo Instruments The very idea of automatic conversion of distressed debt into equity to avoid the expense of bankruptcy and the cost of exchanges is not new. In debt exchange situations, bondholders surrender outstanding bonds in exchange for new bonds with significantly lower interest rates or principal amounts. As one possible contractual solution of that problem, a new security called distress-­contingent convertibles (DCCs) was proposed in 1991 to address the excessive costs of overleveraged US corporate issuers’ junk bond defaults at that time (The Harvard Law Review Association, 1991). In the case of standard convertibles, bondholders will generally exercise their option only in good times, not in times of distress when the company desperately wishes to reduce its debt. DCCs would operate in reverse. Conversion would not occur at the holder’s option as the stock price rises. Instead, DCC conversion would be automatic if the equity value falls below a certain threshold. Flannery (2002) proposed reverse convertible debentures (RCD) that automatically convert into common equity of the bank’s capital ratio falls below a prespecified value. In his view, loss absorption on a going-concern basis addresses resolution problem in the banking sector: for the sake of preserving the stability of the financial system, it is better to bail-in systemically important banks at the cost of bondholders than to let them go bankrupt. Marquardt and Wiedman (2005) examined convertible bonds that cannot be converted into

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shares of common stock until a prespecified stock price is reached; that is, conversion is contingent on reaching the price threshold.8 We mentioned that financial institutions had too much discretion in terms of deferral of payments on Basel II UT2 hybrids, and virtually had no legal tool to defer payments on Basel II LT2 subordinated debt. As a result, coupon deferral was not used for loss-absorption purposes, and Basel II Tier 2 instruments failed to absorb losses. Financial institutions faced the necessity of bail-­ outs and state aid. This aid came at a price: mandatory deferral of payments on hybrid, non-cumulative, preferred T1 shares and T2 instruments. However, Lloyds made an agreement with the UK government that such severe solutions will not be applied to those UT2 hybrid holders who agree to swap these bonds into new hybrids that can be converted to equity if financial stress occurs. They were in many ways the original CoCos, with what now looks like a very low trigger: a Basel II Core Tier 1 ratio of 5%. Hence, the first CoCo notes (Lloyd’s Enhanced Capital Notes) came up in late 2009 as a means of providing public aid to financial institutions, conditional upon coupon deferral on Basel II T2 hybrids. Simultaneously, the first investors in CoCos were holders of ‘failed’ hybrids who faced a threat of coupon deferral. The only way to avoid deferral was to swap Basel II hybrids into new ones that offered high coupon values but incorporated new loss-absorption tools contingent on conversion into equity. Hence, to some extent, they may have regarded this swap as some kind of ‘lesser evil’. An issue by Lloyd’s of London’s was followed in 2010 by Rabobank CoCos in the form of its Senior Contingent Note, issued in 2010. It is a ten-year bullet, with the write-down trigger—the only difference from a normal senior bond. It is worth mentioning that Rabobank is the only bank to have issued senior CoCos. If the trigger were breached, the bonds would be written down to 25% of par. The trigger was a 7% Equity Capital Ratio. The denominator of the ratio were risk-weighted assets (RWAs), while Equity Capital comprised retained earnings plus member certificates, a similar measure to Core Tier 1 capital. Breaching the capital ratio of 7% did not trigger conversion to equity (as Lloyd’s ECNs provided for) but the write-­ down of 75% of the bond’s principal value. The origins of such innovations are simple: Rabobank has no shares admitted to trading and therefore conversion to equity was not attractive to investors. After Rabobank’s successful issue, which was oversubscribed two times, many financial institutions issued CoCos even before the Basel III Accord of December 2011 made clear the eligibility requirements of AT1 and T2, long before the CRD IV package of June 2013 incorporated these requirements in  They used ‘COCOs’ abbreviation for contingent convertibles.

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European law. The market activity of issuers was driven by the urge to exploit market demand for high-yield instruments in an environment of extremely low interest rates. As a result, various types of CoCos emerged, and they were hardly comparable to the homogenous category of standard assets. When the Basel III and CRD IV packages brought clarity in terms of requirements, existing CoCos were classified as AT1 and Tier 2 instruments. It may also be noted that issuers safeguarded themselves against regulatory risk connected with the changing regulatory environment: financial hybrids are equipped with a Regulatory Event clause. This mechanism enables the issuer to call the instrument long before its scheduled maturity, even during the non-call period, if the instrument stops being eligible for the regulatory capital purposes due to changes in the regulatory regime.9

1.2.7 T  he European Unions’ CRD IV Package: Components of Capital Contingent convertibles play an important role in the tier-based capital structure imposed by the CRD IV package. The Capital Requirements Regulation preserves the level playing field inside the Single Market by achieving a single rulebook for all banks in the EU. The CRR groups capital instruments into Tier 1 (T1) and Tier 2 (T2) class. Tier 1 instruments constitute the ‘going-­concern capital’ of the financial institution, while Tier 2 instruments form the ‘goneconcern capital’. This means that Tier 1 instruments may absorb losses of the institution on an ongoing basis, while Tier 2 instruments absorb losses when a financial institution reaches its ‘point of non-viability’ (see Sect. 2.6 of Chap. 2), becomes insolvent or faces liquidation. The core of this system is an instrument known as the Common Equity Tier 1 (CET1). A CET1 must be composed of the highest quality of capital and possess maximum loss-­absorption capacity. CET1 instruments are mainly common shares and retained earnings, while CoCos may be assigned to either the category of Additional Tier 1 (AT1) or that of Tier 2, according to the eligibility criteria described in this section. Alongside with Basel III, CRR introduces the minimum requirement for CET1 capital 4.5% of RWAs and for Tier 1 capital 6% of RWAs and total capital ratio (TCR) of 8% RWAs. So banks can allocate of 1.5% their RWAs to AT1 in the computation of Tier 1 capital ratio minimum. The requirements have not been made more stringent in terms of the 8% minimum ratio. However, the reference value to which the minimum ratio refers (RWAs) increased in comparison to Basel I which requires more own funds to back 8%.  See Sect. 1.3.3.3.

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Additionally, banks must meet a so-called combined buffer requirement (CBR), which is the sum of various capital buffers that are set on top of the base capital requirements. CBR was phased in from 1 January 2016 and is fully effective from 1 January 2019 (CRR Article 162[2]).10 It includes: • a capital conservation buffer—set at 2.5% of RWAs, applicable to every bank • a countercyclical capital buffer—from 0% to 2.5% of RWAs. The countercyclical capital buffer is designed to be implemented during times of high economic growth • a G-SII (global systemically important institution) buffer—also called a G-SIB (global systemically important bank) buffer—which is set by the Financial Stability Board (FSB) at between 1% and 3.5%; there are currently 30 G-SII banks globally, of which 14 are headquartered in Europe, with buffer requirements of between 1% and 2.5% of RWAs • an O-SII (other systemically important institution) buffer—this may be set by national regulators for domestically important banks (also called D-SIB, domestic systemically important bank, or DSIFI, domestic systemically important financial institutions) up to a maximum of 2% of RWAs • a systemic risk buffer—up to 3% of RWAs, although it may be 5% or higher subject to approval by the European Banking Authority (EBA). It would take effect only to the extent it was in excess of the G-SII or O-SII. According to CRD IV Article 141, a bank may meet the combined buffer requirement only with CET1 capital that is not used to meet the 8% own funds requirement. In other words, if it uses CET1 capital to meet any of the 3.5% gap between the CET1 minimum requirement of 4.5% and the total capital requirement of 8%, that capital is not eligible to meet the CBR. The most efficient capital structure is therefore for banks to issue AT1 capital to cover the 1.5% point difference between CET1 and overall Tier 1 requirements, and Tier 2 capital to cover the 2% point difference between Tier 1 and total capital requirements. This avoids having to use CET1 capital for those purposes, which would then not be available to meet the bank’s CBR—a clear incentive to banks to issue both AT1 and T2 bonds, especially as existing, grandfathered Tier 1 instruments have been phased out.11 It is worth pointing out that that the ‘maximum’ or ‘available’ amounts of AT1 and Tier 2 (cumulatively 3.5%) are only  However some countries, for instance Norway and Sweden, applied the buffer requirements in full with immediate effect, Italy has implemented the capital conservation buffer with immediate effect. 11  See Sect. 1.3.3.4. 10

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capped for this specific purpose of calculating how the CBR is met. They are not capped in terms of reported Basel III ratios. The EBA made it clear in its answer to Question 2013_19 of the Single Rulebook Q&A on its website that AT1 issuance is not restricted to 1.5% of RWAs. A bank might, for example, want to issue AT1 securities in excess of 1.5% of RWAs in order to improve its leverage ratio, where the numerator is overall Tier 1, rather than CET1, capital. This would probably apply most to the big trading banks, as they tend to have low leverage ratios (Raymond & Adamson, 2013). Going beyond minimum TCR, national regulators have the discretion to apply additional own funds requirements under a supervisory review and evaluation process (SREP). Pillar 2 requirements (P2R) are additional own funds supposed to cover risks neither addressed by the Pillar 1 capital requirements (i.e. 4.5% RWAs of CET1, 6% of Tier 1, 8% total capital requirement) nor combined buffer requirements, such as interest rate risk in the banking book. The supervisors should determine the quantity and composition of P2R in accordance to CRD IV Article 104(1)(a). The breach of P2R is a potential condition for authorization and may be considered as a resolution trigger.12 The ‘Pillar 2 capital guidance’ (P2G) was introduced in the European Commission’s (EC) CRR/CRD IV Review published on 23 November 2016 as CRD IV Article 104(b) proposal, which is an addition to the existing Article 104 on P2R (formerly Pillar 2). P2G is primarily aimed at addressing concerns over banks’ capital planning revealed by supervisory stress tests. If the outcomes of supervisory stress testing result in inadequacy of the institution’s own funds (in terms of quantity and composition), then ‘competent supervisors should take appropriate supervisory measures to ensure that the institution is adequately capitalised. These include communicating expectations to institutions to have own funds over and over and above the overall capital requirements’ (EBA, Final report— guidelines on the revised SREP and supervisory stress testing, EBA/GL/2018/03). In such instances, the supervisor can require each bank individually to establish own funds at a level above CBR that will act as an early warning metric.13 Unlike P2R, P2G is non-legally binding. A breach of P2G level does not cause automatic supervisory action, but would result in enhanced supervisory dialogue and engagement with institutions in order to provide credible capital plan. The minimum own funds (Pillar 1) and additional own funds requirements (P2R) sum up to so-called total SREP capital requirement (TSCR). Altogether taken, TSCR plus combined buffer requirements plus P2G form the so-called overall capital requirement (OCR).  See Sect. 2.6 of Chap. 2.  In UK Pillar 2 buffer is split into a hard requirement Pillar 2A, which is factored into the MDA calculation (like P2R), and a Guidance amount Pillar 2B, which is not part of the MDA calculation (like P2G). 12 13

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1.2.8 Common Equity Tier 1 Financial Instruments As previously mentioned, this top tier of a bank’s own funds is composed of the highest quality capital items: capital instruments, share premium accounts related to such capital instruments, retained earnings, reserve capital, other accumulated comprehensive income, additional reserves and funds for general banking risk (CRR Article 26[1]). To determine if a given financial instrument is eligible for CET1 purposes, its compliance with requirements laid down in CRR Article 28 and 29 must be analysed. These requirements are comprehensive, and may be described as stipulating a core equity character of the instrument in every dimension: perpetual maturity, non-cumulative deferral, maximum subordination and loss absorption. Any CET1 instrument will have to be qualified as capital both in the meaning of EU law, the applicable accounting framework and the national insolvency law (CRR Article 28[1][c]), which generally excludes any hybrid bonds from this category. However, preference shares must be analysed before they can be deemed eligible to be classified as CET1 instruments. Although preference shares do qualify as capital equity instruments, they do not meet the criteria of the maximum subordination. Pursuant to CRR Article 28(1)(i) and (j), CET1 instruments must absorb losses to the same degree and rank below all other claims in the event of insolvency or liquidation of the issuer. Therefore, CET1 instruments must create a homogeneous category of items in terms of subordination. This requirement excludes preference shares from the CET1 category provided they are privileged in terms of their seniority over common shares. However, the preference shares granting favoured voting rights to their holders are on the list of all the EU-wide instruments issued that qualify as CET1, as published in 2018 by the European Banking Authority (please refer for instance to the Updated CET1 list-Q3 2018 available on EBA homepage). This list lacks non-voting preference shares that do not stand on equal footing with ordinary shares in terms of dividend.

1.3 E  uropean Union’s CRR Additional Tier 1 CoCos 1.3.1 General Remarks Similar to CET1 capital, items categorized as Additional Tier 1 instruments also serve the purpose of loss absorption on a going-concern basis. These items are capital instruments that meet conditions set out in CRR Article 52 and

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share premium accounts related to such instruments, as provided for in CRR Article 51. It is important to note that the goal of categorizing items in a tier-­ based system is the separation of those items: instruments qualified as AT1 items do not qualify to be designated as CET1 or Tier 2 instruments. The most obvious requirements that all AT1 instruments must meet are as follows: 1 . The instrument has to be issued and paid up (CRR Article 52[1][a]). 2. The instruments are not purchased by (a) the issuer or its subsidiaries, or (b) by an undertaking in which the issuer has participation in the form of a direct or controlling ownership of at least 20% of the voting rights or capital of that undertaking (CRR Article 52[1][b]). 3. The issuer does not directly or indirectly finance the purchase of the instruments (CRR Article 52[1][c]). It is also very important to note that CRR Article 52(1)(p) explicitly states that AT1 instruments may be directly issued not only by the financial institution, but also by the so-called special purpose vehicle (SPV) which is concerned with the indirect issuance of own-funds instruments. Such an entity would have to be consolidated under CRR provisions, and proceeds from the issue would have to be immediately made available to the institution. Regulation 241/201414 Article 24 prohibits more-favourable treatment of holders of instruments than holders of instruments issued directly by the bank.

1.3.2 Deep Subordination In the event of the insolvency of the issuer, AT1 instruments rank below Tier 2 instruments (CRR Article 52[1][d]), may not be secured, and may not be subject to a guarantee or any arrangement that would enhance their seniority (CRR Article 52[1][e]). In addition, AT1 instruments may not be subject to any arrangement that enhances the seniority of the claim under the instruments in insolvency or liquidation (CRR Article 52[1][f ]). This means that in the event of insolvency, holders of AT1 instruments will have their claims satisfied senior to shareholders. However, the nature of CoCos may in some cases slightly complicate this capital hierarchy of loss absorption. For example, holders of principal write-down CoCos will suffer losses ahead of equity  Commission Delegated Regulation (EU) No 241/2014 of 7 January 2014 supplementing Regulation (EU) No 575/2013 of the European Parliament and of the Council with regard to regulatory technical standards for Own Funds requirements for institutions. 14

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holders when a ‘high-trigger’15 CoCo is activated. This type of scenario is less likely with a low-trigger CoCo when equity holders already have suffered loss (this phenomenon is widely explained in Sects. 2.6 and 2.7 of Chap. 2). It has to be determined whether the AT1 category may be composed of two classes of financial hybrids: bond-based and share-based. The first class would be bonds equipped with very strong equity-like features, while the second class would be preferred shares. An important point to note is that preferred shares would not rank below the bonds that meet AT1 eligibility criteria, but will rank pari passu instead. Any differentiation between AT1 instruments in term of subordination was not intended by the legislator, as financial items of the same class should be coherent and rank pari passu. Therefore, it is rather unlikely that the same financial institution will issue both non-cumulative perpetual preferred shares and hybrid bonds to fulfil the AT1 capital requirements. An institution issuing both, low-trigger and high-trigger CoCos as Spanish Banco Popular once did (See Table 1.2) does not run counter to rule of equal subordination. In distress condition, high triggers will suffer losses ahead of low triggers (see Sect. 1.3.3.2). European financial institutions issue CoCos, while US financial institutions rely mostly on AT1 preferred shares (see Sect. 5.3.2.5 of Chap. 5 for more on US AT1s). The reason behind this relates to the tax treatment of CoCos and preferred shares. In Europe, interest on CoCos is generally tax deductible. When tax uncertainties concerning CoCos were resolved in 2013, the CoCo market bloomed. That capacity, making CoCos the ‘cheapest equity’, is founded on their bond form, and would not exist if preference shares were engaged. As a result, even Asian financial institutions have started to switch from preference shares to CoCos (See Sect. 4.2.2 of Chap. 4). However, the favourable tax treatment of CoCo is increasingly being abolished. In 2017, Swedish parliament removed the tax deductibility of coupons on Additional Tier 1 securities and subordinated debt. On 29 June 2018, the Dutch government proposed that CoCos were not to be tax deductible as from 1 January 2019. The Dutch government’s announcement came in response to a letter from the European Commission (EC) dated 22 June 2018. The EC argued the tax deductibility of interest payments on Tier 1 instruments was in contravention of EU state aid prohibitions. As EC intends to address these concerns in other member countries, there could be a trend towards general retreat from favourable CoCo tax treatment. 15

 See Sect. 1.3.5.

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1.3.3 Perpetuity 1.3.3.1  R  equirements on Maturity and Avoidance of ‘Synthetic Maturity’ AT1 hybrid bonds have to be perpetual (CRR Article 52[1][g]). The absence of a fixed maturity date makes perpetual bonds similar to common stock that is designed to ‘live’ as long as its issuer, and any stock redemptions are subject to restrictive conditions. Common equity has no scheduled maturity, and thus it poses no refinancing risk to the issuer in a time of financial stress. The provisions governing AT1 instruments may not include any incentive for the issuer to redeem them (CRR Article 52[1][g]). To specify the scope of this condition, the European Banking Authority (EBA) issued Regulatory Technical Standards (RTS) adopted by the EC as a Delegated Regulation 241/2014. First, all the features that provide an expectation at the date of the instrument’s issuance that the capital instrument is likely to be redeemed (Regulation 241/2014 Article 20[1]) have been specified as unacceptable incentives to redeem AT1 instruments. Furthermore, certain provisions have been identified as constituting an unacceptable expectation to redeem the AT1 instrument. These prohibited provisions, set out in Article 20(2), mainly constitute a call option combined with the negative consequence that the issuer cannot exercise the option. Coupon step-up is the most obvious example. Others include a requirement or an investor option to convert the instrument into a CET1 instrument; a change in a reference rate whereby the credit spread over the second reference rate is greater than the initial payment rate minus the swap rate and the future increase of the redemption amount. The last provision is also prohibited, as it constitutes an incentive to redeem when it refers to the remarketing option. Besides, any marketing of the instrument in a way that suggests to investors that the instrument will be called is prohibited because such a suggestion would constitute an incentive. Current market experience shows how issuers have managed to introduce some possibility to change the coupon rate in a way that is not considered to be a prohibited incentive to redeem the AT1 instrument. In 2014, Banco Santander, Deutsche Bank and Unicredit were among the financial institutions that successfully issued AT1 bonds. Accordingly, these instruments were described as ‘no-step-up’, ‘fixed to reset’ and ‘fixed rate resettable’; so, they embedded the same coupon rate reset mechanism after the first call date. The coupon rate is fixed during the first non-call

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period, which lasts at least five years. Then, if the bond is not redeemed, it is subject to reset and calculated as a five-year mid-swap rate correlated to the currency of the issue and the initial credit spread. For example, Deutsche Bank’s EUR AT1 instrument 2 has a fixed rate of 6%, which is the sum of the five-year swap rate that at the date of pricing was 1.302% plus the initial credit spread of 4.698%. If Deutsche Bank skips call at the first call date, the coupon rate will be reset at the value of the determined swap rate plus the credit spread. This reset will determine the coupon rate for the next five years, up to the next call date. Such a coupon rate reset mechanism does not constitute a fixed-to-floating change of coupon, and is not a step-up either. It is almost certain that the coupon’s value will differ from the fixed rate of 6% after the reset, but at the issue date, investors will not be able to determine whether the rate will rise because the swap rate increases, or fall because it decreases (this issue will be more discussed upon in Sect. 1.3.3.5). Thus, a coupon step-up may or may not happen. The coupon reset mechanism being described does not necessarily constitute an incentive to redeem the bond at the first call date, which does not constitute a synthetic maturity of the perpetual instrument. Therefore, such a construction is not prohibited.

1.3.3.2  Exercise of Call Option Any call option may be exercised only at the sole discretion of the issuer, and not at the discretion of the investor (CRR Article 52[1][h]). Hence, hybrid securities qualified as AT1 capital instruments may be structured as a callable perpetual bond with a possible call at year five. This format of hybrid callable is commonly referred to as a PerpNC5 security. Any such call, redemption or repurchase of instruments may not be exercised before five years after the date of the bond issuance (CRR Article 52[1][i]). The very exercise of a call option by the issuer is also subject to detailed conditions set out by the CRR. The CET1, AT1 and Tier 2 instruments may be called, redeemed or repurchased only if the issuer has been granted regulatory permission (CRR Article 77). The conditions that must be met to receive such a permission are set out explicitly: (1) redeemed AT1 instruments are subsequently replaced with own-funds instruments of equal or higher quality at terms that are sustainable for the income capacity of the institution or (2) the issuer demonstrates to the satisfaction of the competent authority that such redemption would not violate the CRD IV requirements (CRR Article 78[1]). The sustainability requirement set forth in CRR Article 78(1)(a) in fine has been specified in the RTS. Pursuant

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to Regulation 241/2014 Article 27, sustainability is preserved if an assessment conducted by the competent authority concludes that the profitability of the institution remains sound, and there is no evidence of any negative change in that profitability after the requested replacement is performed. Moreover, such a ‘no-worse off’ perspective should take into account possible consequences at the date of the assessment and for the foreseeable future. Finally, the assessment examines the likelihood of the institution remaining profitable if conditions of stress arise. The application procedure for redemption of CET1, AT1 and T2 instruments is also subject to formal requirements set out in RTS. First of all, no announcement about redemption may be made before the institution obtains the approval of a competent authority (Regulation 241/2014 Article 28[1]). The application must be accompanied with information on (1) well-founded explanations of the rationale of the action applied for, (2) capital requirements and buffers in at least a three-year period, along with composition of own funds before and after the performance of the action applied for, as well as information on the action’s impact on regulatory capital requirements, (3) the action’s impact on the institution’s profitability, (4) information on the risks to which the institution is or may be exposed, and whether the institution’s own funds ensure coverage of such risks, taking into account stress tests and different scenarios, and (5) any other information considered necessary by the competent authority (Regulation 241/2014 Article 30[1]). A specific application time-frame is provided for in Regulation 241/2014 Article 31. The application may include a plan to carry out redemption or repurchase over a limited period of time for several capital instruments (Regulation 241/2014 Article 29[2]). In case of a repurchase for market-making purposes or employee remuneration programme purposes, approval may be granted for a certain predetermined amount. The limitations of these amounts are set out in Regulation 241/2014 Article 29(3)(a) and (b).

1.3.3.3  Regulatory and Tax Event Calls An exception to the mandatory non-call period of five years or more after the date of issuance is provided by CRR Article 52[1][i]. The issuer may call, redeem or repurchase an AT1 financial instrument before that date only if he or she is permitted to do so by the competent authority. In this scenario, the conditions attached to the granting of such permission are even tighter than those regarding a conventional call option exercise. The issuer must not only meet conditions specified in CRR Article 78(1) but also those set out in

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Article 78(4)(a) or (b). These conditions are defined as a regulatory reclassification of instruments that would probably exclude them from own funds, or classify them as a lower quality form of own funds, provided that the competent authority considers such a reclassification to be sufficiently certain. The conditions also stipulate that the issuer could not have reasonably foreseen such a regulatory reclassification at the time of the instrument’s issuance. Nor could the issuer predict material and unforeseeable changes in the applicable tax treatment of the instruments. These conditions are commonly referred to as a Regulatory Event or a Tax Event. The Lloyds’ ECNs serve the most prominent case of regulatory call. The terms of the ECNs allowed Lloyds Banking Group to call them in the event that they ceased to be taken into account for the purposes of any PRA (UK Prudential Regulation Authority) stress test. Following the December 2014 PRA stress test, Lloyds announced that a Capital Disqualification Event had occurred; the 5% Basel II Core Tier 1 equity conversion trigger translated into a Basel III CET1 trigger of only around 1%. As mentioned in Sect. 1.2.6, ECNs were an early form of Tier 2 CoCo16—Lloyds issued 33 series, mostly in GBP, totalling around £8.3 bn in 2009. Many were held by retail investors. In March and April 2014, Lloyds exchanged into AT1 securities, or made cash buybacks (for retail-held bonds), ECNs totalling £5 bn, leaving £3.3 bn outstanding. The regulatory risk affected any ECNs left outstanding because new securities would have generally lower, and fully discretionary, coupons (ranging from 6.375% to 7.875%, compared with an average 9.3% on the ECNs), deeper subordination and higher risk. Early 2015 Lloyds received permission from the PRA to redeem some of its outstanding Tier 2 ECNs using a regulatory par call. The regulatory call affected 23 series totalling around £715 mn, mostly at par.17 As many of the ECNs were high coupon instruments held by retail investors, and their ­market price had been typically well above par (ranging from 105 to 108), the matter was brought before a court on the grounds that the terms of the bonds did not allow Lloyds to make the call. In June 2016, the Supreme Court finally judged that a Capital Disqualification Event had occurred, which gave Lloyds the green light to exercise regulatory calls on outstanding ECNs. It is estimated, that redemption of all outstanding ECNs saved Lloyds around £330 mn in annual interest expense (Adamson, 2015). Singapore’s DBS acted similarly aggressively towards holders of its SGD 895  mn of the outstanding 4.70% Non-Cumulative Non-Convertible 16 17

 For more on Tier 2 CoCos see Sect. 1.4.  Three of the issues though had a regulatory call at a make-whole price.

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­ on-­Voting Class N Preference Shares (Perpetual Callable 2020) making N early redemption of the securities in full. They constituted Tier 1 capital under Basel II but were being phased out as capital under the new Basel III regulations. This was the same issue which DBS had offered to make an exchange for an equivalent amount of Basel III compliant securities, with the same coupon of 4.70% in November 2013, with an original issue amount of SGD 1.7 bn (Phan & Marshall, 2014). Although the remaining SGD 895 mn continued to qualify as capital until 1 January 2016, DBS decided not to leave them outstanding, and in February 2014 announced redemption of all notes, at a price equal to 101.93% of par, with the additional 1.93% being the accrued but unpaid dividend on the preference shares for the period 22 October 2013 to 21 March 2014 (Phan & Marshall, 2014). This was of course below what they had been traded at before the partial exchange offer. Unlike Lloyds and Asian Banks, the remainder of European banks chose not to antagonize investors with regulatory par calls preferring rather a buyback offer at close to market price. After all, this easing is only little more than an ultimatum, as any holder not accepting the offer will be subject to a regulatory call at par. That solution was chosen by Danske Bank and Société Générale in late-2013 when rating events allowed them to call bonds at par, which is examined more closely in the next section. On February 2014 Credit Suisse announced a tender offer for its 7.875% $1.5 bn Claudius Tier 1 securities (XS0531067659) at 103% of par (structured as 100% plus an early tender premium of 3%) while they had been traded at 106 and fell slightly on the announcement to 104 (Adamson, 2014). The above mentioned regulatory calls of pre-Basel III instruments give an idea how banks can act if they were given an option to redeem their AT1s prematurely subject to regulatory changes. With regard to the new-style (AT1) CoCos alone, the early-calls-at-par risk for bondholders is not so remote. With the changes in CoCo tax treatment introduced in Sweden in 2017 and the Dutch government’s proposal to do so in Netherlands as from 2019, there is rising concern if the removal of tax deductibility would not trigger a ‘Tax Event’ for the Swedish banks AT1s (or ‘Tax Deductibility Event’ for Dutch ones). To make use of this option, banks would have to show that the tax change is material and that it was not foreseeable at the time of issuance. Additionally, if removal of tax deductibility of the interest around Dutch CoCos is to ensure consistency with EU law around state aid, then this would not trigger a ‘Tax Deductibility Event’ for the AT1s (Martin, Tam, Knepper, & Picagne, 2018). It must be remembered that under CRR rules, redeeming these bonds would be subject to the consent of the regulator. As a matter of fact, tax deductibility in itself is not the main reason for banks to issue AT1

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and Tier 2 instruments. They play an important regulatory role in meeting banks’ capital and leverage ratio requirements. Besides, there is no tax-­ deductible alternative to these securities. Even if the banks were allowed to redeem the securities at par prior to the first call, they may still be reluctant to exercise a Tax Event call. With regard to solely AT1 CoCos, EBA, in its Report on the monitoring of AT1 instruments of 20 July 2018, firmly stated that ‘Only regulatory calls for the full amount of instruments are acceptable, regardless of whether regulatory changes trigger a full or partial derecognition from AT1 capital. Partial derecognition from AT1 capital owing to write-down or conversion should not be considered an eligible trigger for a regulatory call’. In addition, EBA stated that ‘there is no specific concern from a purely prudential perspective in allowing calls below and at par, or at par only’.

1.3.3.4  R  egulatory Event and Rating Methodology Event Call on Legacy Tier 1 Bonds The Basel II Tier 1s presented in Sect. 1.2.4 lack three major characteristics to be fully adapted into Basel III capital: (1) lack of CET1 conversion into equity/write-down trigger; (2) lack of discretionary coupon deferral; and (3) they have ‘incentives to redeem’ predominantly in the form of a coupon step­up. The CRR Article 489 and 490 though allow for limited inclusion of Basel II step-up callable Tier 1s and Tier 2s in AT1 and Tier 2 Items, provided the following conditions are met: 1. If the first call date was on or before 31 December 2011 and the bond was not redeemed, it was grandfathered as Tier 1 or Tier 2 capital, subject to the ten-year grandfathering amortization schedule (CRR Article 489 [3]– [5]). As the amortization applies to the starting base of Tier 1 capital rather than to individual securities, the ground for regulatory call seems to be debatable. 2. If the first call date was after 31 December 2011 and on or before 31 December 2013 and the bond was not redeemed, it was derecognized as regulatory capital from 1 January 2014 (the implementation date of CRD IV); 3. If the first call date was after 31 December 2013, the bond is derecognized as regulatory capital at the first call date if not redeemed. To sum up, non-called step-up Tier 1 bonds are derecognized from regulatory capital; they do not count as Tier 2 capital either. There are also Tier 1s

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with long-dated calls, that is, if the first call is after the grandfathering period.18 In such a case, banks might be able to use a regulatory call at par once legacy Tier 1s no longer qualify as Additional Tier 1 capital (i.e. from 2022). Another group of Basel II Tier 1s form those without incentives to redeem (non-step). They are grandfathered as Additional Tier 1 capital until end-­ 2021 subject to grandfathering cap set out in CRR Article 486(3)–(5). The cap is based on end-2012 AT1 capital and decreases by 10% each year. So in 2018, grandfathered securities may be included in AT1 capital up to an amount equivalent to 40% of end-2012 AT1 capital. As the cap is set on a portfolio basis only, with any surplus above the cap derecognized as regulatory capital, triggering of ‘Regulatory Event’ seems to be arguable, because regulatory derecognition can be hardly referred to individual bonds. A separate question arises around Tier 2 treatment of both step-up and non-step (e.g. preference shares) legacy Tier 1s after the end of the grandfathering period (2021). They would need to have at least five years to the next call date; so as a great majority of them have quarterly, semi-annual and annual calls, they don’t meet Tier 2 eligibility criteria set out in CRR Article 63 (see Sect. 1.4.1 on CRR Tier 2 instruments). In view of the above, the main rationale to leave legacy Tier 1s outstanding would be: (1) the reset spread and coupon after the call date are lower than the cost of refinancing with a senior or subordinated bond; (2) because they are useful as part of the buffer of subordinated debt that counts for TLAC/ MREL19 (Raymond et al., 2018) or (3) the regulatory treatment of instruments in excess of the grandfathering cap and, from 2022, after the grandfathering period. Apart from triggering a Regulatory Event or a Tax Event, the terms of the securities usually allow the issuing bank (after consultation with the regulator) to insert an early call at par following a change in rating agency’s recognition (‘Rating Methodology Event’). In September 2013, Danske Bank announced a cash tender offer for its 7.125% $1  bn Lower Tier 2 bond (ISIN: XS0831342679). The good news for bondholders was that Danske Bank was tendering at 101.5% of par, to stay in line with where the bond had been quoted by far. The key consideration for Danske Bank was revised bank hybrid methodology published by Standard & Poor’s (S&P) on 16 June 2013 which resulted in the reclassification of the ‘equity content’ assigned to these Danske Bank bonds from ‘intermediate’ to ‘minimal’, implying they  For example HSBC, the HSBC 10.176% perp-30 $900 mn legacy Tier 1 step-up bond. Therefore, a tender or regulatory call after end-2021, and well before 2030, is highly possible. 19  Total Loss Absorbing Capacity/Minimum Requirement for own funds and Eligible Liabilities. For more on these see Sect. 2.9 of Chap. 2. 18

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will no longer be included in S&P’s proprietary RAC (risk-adjusted capital) measure (Adamson, 2013). Following Danske Bank, on October 2013 Société Générale was tendering for any and all of its $1.5 bn 6.625% Tier 2 issue (ISINXS0813929782), at 102% of par.

1.3.3.5  Call Extension Risk Unlike with many legacy Tier 1 securities, there is no incentive for the AT1 issuer to call these securities and regulators do not expect them to be called if there is not an economic justification. As already mentioned Additional Tier 1 securities have to be perpetual, but they can include a call option after at least five years. The dominant non-call periods are 5–7 years, there are few NC10 issues (almost exclusively USD denominated),20 three NC12 issues on the market (Crédit Agricole, Deutsche Bank and HSBC) and one  EUR-­denominated Lloyds Banking Group NC15 7.875% perp-29 (XS1043552261). The Table 1.1 further in this chapter presents some AT1s with different non-­call years at issue. No wonder, that with a fifth anniversary of CoCo market the question of a call or non-call is the most on the agenda. About 37% of the AT1s have a first call date coming up in the years 2018–2020: majority of them in years 2019–2020. Almost all AT1s reset to a coupon based on five-year mid-swaps plus the initial spread (typically 400–600 bp), so they have a relatively high back-end coupon. The question is whether this will be higher or lower that the implied cost of issuing a new AT1. A look at the Table 1.1 presenting majority of AT1s coming up for their first call next two years, shows one thing they have in common: their current yields-to-call (at 10 July 2018) were trading ­comfortably inside the implied coupons if the bond were not called. This suggested that the market expected all of these bonds to be called. There are two outliers though: Deutsche Bank (DB) 6.250% perp.30Apr20, USD (XS1071551474) and Bremer Landesbank (NDB) 8.50% perp.29Jun20, EUR (DE000BRL00A4). The DB AT1s implied coupon bases on current swap rate plus reset rate of 435.8 bp which gave 7.26% at 10 July 2018. This was well below its yield-tocall at that time of 12.04% (see Table 1.1) implying that Deutsche Bank had an incentive to let extend its AT1s. The reason for double-­digit yield to calls (YTCs) of both, DB’s and NDB’s perpetuals, were their low quotations being well below par (see Table 1.1). The reasons behind that are of structural origin:  For example BNP Paripas NC10 7,375%perp-25, USD (US05565AAN37). One of the rare EUR-­ denominated is Intesa Sanpaolo NC10 7.750% perp-27 (XS1548475968). 20

BE0002463389 XS1066553329 XS1043181269 XS1043550307 XS1068561098 XS1068574828 US06738EAB11 US225313AE58 US65557CAM55 XS1079786239 US404280AR04 US83367TBH14 XS1190663952 CH0271428317 XS1143478847 CH0275764600 XS1044578273 US456837AE31 XS1071551474 XS1150025549 DE000BRL00A4 XS1195632911 XS1328798779 XS1002801758

KBCBB SANTAN NWIDE LLOYDS BACR BACR BACR ACAFP NDASS COVBS HSBC SOCGEN BBVASM UBS SAXOBK KBBS DANBNK INTNED DB ALDMRE NDB NYKRE AIB BACR

5.625% 6.375% 6.875% 7.000% 7.000% 6.500% 6.625% 6.625% 5.500% 6.375% 5.625% 6.000% 6.750% 7.125% 9.750% 3.000% 5.750%** 6.000% 6.250% 11.875% 8.500% 6.250% 7.375% 8.000%

Coupon 102.19 100.28 102.51 102.28 102.69 103.38 100.40 100.64 99.88 102.74 99.90 97.59 105.20 103.23 106.25 102.60 104.89 100.07 91.05 105.46 93.91 108.43 110.43 111.01

2.41% 6.04% 4.12% 4.56% 4.63% 3.55% 6.27% 6.07% 5.60% 4.19% 5.69% 7.69% 3.40% 4.95% 5.66% 1.46% 2.84% 5.95% 12.04% 8.43% 12.16% 2.44% 2.84% 3.26%

Current price Yield to call

Source: CreditSights *5Y Middle swap rate at 10 July 2018 + Reset spread **3-month CIBOR

ISIN

Ticker EUR USD GBP GBP GBP EUR USD USD USD GBP USD USD EUR USD EUR CHF EUR USD USD GBP EUR EUR EUR EUR

Crncy 19-Mar-­19 19-May-­19 20-Jun-19 27-Jun-19 15-Sep-19 15-Sep-19 15-Sep-19 23-Sep-19 23-Sep-19 1-Nov-19 17-Jan-20 27-Jan-20 18-Feb-20 19-Feb-20 26-Feb-20 1-Apr-20 6-Apr-20 16-Apr-20 30-Apr-20 30-Apr-20 29-Jun-20 26-Oct-20 3-Dec-20 15-Dec-20

First call 475.9 478.8 488.0 506.0 508.4 587.5 502.2 469.7 356.3 411.3 362.6 406.7 660.4 546.4 930.0 300.0 464.0 444.5 435.8 998.0 796.8 598.9 733.9 675.0

5.03% 7.69% 6.22% 6.40% 6.42% 6.15% 7.93% 7.60% 6.47% 5.45% 6.53% 6.97% 6.88% 8.37% 9.57% 2.88% 5.05% 7.35% 7.26% 11.32% 7.71% 6.26% 7.61% 7.02%

Reset Implied spread bp coupon*

Table 1.1  Selected AT1 perpetuals with a first call date in 2019–2020. Price quotations and implied coupon on 10 Jul 2018

Quarterly Anytime Anytime 5 years 5 years 5 years 5 years 5 years Semi-annual 5 years 5 years 5 years Anytime Annual Semi-annual Annual Semi-annual 5 years 5 years Annual Annual Semi-annual Semi-annual 5 years

Subsequent calls

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DB has for long been a bank with chronically low distributable items (see Sect. 1.3.4.5) and a business model that needs revision. Moreover, it is remembered that DB once did not call back its Basel II Tier 2 Bonds (DE0003933511) on the first call. On 16 December 2008, 30 days prior to the first call, DB announced it would not exercise the call, which was against market expectations (De Spiegeleer, Schoutens, & van Hulle, 2014). In the peak of the 2018–2019 crisis, it was a rational decision to let the bond extend: if the bank had called back the issue and refinanced it with a new one (€1 bn), it would have paid much more than the extra cost of facing step-up in the coupon (De Spiegeleer et al., 2014). Bremer Landesbank in turn, has been the first issuer to cut coupon payments on its AT1s discussed above (see Sect. 1.3.4.4 for more on the first, and so far the only AT1 coupon cancellation). However, one cannot determine that issuer’s decision of calling versus not calling bonds comes down purely to the above presented calculation. There are lot more drivers for final decision of extending/non-extending. One of the important drivers might be subsequent call frequency, which is another possible factor in the call decision process, as most AT1s have a five-year call frequency but there are a few with as short as one year or even ‘anytime’ calls (see Table 1.1). So, if the market is volatile and issuers are unable to refinance at sensible levels at the first call date, then in theory, the shorter the call frequency, the more likely it is that issuers will look to refinance at the next call date in the hope that the market would have stabilized by then. On the other hand, if the banks expect rates to go up or a credit rating downgrade, they would prefer not to exercise their call. Looking on the other side of the market, investors would probably prefer longer call frequencies to provide more certainty rather than an annual call which could increase price volatility (Knepper, 2018). Another incentive for issuers willing to refinance low-trigger instruments with high-trigger ones, might be that the former are more and more put into question, which will be discussed separately in detail in Sect. 2.7 of Chap. 2. Judging from the YTC levels presented in Table 1.1, the possible incentive for issuers to call low-trigger instruments is not visibly priced into spreads. The UK banks-specific driver for call extension of its outstanding AT1s would be foreign exchange (FX) cost from redeeming the securities that could outweigh the coupon savings from the coupon reset. As the sterling has depreciated substantially against the dollar since the Brexit vote, banks could face FX losses if they call them. Country-limited though it may seem, it is worth noting, that UK banks’ issues constituted in mid-2018 about one-third of the then €141 bn worth AT1s market. By the end of Q3 2018, the first AT1 CoCos call was that of BBVA (Banco Bilbao Vizcaya Argentaria) calling its $1.5 bn 9%perp.19May18. Table 1.2

9.500% 11.500% 8.250% 9.000% 3.500% 5.375% 3.500%

Bremer Landesbank Banco Popular Banco Popular BBVA Glarner Kantonalbank Julius Baer Group Zürcher Kantonalbank

Source: CreditSights *5Y MS—Middle Swap Rate

Coupon

Bank Repurchased Converted in resolution Converted in resolution Called at first call date Called at first call date Called at first call date Called at first call date

Redemption basis

Table 1.2  AT1 and Tier 2 CoCos redemptions by 31 Aug 2018 EUR EUR EUR USD CHF CHF CHF

Crncy 100 500 750 1500 70 250 590

Amnt mn 17-Dec-15 1-Oct-13 5-Feb-15 9-May-13 27-Nov-12 11-Sep-12 19-Jan-12

Issue date

29-Jun-21 10-Oct-18 10-Apr-20 9-May-18 19-Mar-18 19-Mar-18 30-Jun-17

First call

5Y MS* + 913.5 5Y MS + 1074.3 5Y MS + 817.9 5Y MS + 826.2 5Y MS + 317.0 5Y MS + 498.0 5Y MS + 298.0

Coupon reset bp

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presents all the AT1 and Tier 2 CoCos redeemed for any reason. It includes perpetuals issued by Switzerland’s banks that obviously don’t fall under EU’s CRR regime (see Sect. 4.2.1 of Chap. 4 for more on CoCos issued by Swiss banks). 7 June 2017 saw the first real test of the Additional Tier 1 market with the resolution of Banco Popular under the EU Bank Recovery and Resolution Directive (BRRD), and its subsequent sale to Banco Santander for one euro. Both of its Euro AT1s—the 11.5% perp-18 and the 8.25% perp-­20—were converted into equity and were subsequently cancelled, with zero recovery for investors. The resolution process of Banco Popular is described in detail in Sect. 2.7.4 of Chap. 2. The Bremer Landesbank CoCos were redeemed on the grounds that it was merged into Norddeutsche Landesbank (See Sect. 1.3.4.4). So far, Banco Santander became the first and only bank to leave its AT1s outstanding. On 12 February 2019 it announced that it would not call its 1.5 billion euro-denominated 6.25% perp.12Mar19.

1.3.4 Coupon Cancellation 1.3.4.1  General Remarks AT1 CoCos are equity-like instruments, so coupons must be paid out of distributable items in a similar way to share dividends. The AT1 CoCos coupons may be cut fully discretionally, irrespective of capital hierarchy, that is, share dividends may be paid ahead of AT1 coupons. Besides, there are regulatory and legal restrictions on banks’ ability to keep paying coupons. This is based on a mechanism defined in CRD IV Directive, which can set a sliding scale of caps on distributions if a bank does not meet its combined buffer requirement (CBR). Apart from this, AT1 coupons may be paid only if there are sufficient distributable items at the parent company. Putting all this together, there are four reasons why AT1 CoCo coupons may be cancelled: 1. Coupons are, like share dividends, fully discretionary, so a board could decide to cut them at any time. 2. The regulator has the possibility to restrict or prohibit payments of coupons on AT1 bonds if it has concerns inter alia about the bank’s capital strength (CRD IV Article 104[1][i]). 3. Under CRD IV rules, restrictions on distributions are imposed if a bank falls below its CBR, in which case a ‘maximum distributable amount’ (MDA) is imposed. 4. Coupons may, in common with share dividends, only be paid if there are sufficient distributable items (at the parent bank, as at the end of the previous financial year).

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Below, we examine the areas 1 and 3–4 in detail. The detailed conditions for regulatory order to cut coupons as a part of regulatory measures is looked into in Chap. 2.

1.3.4.2  Fully Discretionary Coupon Cancellation The issuer of an AT1 eligible instrument has full discretion to cancel a coupon payment for an unlimited period of time and on a non-cumulative basis. Such a cancellation will not constitute the issuer’s event of default, and no restriction will be imposed on an issuer who makes such a cancellation (CRR Article 52[1][l][iii] and [iv]). This means that the issuer may simply cancel the coupon payment, which significantly strengthens the equity-like character of the instrument. Neither investors nor shareholders have any claim against the issuer in that matter. What is more, banks will have the ability to continue to pay common dividends even if the coupon on AT1 instruments is cancelled (Liberadzki and Liberadzki, 2016). This observation can be drawn from the provisions of CRR Article 52(1)(l) (iii) and (v): CRR respectively prohibits both the dividend pusher and the dividend stopper21 from being embedded in the AT1 instrument structure. Hence, while Basel III banned dividend pushers only, European regulators went a step further. The EC in its proposal of 23 November 2016 to amend rules on capital requirement proposes new CRD IV Article 141(3) where priority is to be given to AT1 coupon payments in the case of Maximum Distributable Items trigger breach (see next section for explanation over MDA) over dividends and variable remuneration. The effect of the present regulation is that it may seem that AT1 investors are in a worse position than shareholders, who may always try to nullify the decision to transfer the earnings to the company’s reserve capital, instead of transferring it to the shareholders in the form of dividends. However, such an action is possible only in ‘continental’ legal systems, such as those of Germany or France, where decisions on dividend distribution are made during annual general meetings of shareholders (AGM). Most AT1 issuers have stated that they intend to rank the payment of AT1 coupons ahead of share dividends, although they acknowledge that they are unable to guarantee this. Furthermore, the level of distributions, known as the coupon rate, may not be amended on the basis of the credit standing of the issuer or its parent company (CRR Article 52[1][l][iv]). Finally, cancellation of dividend distribution  Dividend stoppers and pushers ensure that shareholders will not be able to receive dividends unless the coupon is paid to bondholders. For more on dividend stoppers/pushers and look-back provisions see Sect. 5.1.3 of Chap. 5. 21

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29

imposes no restriction on the institution (CRR Article 52[1][l][v]). The last requirement significantly limits the contractual freedom of counterparties— debt issuers and creditors—to shape their contractual relation.

1.3.4.3  Maximum Distributable Amount In discussing coupon cancellation, one must take into account that a financial institution that meets the combined buffer requirement (defined in CRD IV Article 128[6]) is prohibited from making a distribution on CET1 instruments that would result in breach of combined buffer requirement (CRD IV Article 141[1]). If an institution fails to meet that requirement, then payments on AT1 instruments are also prohibited (CRD IV Article 141[2][c]) until the institution calculates the maximum distributable amount (MDA) and notifies the competent authority. As long as an institution fails to meet or exceed its CBR, it is prohibited from discretionally distributing more than the MDA. This prohibition applies to share dividends, AT1 coupon payments and some staff bonus payments, but not to Tier 2 instruments (CRD IV Article 141[3]). Of course, any distribution concerning instruments or obligations referred to in CRD IV Article 141(3) results in a reduction of the MDA. The MDA is essentially the post-tax profit of the bank after it made its last distribution and which is not already included in CET1 capital. While the MDA restricts the overall amount a bank may distribute, it is up to the bank how it applies the MDA across the various types of distribution. An ­issuers’ pledge that it would prioritize AT1 coupons payment over share dividends is neither regulatory nor a legal obligation. A detailed method of MDA calculation is set out in CRD IV Article 141(5). The CRD IV in its current form has resulted in some differences in the way in which member countries interpret the stacking order for determining MDA relevance and calculating MDA. Defining MDA trigger at the level of the CBR (CRD IV Article 141[1]–[3]) and mis-leading wording of CRD IV Article 141(6) (to narrow a reference to Pillar 1 for the definition of excess capital for calculating the MDA factor) made the European Banking Authority publish on 18 December 2015 an opinion—to which the European Central Bank (ECB) referred in its calculation of MDAs—in which it clarified that the MDA should be calculated taking into account both minimum (Pillar 1) and additional P2R capital requirements, including the CBR. The EBA explained that MDA had the objective to ensure timely restauration of capital levels and protection of capital buffers being aimed at protecting bank’s TSCR requirement. Keeping in mind that the stacking order of Pillar 2 below the

30 

M. Liberadzki and K. Liberadzki

CRD IV buffers is in line with other CRD IV articles on supervisory measures, the MDA trigger should sit at the level of Pillar 1  +  P2R  +  CBR.22 Regarding MDA calculation, as Pillar 1 and 2 requirements are own funds minimum to be preserved at all times, only CET1 capital in excess of both Pillar 1 and Pillar 2 should be taken into account for the calculation of the MDA factor. The Commission’s CRR/CRD IV review proposes an additional Article 141a on the definition of a breach of the combined buffer. In particular, it proposes no double-counting of CET1 towards both the CBR and MREL23 to be achieved through a stacking order with combined buffers stacking on top of MREL (Article 141a defines the failure to meet the CBR). It is to result in effective use of buffers and higher levels of MDA triggers. Besides, the EC’s proposition is to introduce some flexibility with respect to MDA restrictions. The proposed Article 141a(2) defines the situations in which an institution should not be considered as failing to meet its buffer, including the inability of the institution to replace liabilities that no longer meet the eligibility criteria or maturity criteria for no longer than six months. In the view of the above, MDA becomes a crucial metric for holders of AT1 CoCos. For the sake of improved investor certainty, more transparency on P2R is needed, especially that different rules apply in different countries with regard to the determination and treatment of Pillar 2 requirements. The ­current practice shows that P2R is fully disclosed only in some countries. EBA is of the opinion that this should be disclosed at all times, especially given the stacking order (EC, 2016). CRR Article 438(b) could serve as a legal basis for such obligation. With regard to P2G, generally, there are no disclosure requirements and banks generally do not reveal their P2G. Disclosure may be requested though on a case-by-case basis if it qualifies as insider information under Market Abuse Regulation.24 For AT1 issuing banks whose disclosure is good enough, we try to calculate the minimum CET1 that they will need to maintain in future, to avoid any MDA related restrictions on AT1 distributions. The calculation takes account of any CET1 capital that has to be used to cover a shortfall in AT1 and Tier 2 capital in order to meet minimum capital requirements (Tier 1 of 6% and Total of 8%). Figure  1.1 presents ‘CET1 cushion’ metric (the difference  For MDA trigger exact place among other bank’s regulatory triggers see Sect. 2.7 of Chap. 2.  For more on MREL see Sect. 2.9 of Chap. 2. 24  Regulation (EU) No 596/2014 of the European Parliament and of the Council of 16 April 2014 on market abuse (market abuse regulation) and repealing Directive 2003/6/EC of the European Parliament and of the Council and Commission Directives 2003/124/EC, 2003/125/EC and 2004/72/EC.

22

23

1  Contingent Convertibles Issued by EEA Banks  45,000

31 25%

40,000 20%

35,000 30,000

15%

25,000 20,000

10%

15,000 10,000

5%

0

Raiffeisen Bank Int'l Belfius Bank DNB Caixa Geral Santander UK Bank of Ireland Banco Sabadell Bankia Erste Group Bank Allied Irish SEB Swedbank Caixabank Nykredit Group SHB KBC Nationwide ABN AMRO Danske Bank Credit Suisse Nordea UBS Lloyds Crédit Agricole S.A. Rabobank Société Générale BBVA Standard Chartered Barclays RBS Intesa Sanpaolo UniCredit ING Group Deutsche Bank BNP Paribas Santander Crédit Agricole Group HSBC

5,000

€mln (left scale)

0%

% RWAs (right scale)

Fig. 1.1  CET1 cushion above MDA restrictions of the major European banks in €mn and as a percentage of RWAs, at end-2017. Source: CreditSights

between a bank’s CET1 ratio and its MDA threshold) at 31 December 2017 for 43 major European banks. The lowest MDA cushion is DNB’s at 2.82% (equivalent to NOK 29.4 bn), reflecting Norway’s particularly high MDA threshold. It should be also noted that Swedish banks’ Pillar 2 requirements are not factored in to MDA calculations.

1.3.4.4  Distributable Items Another important feature of the AT1 instruments in the context of mandatory deferral is that distributions under these instruments may be paid out only from the distributable items (DIs): profits and reserves (CRR Article 52[1][l][i]). They are essentially retained profits in the parent bank’s accounts at the end of the previous financial year. This feature makes such distributions very similar to dividends; they may be paid out only where there are certain funds for this purpose, and a lack of such funds simply results in the absence of a distribution, without any default on the part of the issuer. Even if there are funds that may be used for a coupon payment, this does not guarantee that the payment will be made. The risk of distributable items being wiped out is probably smaller in a holding company structure than for an operating

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bank (please refer to Sects. 2.9.6 and 2.9.9 of Chapter 2 for more on models of banking groups). The unconsolidated distributable items of a bank holding company would be reduced if it had to write down the value of its operating bank subsidiaries. However, the unconsolidated distributable items of an operating bank could be affected by various types of loss. So far, four banking groups have issued AT1s out of a bank holding company: Barclays, Credit Suisse Group, KBC Groep and Lloyds Banking Group. The first and only coupon cancellation so far was announced by the medium-sized German bank Bremer Landesbank (Bremer LB). Bremer LB announced that it would not be paying the coupons on its two Euro AT1s— €100  mn 9.5% perp-21 (DE000BRL00B2) and €50.2  mn 8.5% perp-20 (DE000BRL00A4). The coupons on both of these bonds were due to be paid on 29 June 2017. In the press announcement, the Board stated that the coupon cancellation had been made at its sole discretion.25 It is believed however that it reflected insufficient available distributable items (ADIs) at Bremer LB. It is noteworthy that €100 mn of its €150 mn AT1s (i.e. the 9.5% notes) were held by Bremer LB owner, Norddeutsche Landesbank (Nord LB), leaving just €50 mn of AT1s held by third party investors (i.e. the 8.5% perpetuals) (Martin & Knepper, 2017). This ‘mini bail-in’ did not have much impact on the broader AT1 and was somehow overshadowed by the write-off of AT1s in Banco Popular. As Bremer LB was merged into Nord LB later that year, the outstanding amount was soon repurchased (see Table 1.2). The rule is that all major EEA banks report DIs sufficient to pay ATs coupons. Figure 1.2 presents distributable reserves as a percentage of outstanding AT1 securities to give an idea of their relative size as of end-2017. Although Deutsche Bank (DB) had the smallest distributable reserves of €1.1 bn, this was sufficient to pay DB’s annual AT1 coupons of around €315 mn, which were due on 30 April 2018.

1.3.4.5  D  eutsche Bank ADI and AT1 Market Turmoil on Beginning 2016 Deutsche Bank AT1 coupons payment capacity have been always much lower than for most AT1 issuers. The concerns over its payment ability severely affected its AT1 prices in 2016 and dragged down all AT1 CoCos market. DB had been long struggling with restructuring costs and a fall in revenues in its securities trading unit. The trigger for the price slump of DB’s shares and CoCos was its announcement on 21 January 2016 that it expected to report  Orig. ‘in Ausübung seines freien Ermessens’. See Memorandum §3(8)(a) (Finanzmarktwelt, 2017).

25

33

1  Contingent Convertibles Issued by EEA Banks  60,000

2200%

55,000

2000%

50,000

1800%

45,000

1600%

40,000

1400%

35,000

1200%

30,000

1000%

25,000

800%

20,000

600%

15,000

400%

5,000

200%

0

Deutsche Bank Raiffeisen Bank Int'l Caixa Geral Banco Sabadell Erste Group Bank Caixabank Belfius Bank Nykredit Group Santander UK Allied Irish Bank of Ireland Swedbank KBC SEB SHB Barclays Bankia BBVA Lloyds Nationwide Standard Chartered Credit Suisse Société Générale UniCredit DNB Danske Bank ABN AMRO Intesa Sanpaolo Nordea Rabobank Crédit Agricole S.A. Crédit Agricole Group HSBC UBS BNP Paribas RBS ING Group Santander

10,000

€mn (left axis)

0%

% of AT1s (right axis)

Fig. 1.2  Distributable items of the major European banks in €mn and as a percentage of AT1s outstanding, at end-2017. Source: CreditSights

a full-year net loss of about €6.7 billion in March—following rumours that the US Department of Justice (DoJ) was seeking a fine of $14 bn to settle its investigation into DB’s origination and securitisation of US Mortgage-Backed Securities between 2005 and 2007. The bondholders questioned DB’s ability to continue paying AT1 coupons due annually on 30 April. This resulted in the DB CoCo price falling to 72% of par on Monday 8 February, from 93% at the start of the year.26 Next day, John Cryan, CEO of DB, sent out a message to the bank’s employees, where he stated that the bank ‘remains absolutely rock—solid’. On 12 February, DB announced that it would launch a US$5.4 billion buyback of its own bonds. The bank said that it took the decision in order to lower ‘its debt burden at attractive prices’ and ‘to provide liquidity to bond investors in challenging market conditions’. After all, it was the numbers that appeased bondholders: Although end 2015 distributable items (called in DB reports ADIs—‘available’) were only €1.092 mn, this was sufficient to pay DB’s AT1 coupons of around €330 mn.  There were three AT1 CoCos issues from DB, all of 20 May 2014: €1.75 billion tranche with a coupon of 6%, $1.25  billion tranche with a coupon of 6.25%, and £650  million tranche with a coupon of 7.125%. All of issues had partial and temporary principal write-down loss-absorption mechanism. 26

34 

M. Liberadzki and K. Liberadzki

140 130 120 110 100 90 80 70 60

27.12.2014 15.02.2015 06.04.2015 26.05.2015 15.07.2015 03.09.2015 23.10.2015 12.12.2015 31.01.2016 21.03.2016 10.05.2016 29.06.2016

Deutsche Bank, 7.125% perp., GBP

Societe Generale, 4.75% 2mar2021, EUR

Volkswagen, 2.625% 22jul2019, GBP

Intesa Sanpaolo, 2% 18jun2021, EUR

BBVA, 2.375% 22jan2019, EUR

BBVA, 7% perp., EUR

Deutsche Bank, 6% perp., EUR

Societe Generale, 6.75% perp., EUR

Credit Suisse, 2.375% 21jun2017, CHF

BBVA, 4% 25feb2025, EUR

Deutsche Bank 2,375% 11jan2023, EUR

Fig. 1.3  Reaction of selected bonds’ prices to DB 7.125% (GBP) and 6% (EUR) perpetuals’ price slump. Source: Cbonds

What is noticeable is that the DB AT1 CoCos price slump of 8 February spilled over all €91 bn worth AT1 market (see Fig. 1.3). There were no fundamental reasons for such AT1s drop, as among major European banks—CoCo issuers only DB was short of ADIs (See Fig. 1.4). What is more, the ‘distance to trigger’ for DB (i.e. the difference between the bank’ actual CET1 ratios at end-2015 and the write-down trigger of its AT1 securities, see Sect. 1.3.5.6) was comfortable at 8.07% RWAs, in number terms €32.083 bn (more than enough to absorb €6.7 bn alleged loss). The MDA cushion was safe 2.44% (€9.7 bn). The uncertainty for bondholders over DB’s ability to continue paying AT1 coupons spread beyond AT1 market: to some extent it affected also prices of similar to bank perpetuals class of hybrid securities, issued by Volkswagen, which will be discussed in detail in Sect. 5.2 of Chap. 5. This means that chronically low DIs of only one persistently unprofitable major bank with a structural cost problem and a business model that needed radical revision, was the single factor responsible for the sell-off of the AT1 market at the beginning of 2016. Therefore, we measured the contagion effect

1  Contingent Convertibles Issued by EEA Banks 

35

400 350 300 250 200 150 100

0

Deutsche Bank Barclays Lloyds BBVA Société Générale Banco Popular Bank of Ireland Crédit Agricole S.A. Crédit Agricole Group Credit Suisse Santander UK KBC UBS HSBC RBS BNP Paribas SHB Standard Chartered UniCredit SEB Nationwide Swedbank Nordea Intesa Sanpaolo Santander Allied Irish Danske Bank ABN AMRO ING Group Rabobank DNB

50

Fig. 1.4  Major European banks’ end-2015 DIs as multiple of their annual AT1s coupon payments. Source: CreditSights

understood as an increase in interdependency among the selected bond yields. We propose contagion index basing on the copula theory (Jaworski & Liberadzki, 2017a). The positive values indicate that the co-movements are stronger and more frequent, when the price of the reference bond (DB AT1s) drops significantly. The negative values indicate that the movements in opposite direction are stronger and more frequent, when the price of the reference bond drops significantly. In the first case, we observe contagion and in the second, divergence (Jaworski & Liberadzki, 2017a). As Table  1.3 shows, there was no contagion on the AT1 market at that time. However, the observation that the prices of other perpetuals almost instantly followed the DB perpetuals reveals the vulnerability of these instruments to coupon cancellation risk, or better said, just to speculations over DB’s ability to pay AT1 coupons in 2016. In the end, Deutsche Bank found a way to continue AT1 payments, as ADIs could remain positive even after a reasonably significant litigation settlement with DoJ which after all turned out not to be as punitive as feared. Besides, DB performed better than expected in the EU-wide 2016 stress test (see Sect. 1.3.5.6). Although certainly not one of the stronger performers, its fully loaded CET1 ratio of 7.8% under the adverse scenario was not too bad, and it scraped through with a fully loaded leverage ratio of 3.0%. In addition, DB raised significant amounts of equity in end-2016 amounting to €8  bn

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M. Liberadzki and K. Liberadzki

Table 1.3  Contagion index for selected CoCos and straight bonds, 1Q2016 vs. Deutsche Bank, 7.125% perp., GBP Deutsche Bank, 7.125% perp., GBP Deutsche Bank, 6% perp., EUR Deutsche Bank, 2.375% lljan2023, EUR Credit Suisse, 2.375% 21jun2017, CHF 3BVA, 2.375% 22jan2019, EUR ntesa Sanpaolo, 2% 18jun2021, EUR Volkswagen, 2.625% 22jul2019, GBP Société Générale, 4.75% 2 mar2021, EUR 3BVA, 7% perp., EUR Société Générale, 6.75% perp., EUR 3BVA, 4% 25feb2025, EUR

vs. Deutsche Bank, 6% perp., EUR

X

0.25

0.24

X

0.35

0.32

0.15

0.15

−0.01 0.01

0.11 0.05

0.08

−0.13

−0.05

−0.04

−0.07 −0.11

−0.23 −0.04

−0.17

−0.22

Source: Own study

which improved its MDA cushion. These circumstances, combined with ­regulatory changes, revived AT1 market going into 2017 by reducing risk of banks deferring coupons. A broader look at the 2016 AT1 market turbulences clearly shows how prone it was (and probably still remains) to the regulatory amendments. A glance at Fig. 1.5 is enough to observe almost perfect synchronization of AT1 prices with regulatory announcements. Our starting point is 18 December 2015, when the European Banking Authority published an opinion—to which the European Central Bank referred in its calculation of MDAs—in which it clarified that the MDA should be calculated taking into account both minimum (Pillar 1) and additional (Pillar 2) capital requirements, including the combined buffer requirement, thus narrowing the distance to a breach of the combined buffer requirements to 1–3%. This drove the AT1s prices down a steep slope. The February 2016 sell-off of the AT1 market was stopped by positive actions taken by DB as well as the EC and the ECB taking a lot of the concern out of the market by reducing the Pillar 2 requirement included in the MDA threshold. The improvement in banks’ MDA cushions in 2017 came from two sources. The first was the elimination of a former requirement to maintain a specific amount within Pillar 2 to bring the capital conservation buffer up to its fully

1  Contingent Convertibles Issued by EEA Banks 

37

Fig. 1.5  Prices of selected AT1 CoCos and regulatory amendments throughout 2016. Source: Assenagon Asset Management, 2016

loaded level. Under 2016 SREP rules, this accounted for 1.875% of RWAs (i.e. the difference between the 2.5% fully loaded capital conservation buffer and the 0.625% Pillar 1 requirement in 2016 being the first year of the four-­ year phase-in). The second source of improvement was the ECB’s splitting of the remaining Pillar 2 buffer into a hard requirement (P2R), which was

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f­ actored into the MDA calculation and a guidance amount (P2G), which was not to be part of the MDA calculation (see Sect. 1.3.4.3). Since then the ECB has been making case-by-case decisions, in which each bank’s stress test performance is an important factor. In DB’s case, this remaining Pillar 2 buffer was 3.25% in 2016, reducing to 2.75% for 2017. Offsetting these two positive effects of the change in methodology, banks were facing the pre-set step-­ ups in the phase-in of their G-SIB or D-SIB buffer and their capital conservation buffer (from 0.625% to 1.25%).

1.3.5 Contingent Conversion and Write-Down 1.3.5.1  CoCo Trigger Mechanisms It has been already mentioned that the contingent conversion/write-down feature are the unique aspect of CoCo financial instruments and fundament for their going-concern (i.e. without undergoing a bankruptcy or restructuring) loss-absorbing capacity. The coupon cancellation mechanism forms ‘the first line of defence’ against capital depletion. Stress event-triggered conversion of AT1 instrument to common equity thus preserving the entity from winding up forms the backbone of CoCos loss-absorbing capacity on an ongoing basis. As discussed in Sect. 1.2.6, the idea of automatic conversion of a security into more subordinated one is not new; it is Europe’s CRR though that first translated this proposition into law. To some extent contingent convertible bonds can be seen as the newest member of the big ‘convertibles’ family. To begin with, the convertible/exchangeable bonds27 can be seen as the remotest predecessors. Convertible bonds fall within a broader group of convertible securities, which may also include equity instruments (see Sect. 5.3.2.2 of Chap. 5). Innovative financial markets soon developed another type of convertible, dubbed ‘reverse convertibles’. Unlike with convertibles/exchangeables, it is the issuer who—at the maturity date of such bonds—has the option to redeem the bond for a cash settlement or deliver a predetermined number of underlying shares to investors, usually listed as the stock of a different company.28 Mandatory convertible bonds (developed through the 1990s) fall within a special category of convertible bond. They pay higher coupons or  Convertible instruments may be converted into new shares of the same issuer, while exchangeables may be exchanged into existing shares of a company other than the issuer of the bond. The underlying instrument of an exchangeable bond will be a ‘basket’ of already existing and listed securities, see Liberadzki (2016). 28  For more on reverse convertibles see Liberadzki (2016). 27

1  Contingent Convertibles Issued by EEA Banks 

39

fixed dividends than common stock for a certain number of years and then, on a prespecified date, automatically convert to common equity. Conversion is inevitable as these bonds are usually non-callable (Liberadzki and Liberadzki, 2016). It is important to note that, unlike CoCos, neither of the abovementioned securities classes were designed to act as regulatory capital and therefore they may be issued by corporations outside the regulated industry. CRR provides for CoCos’ loss-absorbing capacity going beyond conversion into ordinary shares of an issuer: mandatory write-downs of bond principle upon the occurrence of the trigger event. The origins of so-called principal write-down (PWD) CoCos are to be found at catastrophe bonds (or ‘CAT’ bonds). CAT bonds were developed in the mid-1990s as a tool to transfer catastrophic risk. The provisions of such instruments specify in a very detailed manner the catastrophic ‘trigger event’ in a form of natural disaster that will cause a write-down of the bond’s nominal value. Usually trigger event is linked with industry loss indices such as the Property Loss Services (PCS) loss index (Bauer & Kramer, 2016). With CAT Mortality (CATM) bonds, the write-­down trigger event does not depend on any underlying loss index, but on ‘less artificial’ events: the catastrophic evolution of death rates in a given population. The unique loss-absorption feature of CAT bonds upon the occurrence of a specified trigger event may be regarded as a cornerstone of the write-down mechanism embedded in the structure of a CoCo. When it comes to CoCos, the trigger event of a natural disaster is replaced by regulatory trigger but the underlying idea remains similar. This observation bring us to the conclusion that it is possible to trace the evolutionary path of the trigger event mechanism leading from the underlying loss index of CAT bonds to CATM bonds, which are triggered by an observable event in a natural population, to the regulatory trigger of CoCos, and finally to bail-in bonds, which are subject to the discretionary decision of a resolution authority (Liberadzki and Liberadzki, 2016). Basel III attributes a matter of key importance to regulatory capital ratio as an indicator of the soundness of financial institution. Therefore hitting ‘capital ratio’ trigger, results in the conversion of a bond into a predetermined number of shares in the case of the CE (‘conversion into equity’) CoCo, or the trimming of its face value as with a PWD (‘principal write-down’) CoCo. In line with Basel III, CRR sets trigger event in form Common Equity Tier 1 capital ratio falling below specified level. Pursuant to CRR Article 92(1)(a) and (2)(a) CET1 capital ratio is the Common Equity Tier 1 capital of the institution expressed as a percentage of the total risk exposure amount (RWAs) and should be at least 4.5%.

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As far as calculation of CET1 ratio denominator is concerned, the CRR distinguishes three significant types of risk: credit-, market- and operational risk used to calculate the RWAs. In each case, an institution has an option of choosing between standardized approach and more advanced approaches of internal models. The calculation of RWAs using credit risk-standardized approach starts by dividing all assets into a total of 17 exposure classes. Each position is then allocated a rating category and subsequently a corresponding risk weight (W) within these classes. The risk-weighted position is obtained by multiplying the position by its risk weight. Secondly, total risk exposure amount includes market risk and operational risk. Additionally, large exposures exceeding the limits specified in CRR Articles 395 to 401 as well as credit valuation adjustment risk of over-the-counter (OTC) derivative instruments other than credit derivatives recognized to reduce risk-weighted exposure amounts for credit risk (CRR Article 92[3]) are put into calculation. However, the method for measuring capital requirements in the abovementioned types of risk differs from the approach used for credit risk. Here, the capital requirements must be multiplied by the reciprocal of the minimum capital ratio of 8% (i.e. 12.5—CRR Article 92[4]) in order to determine in what manner the reference value of the 8% ratio has increased. Therefore, RWAs can be defined as: 17



RWAs = 12.5 ( OR + MR + OTC + LE ) + ∑Wi Ai i =1

(1.1)

where: OR  – operational risk MR  – market risk OTC  – credit valuation adjustment risk of OTC derivative instruments LE  – large exposures Wi  – an i-th asset’s risk weight Ai  – an asset of i-th class. Apart from credit risk-standardized approach, another option for an institution is to choose more advanced internal ratings based (IRB) approach. It is based on the institution’s ‘best’ estimation of expected loss (EL) determined on basis of historical and average data with the help of probability of default (PD) and loss given default (LGD). A switch to using the IRB approach requires supervisory permission (CRR Articles 143–148).

1  Contingent Convertibles Issued by EEA Banks 

41

Regulatory capital ratios are not only underlying values CoCos triggering may rely on. Triggers are classified into one out of three groups: regulatory triggers, accounting triggers and market triggers (Buergi, 2013) with various pros and cons for each of them. At first glance, a market value-based trigger seems to be most ‘obvious’ one to choose. When it comes to standard convertibles, conversion is usually coupled to the market stock price. However, there are some fears surrounding the market triggers. The concern centres on their vulnerability to manipulation, and the notorious tendency of markets to become illiquid in critical situations (Buergi, 2013). This could lead to forced conversion during extreme market volatility, while the bank may have an extremely sound regulatory capital position. Besides, only about one-third of the eurozone banks supervised by the ECB are publicly listed (Bundesbank, 2018). On the other hand, a drop in a share market price below the specified level can be monitored much more effectively than an accounting event can be monitored. The probability of such a drop may be assessed, and its risk quantified. This would help to develop a more precise and accurate model of the AT1 hybrid pricing model, which is a goal in itself. To reconcile these pros and cons, Equity Recourse Notes (ERNs) were proposed. In the event of a drop in the shares’ market price, contingent conversion would be applied only to due payments, while bondholders who claim to receive a coupon would be satisfied by banks’ shares. Moreover, ERNs might convert more gradually than CoCos. Conversions would be relatively small, because they would occur only when current payments are due on ERNs, and only for those ERNs that had been issued when the share price was at least four times above the current level (Business Wire, 2014). From the point of view of a CoCos’ trigger analysis, the crucial issue is whether the Basel CET1 ratio concept provides a good enough indication of the solvency of the bank. As the financial literature points out, it is a poor measure of bank safety due to the ability of banks to use their internal models to adjust risk weights and use derivatives to engage in regulatory arbitrage. Blundell-Wignall et al. (2014) examined 22 US and European G-SIFIs. They came to the conclusion that the ease with which Tier 1 targets are achieved and exceeded is not mirrored in equity ratios. Some of the banks were weakly capitalized in equity, despite very high Tier 1 ratios. Furthermore, between 2006 and 2009, even banks thought to be in a distressed state never published Tier 1 ratios lower than 7% (Buergi, 2013). A. Haldane, the Bank of England’s executive director for financial stability, observed that the ratio of RWAs to total assets at major international banks shrank by almost half between 1993 and 2011 (Business Wire, 2014). One should expect that if the conversion is triggered by a bank’s regulatory capital, banks are likely to use every trick in

42 

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the book to keep their official capital above the trigger point. Moreover, the discretionary nature of this trigger class makes it difficult to assess the probability of conversion, thus the pricing of the CET1 ratio triggered CoCos. To some extent, the solution may be to find a linear regression between regulatory ratio and book ratios, such as a leverage ratio, as some authors do (Buergi, 2013). Requiring banks to have more equity and less debt directly addresses the questions of the banks’ solvency. When the financial crisis began in 2007, the equity of some of the major financial institutions worldwide was 2% or 3% of their total assets.29 The fact that these margins of safety were so thin played a major role in the crisis. The evidence suggests that a simple leverage ratio strongly outperforms the complex risk-weighting approach of the CET1 ratio (Blundell-Wignall & Roulet, 2014). Also in 2013, Demirguc-Kunt et al., found that during the crisis, the stock returns of large banks were more sensitive to the leverage ratio than the risk-adjusted capital ratio. Their explanation was that market participants viewed the risk adjustment under Basel rules as subject to manipulation or in any case, or not reflective of the true risk in the case of large banks. They also found that the positive association with subsequent stock returns was stronger for higher quality capital (Tier 1 leverage and tangible common equity). The third group of CoCo triggers constitute accounting trigger calculated basing on book values. Before the great financial crisis, markets valued global banks at two or three times the book value of their equity. After the crisis, it was the other way around for many banks: today, most global banks are valued at a discount—many at a small fraction—of their equity book value (Haldane, 2012). Taken separately, each trigger system has its advantages and disadvantages for the bank and the investor. A natural solution would be to ensure that CoCo conversion or write-downs do not depend on a single trigger condition. The number of such multivariate trigger combinations is enormous. It can combine bank-specific characteristics with state-of-the-economy indicators to identify systemic risk (De Spiegeleer et al., 2014) or to replace accounting or regulatory triggers with market triggers, to be fulfilled either simultaneously or on an if-or basis. At the beginning of twenty-first century, many different versions of contingent capital instruments were proposed, and some standalone financial contracts designed to achieve that result were created (Bolton & Samama, 2012). Back in 2009, even before Lloyd’s had issued its ‘ECNs’,  Under Basel III, banks’ equity can still be as low as 3% of banks’ total assets. It is not clear that anything would have been substantially different in the 2007–2009 crisis had Basel III already been in place. See Admati and Hellwig (2013). 29

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a double-trigger hybrid security was proposed. The proposed hybrid would convert from debt to equity only if regulators declare that the financial system is facing a systemic crisis, or if a bank’s covenants governing the hybrid’s terms of issue are breached. We may call these ‘macro’ and ‘micro’ triggers. An analysed proposal also aims to identify the covenant that would be the best ‘micro’ trigger, that is, an indicator of a bank’s financial soundness. An important concern about CoCos is that they would all convert at once, which could become a panic-inducing event of its own. Therefore, it is proposed that CoCo conversions be made in several incremental stages. Another solution addressing the problem of automatic triggers is a contingent capital instrument in the form of so-called capital access bonds (CABs) that give the issuer the unconstrained right to exercise the option to repay the bond in stock at any given time during the life of the bond. In other words, CABs are akin to a bank buying put options on its own equity at a predetermined strike price (Bolton & Samama, 2012).

1.3.5.2  AT1 CoCos Trigger Event Upon the occurrence of the trigger event, the AT1 instrument shall be converted into a CET1 instrument, or its principal amount shall be written down (CRR Article 52[1][n]). Therefore, each AT1 debt instrument must be either a CE CoCo or a PWD CoCo, according to the choice made in the provisions regarding the instrument. In general, Basel III does not require mandatory write-down or equity conversion features in order for instrument to qualify as additional Tier 1 capital unless it is reported as liabilities’ item. Unlike in Europe, Canada and certain Asian countries,30 under U.S. rules preferred stock/AT1s are classified as equity so they don’t carry such write-down or equity conversion features. The trigger event occurs when the CET1 capital ratio falls below 5.125% or below some higher ratio, specified in the terms and conditions of the instruments (CRR Article 54[1][a]). The CRR sets out only the minimum requirement for CET1 ratio, and issuers may decide to model a CoCo with a higher-value contingent conversion trigger. Such an instrument has more loss-absorbing capacity, as is reflected by the higher risk of conversion borne by its holders. Hybrid bonds with embedded contingent conversion triggers on the 5.125% level are referred to as ‘low-trigger CoCos’, while those with a trigger of 7% or more (8%) are referred to as ‘high-trigger CoCos’. 30

 See Sect. 4.2.2 of Chap. 4.

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The RTS sets out the exact procedures for how a financial institution’s board should manage the occurrence of a trigger event scenario. First of all, Regulation 241/2014 Article 22(1) provides that if the CET1 ratio falls below the parameter set out in CRR Article 54(1), the management board shall determine without delay that the trigger event has occurred. It is important to note that this is the duty of the management board or any other relevant body of the institution. Furthermore, analysed provisions emphasize that the obligation to convert hybrids or write-down their nominal value is irrevocable. EBA in its report on the monitoring of AT1 instruments of July 2018 firmly states that the terms and conditions of any CoCo issuance ‘should make clear that the trigger event may be calculated at any time. Therefore, the definition of the CET1 ratio should not refer to the last quarterly financial date or any extraordinary calculation date’. The write-down of the principal amount shall apply on a pro rata basis to all holders of Additional Tier 1 instruments that include a similar write-down mechanism and an identical trigger level (Regulation 241/2014 Article 21). This clearly shows that high triggers suffer losses ahead of low triggers. When a trigger event occurs institution should ‘immediately’ inform the competent authorities and holders of the AT1 instruments (CRR Article 54[5][a]-[b]). The next step is to determine the amount being subject to conversion or write-down. This amount should be determined as soon as possible but no later than one month after the occurrence of the trigger event has been determined (Regulation 241/2014 Article 22[2]). In this instance, no specific party is named to carry out that obligation. But it is understood that the same bodies will be tasked with determining the occurrence of a trigger event. Under Regulation 241/2014 Article 22(3), the competent authority may require that the maximum period of one month is reduced, if the authority assesses with sufficient certainty that this amount is established or determines that an immediate write-down conversion is needed. Provisions governing the CoCo may require an independent review of the amount that has to be converted or written down; such an independent review may also be demanded by the competent authority. In both cases, a management board or any other relevant body has to see to it that this is done immediately (Regulation 241/2014 Article 22[4]). Another matter concerns triggers for CoCos issued within a banking group. EBA in the abovementioned report points out that ‘under the CRR provisions, triggers for the loss absorption of AT1 instruments shall be based on the CET1 of the institution, at a level of 5.125% or more. However, it is unclear whether these triggers should be based on the institution’s solo CET1 or on the institution’s (sub-) consolidated CET1. An additional question is whether the trigger should be based

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not only on the CET1 of the issuer but also on the CET1 of the group, particularly when the issuer is not the head of the group’. EBA differentiates an approach with respect to banking groups with a parent institution; banking groups with a parent holding company; and mutual groups with a central body. Consolidated supervision is aimed at general assessement of the whole capital group strength, including the bank being part of the group. By the consolidated approach it is possible to discover the potential influence of other units belonging to the group on banks’ resilience together with the risk generated by the subsidiary units and related parties. According to the CRR Article 11 (1)–(4) the supervisory requirements should be fulfilled on a consolidated basis with regard to parent institution in a member state (CRR Article 11[1]) and the institutions being a subsidiary of a parent financial holding company in a member state or of a parent mixed financial holding company in a member state (CRR Article 11[2]). Within the scope of supervisory consolidation the own funds (capital) requirements, large exposures and financial leverage must be fulfilled on a consolidated basis. The CRR Article 11(5) stipulates that in addition to the requirements set out in Article 11(1)–(4), when it is justified for the supervisory purposes by the specific risk or the capital structure of a bank or where a member state adopts national laws requiring the structural separation of activities within a banking group, competent authorities may require the structurally separated institutions to comply with the requirements on a sub-consolidated basis. The definition of ‘a sub-­consolidated’ basis may be found in the CRR Article 4(4)(49), and means ‘on the basis of a consolidated statement of parent institution, financial holding company or mixed financial holding company excluding the subgroup of entities, or on the consolidated basis of parent institution, financial holding company or mixed financial holding company that are not the ultimate parent institutions’. It is worth explaining the rationale lying behind the sub-consolidation. The legal provision of CRR Article 11(5) may be very useful in case the capital group is being so structured, that the entities do not qualify for the consolidation criteria set in CRR Article 11(1)–(4). What is more, the supervisory authority has a freedom to some extent to determine the level and scope of consolidation, which is labelled in the CRR as sub-consolidation. Besides, the CRR in its Article 18(6) authorizes the supervisor to determine how the consolidation is to be carried out, where an entity exercises a significant influence over one or more institutions even without holding a participation or other capital ties in these institutions. This may also occur, when the two or more institutions are placed under single management, other than resulting from contract or statutory clauses.

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As far as AT1 triggers are concerned, the EBA considers ‘that there should be a trigger on the basis of all levels of solvency applicable to the institution (or the banking group). This means that there should be a trigger on the basis of consolidated CET1 when the entity is supervised on a consolidated basis, based on sub-­ consolidated figures when the entity is supervised on a sub-consolidated basis, and based on solo figures when the entity is supervised on a solo basis, as well as any applicable combination of any of the cases mentioned above’. For instance, issuing terms for ABN AMRO BANK NV 5.750% NC5 perp.22Sep20 (XS1278718686) provide that the write-down amount should be ‘sufficient to immediately restore the issuer CET1 ratio to not less than 5.125% and the Group CET1 ratio to not less than 7%’. Similarly, Credit Agricole SA 7.875% NC10 perp.23Jan23 (USF22797RT78) call for principal amount of the notes to be reduced ‘by an amount that is sufficient to restore the relevant capital ratio above 5.125% at SA or above 7% at Group’ (See also Table 1.4 for more detailed issue parameters). These two excerpts have a common meaning that trigger on solo basis is 5.125%, and on a consolidated level is 7%. Additionally, EBA finds the inclusion of triggers referring to the application scope of supplementary supervision pursuant to the Financial Conglomerates Directive (FICOD)31 non-obligatory. In case bank is controlled by a holding company (CRR Article 11[2]) ‘in order for AT1 instruments to be included as qualifying Tier 1 instruments in the consolidated Tier 1 capital of the holding company within the limits laid down in Article 85 of the CRR, the terms and conditions of the instruments issued by that institution should include a trigger event on the basis of the consolidated CET1 of the parent financial holding company or parent mixed financial holding company. The absence of this trigger would make the issuance ineligible for the purpose of the computation of the consolidated Tier 1 of the holding company. However, the issuance would still be eligible at the sub-consolidated and solo levels if it included triggers at these levels’. Finally, ‘it would not be possible for an AT1 instrument issued by a subsidiary to have only a trigger based on the consolidated solvency of the parent holding company: the trigger at the level of the issuing entity is mandatory, except in cases where CRR Article 7 is applied. Without that trigger, the instrument would be disqualified at all levels, based both on a reading of Article 54 of the CRR and on concerns that the absence of this trigger would not be prudentially sound’ (EBA, Report on the Monitoring of Additional Tier 1 (AT1) instruments of 20 July 2018).  Directive 2002/87/EC of the European Parliament and of the Council of 16 December 2002 on the supplementary supervision of credit institutions, insurance undertakings and investment firms in a financial conglomerate and amending Council Directives 73/239/EEC, 79/267/EEC, 92/49/EEC, 92/96/ EEC, 93/6/EEC and 93/22/EEC, and Directives 98/78/EC and 2000/12/EC of the European Parliament and of the Council. 31

EUR

EUR

USD USD SEK

3.625%

6.125% 6.750% 8.125% 6.500% 7.375% 6.750% 7.125% 6.000% 6.250% 7.375% 7.750% 6.625% 4.750% 6.875% 6.625% 3mN + 5.25%

10.750%

6.125% 6.375% 3mS + 3.10%

Danske Bank BNP Paribas Crédit Agricole Crédit Agricole Société Générale Société Générale Deutsche Bank Deutsche Bank Deutsche Bank Allied Irish Banks Intesa Sanpaolo UniCredit ABN AMRO Bank ING Groep Rabobank DNB Bank

Caixa Geral de Depositos BBVA Santander Nordea Bank

(continued)

EUR

4.500%

USD USD USD EUR USD USD GBP EUR USD EUR EUR EUR EUR USD EUR NOK

EUR

Coupon

6.500%

Bank

Erste Group Bank Raiffeisen Bank International Belfius Bank

1000 1500 2250

500

750 750 1250 1000 1500 1250 650 1750 1250 500 1250 1250 1000 1000 1250 1400

500

500

500

First call

28-­Mar-­24 14-­Mar-­22 23-­Dec-­25 23-Jun-­21 13-Sep-­21 6-Apr-­28 30-­Apr-­26 30-­Apr-­22 30-­Apr-­20 3-Dec-­20 11-Jan-­27 3-Jun-­23 22-Sep-­27 16-­Apr-­22 29-Jun-­21 27-Jun-­21

16-­Apr-­25

15-Jun-­25

15-­Apr-­24

8-Nov-­17 8-May-­14 5-Mar-­15

16-­Nov-­27 Anytime 19-­May-­19 Anytime 12-­Mar-­20 Quarterly

Temp Temp

Partial Partial

Conversion Conversion Write-­down Partial

Temp

Temp

Temp Temp Temp Temp Temp Temp Temp Temp Temp Temp Temp Temp

Temp

Temp

Temp

Partial Partial Partial Partial Partial Partial Partial Partial Partial Partial Partial Partial

Write-­down Partial

Conversion Write-­down Write-­down Write-­down Write-­down Write-­down Write-­down Write-­down Write-­down Write-­down Write-­down Write-­down Write-­down Conversion Write-­down Write-­down

Semi-­annual Write-­down Partial

Semi-­annual Write-­down Partial

Semi-­annual 5 years 5 years 5 years 5 years Semi-­annual 5 years 5 years 5 years Semi-­annual Quarterly Semi-­annual Semi-­annual 5 years Semi-­annual Quarterly

Trigger 1

Group Group Group

Group

Bank (cons) Group Group CA Group CA Group Group Group Group Group Group Group Group Group Group Group Group Group

Group

Group

Conversion/ Partial/ Temp/ write-down full perm Entity

Write-down terms

Semi-­annual Write-­down Partial

Subsequent calls

23-­Mar-­17 30-­Mar-­22 Quarterly

21-­Mar-­17 7-Dec-­16 12-Jan-­16 1-Apr-­14 9-Sep-­16 4-Apr-­18 25-­May-­14 20-­May-­14 20-­May-­14 26-­Nov-­15 4-Jan-­17 15-­May-­17 27-Sep-­17 16-­Nov-­16 19-­Apr-­16 16-Jun-­16

25-Jan-­18

17-Jan-­18

5-Apr-­17

Amount Crncy mn Issue date

Table 1.4  Selected AT1 CoCos outstanding

Entity

5.125% Bank 5.125% Bank 8.000% Bank

5.125% Bank (solo) 7.000% Bank 5.125% 7.000% CA SA 7.000% CA SA 5.125% 5.125% 5.125% 5.125% 5.125% 7.000% Bank 5.125% Bank 5.125% Bank 7.000% Bank 7.000% 7.000% Bank 5.125% Bank Group 5.125% Bank

5.125% Bank

5.125% Bank

CET1

Trigger 2

5.125% 5.125% 5.125%

5.125%

5.125% 5.125%

7.000% 5.125% 5.125% 5.125%

5.125% 5.125%

7.000%

5.125%

5.125%

5.125%

CET1

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47

USD USD

CHF

USD CHF

GBP EUR EUR GBP

USD

GBP

6.000% 7.500%

3.875%

5.000% 2.125%

5.875% 8.000% 4.750% 7.875%

8.625%

6.750%

500

2650

1250 1000 1250 750

2000 750

200

500 2250

1200

Source: CreditSights 3mN—3-month NIBOR; 3mS—3-month STIBOR

USD

Coupon

5.250%

First call

5 years 5 years 5 years 5 years

Annual Annual

5 years

5 years

15-­Aug-­21 5 years

15-Sep-­24 15-­Dec-­20 4-Jul-­29 27-Jun-­29

31-Jan-­23 30-Oct-­23

30-­Mar-­17 24-Jun-­24

8-Aug-­16

3-Aug-­17 10-­Dec-­13 27-Jun-­17 20-­Mar-­14

24-Jan-­18 15-Jun-­17

5 years

Subsequent calls

17-­Mar-­22 5 years 11-­Dec-­23 5 years

1-Mar-­21

15-­Mar-­17 22-Sep-­23

9-Dec-­16 11-­Dec-­13

18-Feb-­15

Amount Crncy mn Issue date

Bank

(continued)

Svenska Handelsbanken Swedbank Credit Suisse Group Credit Suisse Group UBS Group Zürcher Kantonalbank Barclays Barclays HSBC Holdings Lloyds Bkg Group Royal Bank of Scotl. Group Santander UK Group Hold.

Table 1.4­  Trigger 1

Write-­down Full

Conversion

Conversion Conversion Conversion Conversion

Write-­down Full Write-­down Full

Write-­down Full

Conversion Write-­down Full

Write-­down Partial

Perm

Perm Perm

Perm

Perm

Temp

Group

Group

Group Group Group Group

Group Group

Group

Group Group

Group

Conversion/ Partial/ Temp/ write-down full perm Entity

Write-down terms Entity

7.000%

7.000%

7.000% 7.000% 7.000% 7.000%

7.000% 7.000%

7.000%

8.000% Bank 5.125%

8.000% Bank

CET1

Trigger 2

5.125%

5.125%

CET1

48  M. Liberadzki and K. Liberadzki

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1.3.5.3  Conversion into Equity As a rule, any contingent conversion would have an impact on the structure of company ownership. Contingent conversion of bonds would result in the increase of share capital and the dilution of other shareholders’ rights. With regard to CRR, we have to say that the general regime of EU company law (lex generali) is waived by contingent conversion to equity mechanism (lex speciali). CRR explicitly sets out that conversion of CE CoCos is automatic and there is no room for any pre-emptive option for existing shareholders to acquire shares of new issue (resulting from the conversion). Hence, the CE CoCo mechanism is exempted from the pre-emptive right application (Liberadzki and Liberadzki, 2016). It must be emphasized that the pre-emption right of shareholders to subscribe to shares of new issue in proportion to their stake in the company’s registered capital is one of basic rights of shareholders. To be protected against dilution of their corporate rights (i.e. voting right, dividend claims, etc.), shareholders are equipped with the option to subscribe to new shares. European company law is very restrictive on that matter, and joint-­stock companies in all EU member states must be governed by national corporate law in a manner that safeguards this right. In particular, the pre-emption right may not be generally excluded from company statutes, and its exclusion has to be made on each individual issue, by means of resolutions taken at a meeting of shareholders. Usually, national company law requires such a resolution to be valid only when backed by some qualified majority of votes (i.e. 75%). Hence, the offering of new shares to a new shareholder versus a cash contribution would always require such a resolution to be taken (Liberadzki and Liberadzki, 2016). As a form of preserving pre-emption right to shareholders, EBA has been accepting, since mid-2018, share conversion clauses included in some ATs issuances, giving shareholders the priority to buy the shares from the conversion in exchange for cash compensation for bondholders  (see EBA report on AT1s of 2018). For instance, the UK’s Standard Chartered terms and conditions of its 7.750% perp.02Apr23, USD notes (USG84228CX43) provide that at the issuer’s discretion, the bondholders might receive the shares, cash proceeds from the sale of the shares to shareholders at a price no less than the conversion price, or a combination of shares and cash. After all, when a financial institution is weak and stressed, shareholders may simply not be interested in executing their pre-emptive right. Contingent conversion of a preferred share would not result in an increase of the share capital, but the voting rights of other shareholders would still be diluted because the preferred shares are stripped from voting rights, so their

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conversion into common equity would inevitably result in the reappearance of such rights. Such a change would also have an impact on the distributions paid by the issuer as a dividend: there would no longer be any fixed income preference dividend payments. However, if the CET1 items are in a form non-voting preferred shares, as in certain EU jurisdictions (see Sect. 1.2.8) then contingent conversion would not result in dilution. CRR Article 54(6) requires from an institution issuing CE CoCo that its authorized share capital is at all times sufficient, for converting all such convertible AT1 instruments into shares if a trigger event occurs. ‘All necessary authorisations shall be obtained at the date of issuance of such convertible Additional Tier 1 instruments. The institution shall maintain at all times the necessary prior authorisation to issue the Common Equity Tier 1 instruments into which such Additional Tier 1 instruments would convert upon occurrence of a trigger event’. In considering a CE CoCo instrument, terms and conditions will have to specify the rate of conversion, the permitted amount of conversion and a range within which the instruments will convert into CET1 instruments. This requirement may give rise to some national legislation issues, as the rules governing contingent conversion will need to be established in national company laws governing the issue of convertible bonds. The European company law rules applicable to the issue of convertible securities and their conversion into shares of the issuer are set out in the Directive 2012/30/EU.32 The transposition of the directive into the laws of EU member countries has produced many differences between national company laws with regard to the limits of management authorization to issue CoCos and shares upon their conversion, the shareholders rights of pre-emption and conditions for its disapplication as well as limits of authorized capital and minimum nominal share value (Busch & Ferrarini, 2016). CoCo bonds can be structured to convert into either a fixed number of shares or a fixed value of shares. At conversion, the bond holder is forced to accept delivery of Cr shares and therefore give up bonds of N principal. The embedded purchase price is the conversion price Cpurchase of the CoCo bond: Cpurchase =

N Cr

(1.2)

 Directive 2012/30/EU of the European Parliament and of the Council of 25 October 2012 on coordination of safeguards which, for the protection of the interests of members and others, are required by Member States of companies within the meaning of the second paragraph of Article 54 of the Treaty on the Functioning of the European Union, in respect of the formation of public limited liability companies and the maintenance and alteration of their capital, with a view to making such safeguards equivalent. 32

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Unlike the conversion ratio for traditional convertible bonds, wherein the bonds are converted into a fixed number of shares of common stock, CoCo bonds can be structured to convert into either a fixed number of shares or a fixed value of shares, with varying pros and cons to the bondholders and the bank shareholders. For example, a fixed-share conversion ratio established at issuance of the bond would be less dilutive to the existing shareholders of the bank, but also of less value to CoCo bondholders. As a result, the bank may have to compensate the bondholders with a higher coupon as the tradeoff. On the other hand, a fixed-value (equal to the bond par value, premium or discount to par value) conversion ratio, based on the then market value of the bank shares at conversion, could be significantly dilutive to shareholders, but more appealing to the bondholders in preserving their bond value. Therefore, the bondholders would require a lower risk premium in terms of the bond coupon, a tradeoff benefit to the bank. It would appear that conversion at par value would be more adequate from the perspectives of both the bank and the investor (Liberadzki and Liberadzki, 2016). Contingent capital design (in particular the conversion ratio, the fraction of post-conversion common equity that contingent capital holders receive) has an important impact on risk-taking motivation. For relatively low conversion ratios, stockholders have an incentive to increase asset risk, while a high conversion ratio leads to a desire to reduce risk (Hilscher & Raviv, 2014). The latter creates an incentive for an excessive risk-taking by bank shareholders and management and needs regulator’s involvement (Berg & Kaserer, 2015). The CE CoCos are mostly issued by Spanish and UK Banks. As far as AT1 issue conditions are concerned, usually conversion ratio is presented in terms of price variables. Typical conversion provision of floored conversion price, that is, the larger of the two: floored price and the ‘trigger price’ may be shown on example of terms and conditions of BBVA’s 5.875% NC5 perp.24May22 (XS1619422865) which stipulate conversion into ordinary stock, at the average closing price of the last five trading days preceding the delivery of the conversion notice while conversion price is floored at €3.75. Another possible loss-absorbing scheme may be conversion equal to or at fraction of issue price: UK’s Aldermore Group 11.875% NC5.5 perp.20Apr20, GBP (XS1150025549) incorporate different mechanism of conversion into ordinary stock prior to an  initial public offering (IPO) at £1.80 and after IPO the higher of the pre-IPO price or 66% of the final IPO price. Interesting conversion clause is built into HSBC Holdings’ 4.750% NC12 Perp.04Jul29 EUR (XS1640903701): ‘Conversion into ordinary stock at a fixed price of €3.05451, the € equivalent of the initial conversion price of £2.70 (subject to certain anti-­dilution adjustments). At the issuer’s discretion, the bondholders might receive the shares, cash proceeds from the sale of the shares to shareholders

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at £2.70 per share (subject to certain anti-dilution adjustments), or a combination of shares and cash’. (See also Table 1.4 for detailed parameters of this very issue). The Virgin Money’s HLGD 7.875% perp.31Jul19 NC5 (XS1090191864) are ‘written down to 0 on occurrence of trigger event and ordinary shares are issued to or to the order of each security holder equal to the aggregate principal amount of the notes divided by the £35 conversion price (subject to certain anti-dilution adjustments) rounded down to the nearest whole number of shares’. As the number of shares that must be issued upon conversion increases with a decline of the share price, the minimum conversion price would expose investors to a share price risk. As a result of conversion, CET1 amounts will increase by the amount of converted AT1 instruments. Of course, this dilutes the value of the instruments held by existing shareholders. Simultaneously, if the Tier 1 capital ratio falls below a minimum of 6%, under the provisions of CRR Article 92(1)(b) the institution will have to issue new AT1 instruments to replace the converted ones.

1.3.5.4  Principal Write-off Another way to restore the CET1/RWA ratio is to perform a full or partial writedown of the AT1 face value. Although the first PWD CoCo issued by Rabobank in 2010 emerged from a mere lack of ability to issue convertible bonds (resulting from non-listed character of its issuer), the CRR allows listed banks that constitute the overwhelming majority of CoCo issuers to issue PWD CoCos. Of the 165 AT1 instruments outstanding mid-2018, only 64 were equity conversion and the remainder were write-down structures (Knepper, 2018). The purpose of the write-down requirement is loss absorption, so the write-­ down of a principal amount of AT1 hybrid bonds will result in its partial cancellation. Such an action will reduce the debt and boost the capitalization of the institution. That, in turn, will lead to the restoration of the CET1 capital ratio. The write-down procedure is detailed in Regulation 241/2014 Article 21. This regulation applies on a pro rata basis to all holders of AT1 instruments that include a similar mechanism and an identical trigger event. This requirement clearly shows the difference between high-trigger and low-trigger bonds: the occurrence of a high trigger would only result in the write-down of high-trigger bonds, while holders of low-trigger bonds simultaneously suffer no loss. It is worth noting that it is a permanent PWD CoCo that is most similar to CAT bonds, which possessed no temporary write-down feature. A write-down may take various forms: a full write-down, a partial write-­ down and finally a staggered write-down. In the second case, the terms of the

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issue will have to specify the haircut ratio (in case of a full write-down, this ratio is obviously 100%). A staggered write-down was introduced for the first time by Zürcher Kantonalbank in 2012. This feature is more flexible: trigger events result in haircuts that occur in multiples of 25%, up to the point where the required capital is restored. Hence, upon the trigger event, the investor may lose 25%, 50%, 75% or finally even 100% of a CoCo’s nominal value. Although it is not explicitly expressed in the CRR, following 2014, the RTS allowed a write-down to be temporary (i.e. followed by a nominal value write­up). Since then, a typical, permanent write-down component of a CoCo has been systematically losing importance and share in the CoCo market. If a write-down is to be considered temporary, all detailed and rigorous requirements set out in Regulation 241/2014 Article 21(2) have to be met simultaneously: (1) distributions payable after a write-down shall be based on reduced amount of the principal; (2) write-ups shall be based on final profits, that is, profits confirmed in a formal decision taken by the bank; (3) any write-up or payment of coupons on the reduced amount of the principal may be initiated at the full discretion of the bank, and the bank may not be obligated to operate or accelerate a write-up under specific circumstances. These circumstances are set out in CoCos’ terms of issue. The bank’s discretion shall be subject to the following provisions: (4) the write-up shall be operated on a pro rata basis among similar AT1 instruments that have been subject to a write-down; (5) the maximum amount of write-ups and coupon payments on the reduced amount of the principal is determined; and finally (6) the sum of any write-ups and coupon payments on the reduced amount of the principal shall be treated as a payment that results in the reduction of the CET1 and shall be subject to national laws transposing Article 141(2) of CRD IV, imposing restrictions on the maximum distributable amount. In other words, write-up must not cause MDA to be exceeded. Regulation 241/2014 Article 21(2)(e) sets out method of calculation of the maximum amount of write-ups and coupon payments on the reduced amount of the principal:

D = E × AT1 / T1 (1.3)

where: D  – maximum distribution (write-ups and payments of coupon) E  – profit of the institution AT1  – the sum of the nominal amount of all AT1 instruments before write-­ down that were subject to a write-down T1 – the total Tier 1 capital of the institution.

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Pursuant to Regulation 241/2014 Article 21(3), this calculation shall be made at the moment when the write-up is operated. It should also be noted that Regulation 241/2014 Article 21(2)(d) stipulates that write-ups are to be operated on a pro rata basis among similar AT1 instruments that have been subject to write-downs. Hence, if the institution issues both write-down and temporary write-down CoCos, only the last ones would be subject to write-up. In view of the existence of different CoCo triggers, EBA in its report on AT1s explained the question on the calculation of the amount available for the write-up (and thus the length of the write-up period) when there are different net incomes calculated on a (sub-)consolidated or a solo basis (sometimes called the ‘maximum write-up amount’) and when the triggers on the solo and the (sub-)consolidated levels are hit at the same time. EBA states that the available amount can be calculated on the basis of the solo or (sub-)consolidated net income, which is then multiplied by the aggregate original amount of AT1 capital divided by the total Tier 1 capital. For  instance terms and conditions for Bank of Ireland’s 7.735% NC5 perp.18Jun20 (XS1248345461) provide that ‘at the sole discretion of the issuer and subject to MDA, the principal amount of the notes can be written up, pro-rata with similar loss-absorbing securities, if both the issuer on unconsolidated basis and the Group on a consolidated basis report a net profit. The amount of net profits used to write up the notes will be proportional to the original principal amount of all similar loss-absorbing securities divided by the total tier 1 capital of the issuer as of the write-up date’. In its report on AT1s EBA considers that, ‘when there are triggers on the basis of more than one level of solvency, the relevant available amount for the write-up should be the lower amount of the profits (or net income) arising from the different levels. For instance, assuming that the profit calculated on a solo basis is lower than the profit calculated on a consolidated basis, the relevant amount for the purposes of the write-up should be capped at the level of the profit calculated on a solo basis’. It is believed that shareholders should be more motivated to avoid CE trigger events than PWD trigger events, because they will be generally afraid of the dilution of their corporate rights, which—in the extreme scenario—may result in losing control of the financial institution. Besides, the pre-emption right is a marketable financial instrument. One solution would be to require the resolution of a CE CoCo issue to be supplemented with a resolution on the exclusion of the pre-emption rights of shareholders with regard to possible conversion of these CoCos into equity. However, taking into account the BRRD’s contingent conversion provision described further in Chap. 2, we would have to require such a resolution to be taken also with regard to all ‘relevant capital instruments’: PWD CoCos and even Tier 2 financial instruments (Liberadzki and Liberadzki, 2016).

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1.3.5.5  AT1 CoCo Market The AT1 market has grown steadily since the first issuance in 2013 (2012 for Swiss banks). At mid-2018, outstanding AT1 volumes amounted to €141 bn equivalent, spread across 65 issuers with a bulk in USD (50%) and EUR (36%). Over a third of the issuance has been by UK banks. Out of 165 AT1s, 71 (43%) were low-trigger instruments, the remainder 94 were high triggers. Around 60% of the bonds had a write-down structure (mostly partial) and the rest were convertibles (at a fixed or floor share price). Most AT1s carry sub-investment grade ratings at the instrument level, although almost all the banks are investment grade rated at the deposit and senior level (Knepper, 2018). The AT1s become more and more standardized. They differ from one another mainly in terms of non-call period (typically 5–7 years but there are non-calls of 10, 12 and 15 years), frequency of subsequent calls (ranging from five years to one year, quarterly, one month or even ‘anytime’ calls) and precise conversion/write-down terms. Issuing banks use their own terms and conditions which does not facilitate comparison between various AT1s. Without too much exaggeration, one can say that there are no two identical AT1 perpetuals on the market. Further standardization would be of assistance to all market participants as well as supervisors. With regard to unfirming the prudential side of provisions, the EBA published on 10 October 2016 standardized templates for AT1 to help banks conform with CRR. The variety of CoCo instruments can be observed from Table 1.4. Some 60% of the AT1s are rated sub-investment grade or are unrated. All three big rating agencies rate them predominantly at one notch below the issuer’s other subordinated debt and up to five notches below the issuer’s senior debt: usually a two notch reduction is for conversion/write-down risk, and another three notches for the coupon cancellation. Usually AT1s are rated in the BB (Ba) range and no higher than BBB (Baa2). With regard to the supply forecast for the AT1 market, the most efficient capital structure is for banks to issue AT1s of at least 1.5% of their risk exposure. As mentioned earlier, important aspect of the ECB’s SREP methodology for eurozone banks is its calculation of the combined buffer requirement (CBR) to determine the MDA (limiting a bank’s ability to pay common dividends, AT1 coupons and staff bonuses). The calculation takes account of any CET1 capital that has to be used to cover a shortfall in AT1 and Tier 2 capital in order to meet minimum capital requirements (Tier 1 of 6% and Total of 8%). The most efficient capital structure is therefore for banks to issue AT1 capital to cover the 1.5 pp difference between CET1 and overall Tier 1 requirements, and Tier 2 capital to cover the 2 pp difference between Tier 1 and total

6.0% 5.5% 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0%

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Potential as % RWAs

1.5% RWAs

Erste Group Bank Raiffeisen Bank Int'l Belfius Bank KBC Group Danske Bank Nykredit Group BNP Paribas BPCE Crédit Agricole Group Crédit Agricole S.A. Société Générale Commerzbank Deutsche Bank Allied Irish Bank of Ireland Banca MPS Banco BPM Intesa Sanpaolo UniCredit ABN AMRO ING Group Rabobank DNB Banco Sabadell Bankia BBVA CaixaBank Santander Nordea SEB Svenska Handelsbanken Swedbank Credit Suisse UBS Barclays HSBC Holdings Lloyds Banking Group Nationwide Royal Bank of Scotland Group Santander UK Group Holdings Standard Chartered

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Fig. 1.6  AT1 capital fulfilment of major European banks 1Q2018. Calculation for UK Banks is following: 1.5% RWAs + AT1 Pillar 2. For Swiss CS and UBS: high-trigger, 1.5% leverage exposure (see Sect. 4.2.1  of Chap. 4 for details  on Swiss capital adequacy rules). Source: CreditSights

capital requirements. This avoids having to use CET1 capital for those purposes, which would then not be available to meet the bank’s CBR. On this basis, an eventual market of €200–250  bn equivalent is predicted, which means that a further issuance of roughly €60 bn equivalent is to be expected (Knepper, 2018). This calculation is simplified as it doesn’t take into consideration refinancing of any existing issues that are called neither includes phasing-­out of legacy Tier 1s. Most of this will come from banks that have already issued AT1s, however, as presented in chart (Fig.  1.6) a few major banks still have to fill the AT1 capital layer up to the 1.5% prescribed. Figure 1.6 shows the amount of AT1 capital composed both of new-style and AT1 instruments subject to phase out, net of regulatory deductions by selected major EEA banks.

1.3.5.6  Distance to Trigger ‘Distance to trigger’, that is the difference between the bank’s current CET1 capital ratio and the write-down or conversion trigger in the instrument, is the vital metric for AT1 securities holders. For the UK, Swedish and Norwegian

57

1  Contingent Convertibles Issued by EEA Banks  25.00%

60,000

50,000

20.00%

40,000 15.00% 30,000 10.00% 20,000 5.00%

Caixa Geral Bank of Ireland Santander UK Belfius Bank Raiffeisen Bank Int'l Nykredit Group Banco Sabadell Swedbank SEB SHB Bankia Allied Irish Nationwide Erste Group Bank KBC Danske Bank Caixabank ABN AMRO DNB Nordea Credit Suisse UBS Standard Chartered Lloyds Rabobank Crédit Agricole S.A. RBS Barclays Société Générale Intesa Sanpaolo BBVA ING Group UniCredit Deutsche Bank Crédit Agricole Group Santander BNP Paribas HSBC

0.00%

10,000

€mn (right axis)

0

% (left axis)

Fig. 1.7  Distance to trigger of the major European banks at end-2017. Calculations based on transitional CET1 levels. UK, Norwegian and Swedish banks operate on fully loaded CET1 levels. Source: CreditSights

banks, the CET1 transitional and fully loaded data are the same, as those countries implemented the capital rules immediately without a transitional period. Therefore these banks tend to have a smaller than average distance to trigger, though this gap with other European banks should narrow as regulatory adjustments are phased in. Additionally, the AT1 issued by UK banks are high triggers only which is another reason for relative smaller CET1 cushion. Figure 1.7 presents distance to trigger of 40 major European banks at the end-2017. All the banks presented have comfortably thick CET1 cushions in both, relative and number terms. Deutsche Bank (DB) so plagued with low ADI, had a distance to trigger of €33,213 mn (9.67%), more than enough to absorb any possible losses. Note that all the DB’s perpetuals are low triggers. A good indication, how well would be bank’s CET1 capital ratio preserved in stressed conditions is offered by the 2016 EU-wide stress test. It included 51 banks in 15 countries, 37 of them were supervised by the ECB.33 It was led  The ECB also conducted a parallel stress test of an additional 56 banks under its direct supervision, using the same methodology. This was an internal supervisory exercise conducted by the ECB, which did not publish the results, although some banks chose to publish their own results. 33

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by the EBA, which developed the methodology for the exercise, and the aim was to analyse how a bank’s capital position would develop on the basis of end-2015 data over a period of three years until 2018, under both a ‘baseline’ and an ‘adverse’ scenario. The stress test assumed a static balance sheet (including leverage exposure) over a period of three years until 2018, under both a baseline and an adverse scenario. The adverse scenario reflects the four systemic risks that are considered to be the most material threats to the stability of the EU banking sector: (1) an abrupt rise in currently low global bond yields, amplified by low secondary market liquidity, (2) weak profitability prospects for banks in a low nominal growth environment amid incomplete balance sheet adjustments, (3) rising debt sustainability concerns in the public and non-financial private sectors amid low nominal growth, and (4) prospective stress in a rapidly growing shadow banking sector, amplified by spillover and liquidity risk. Banks had to stress their credit risk, market risk, sovereign risk, securitisation and cost of funding. The stress test applied to both trading and banking book assets, including off-balance sheet exposures. The weighted average transitional CET1 ratio capital of the 51 banks included in the stress test at 31 December 2015 was 14.9%. The aggregate impact of the adverse scenario was 428 bp for the transitional CET1 ratio (reducing the average ratio to 10.6%). Taken individually, Monte dei Paschi was the clear outlier, with transitional CET1 ratios under the adverse scenario of −2.2%. Apart from Monte dei Paschi, only Raiffeisen Landesbank Holding was clear below 7% trigger level with its adverse scenario transitional CET1 ratio of 6.15% (see Fig. 1.8). Presumably, this observation stays behind the bank’s decision on issuing low-trigger AT1s in June 2017 and January 2018. With regard to the DB suffering from low ADIs, its transitional CET1 ratio fell from 13.2% to 7.8% under adverse scenario, so well above 5.125% trigger level. On 2 November 2018, the EBA published the results of the 2018 EU-wide stress test, which involved 48 banks from 15 EEA countries, covering broadly 70% of total EU banking sector assets. The methodology, in line with the 2016 approach, is based on constraints including a static balance sheet assumption but with adjustments to incorporate the implementation of IFRS 9 (International Financial Reporting Standard ‘Financial Instruments’) (see next section). The weighted average transitional CET1 ratio capital of the 51 banks included in the stress test at 31 December 2017 was 14.5%. The aggregate impact of the adverse scenario was 419 bp for the transitional CET1 ratio (reducing the average ratio to 10.1%). No one bank fell below 7% trigger level in adverse scenario. German Nord LB with adverse 2020 CET1 ratio of 7.07% is the worst performer (see Fig. 1.9).

-5.0% Monte dei Paschi Allied Irish Banco Comercial Português Raiffeisen-Landesbanken-Holding Bank of Ireland Banco Popular UniCredit Barclays Commerzbank Société Générale Deutsche Bank Criteria Caixa Erste Bank Banco Sabadell RBS Rabobank BBVA Santander BayernLB CaixaBank BNP Paribas NordLB HSBC Holdings UBI Banca ING Groep Banco Popolare OTP Bank LBBW BPCE ABN AMRO DekaBank VW Financial Services BFA (Bankia) La Banque Postale Helaba Lloyds Banking Group Intesa Sanpaolo Crédit Agricole Group KBC Group Belfius Bank PKO Bank Groupe Crédit Mutuel Nykredit Realkredit Jyske Bank Danske Bank Nordea DNB Bank Group OP Osuuskunta SEB Bank Nederlandse Gemeenten Svenska Handelsbanken Swedbank NRW.Bank

0.0%

35.00%

0.00%

NordLB Barclays Société Générale Deutsche Bank La Banque Postale UBI Banca Banco Sabadell Erste Bank Banco BPM Lloyds Banking Group BNP Paribas DZ Bank CaixaBank BBVA UniCredit HSBC Holdings Bayerische LB Santander Raiffeisen Bank International Commerzbank RBS LB Hessen-Thüringen Crédit Agricole Group Intesa Sanpaolo BPCE LBBW ING Groep Bank of Ireland Rabobank Jyske Bank Danske Bank OTP Bank Belfius Bank Groupe Crédit Mutuel KBC Group Allied Irish ABN AMRO DNB Bank Group OP Osuuskunta Bank PEKAO Nykredit Realkredit PKO Bank SEB Nordea Svenska Handelsbanken Swedbank BNG Bank NRW.Bank

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2015

Baseline 2020

Adverse 2018

Adverse 2020

5,125%

5.125%

59

45.0%

40.0%

35.0%

30.0% 7%

25.0%

20.0%

15.0%

10.0%

5.0%

Fig. 1.8  EBA 2016 EU-wide stress test*: Transitional CET1 ratio: (1) in 2015 beginning and (2) under adverse scenario in 2018. *Banco Comercial Português and CaixaBank were not included in the stress test but published their own results separately. Source: Own study

45.00%

40.00%

30.00% 7%

25.00%

20.00%

15.00%

10.00%

5.00%

Fig. 1.9  EBA 2018 EU-wide stress test: Fully loaded CET1 ratio: (1) under baseline scenario in 2020 and (2) under adverse scenario in 2020. Source: Own study

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Another question is that any erosion of a bank’s capital cushion might not only be the result of the bank’s capital declining whether as a result of making losses or for other reasons. It could also be affected by a change in the denominator, risk-weighted assets (RWAs). Changes in regulation, such as the ongoing review of trading book positions by the Basel Committee or a reassessment of risk weights for certain types of asset (e.g. the application in the UK of higher risk weights for commercial real estate and a higher LGD (loss given default) floor for sovereign exposures), could have a significant impact on capital ratios. Nationwide Building Society, which has the biggest distance to trigger of 23.49% is followed by Nordic banks in terms of the thickest CET1 cushions (see Fig.  1.7). These banks take advantage of low mortgage risk weight application which is reflected in their low RWAs/total assets ratio (see Fig. 1.10). In 2018, the Swedish supervisor (FSA) proposed amendments to the current mortgage risk-weight application for Swedish banks which will result in increase in reported risk-weighted assets. 70% average 60% 50% 40% 30% 20%

0%

Nationwide Sv Handelsbanken Swedbank Crédit Agricole S.A. Danske Bank Nordea Deutsche Bank Nykredit Group SEB Lloyds Banking UBS ABN AMRO RBS Barclays Santander UK SocGen Crédit Agricole Group Belfius Bank BPCE KBC Group BNP Paribas Rabobank Credit Suisse HSBC Holdings Banco Sabadell Intesa Sanpaolo ING Group Bank of Ireland Commerzbank DNB CaixaBank Bankia Santander Standard Chartered UniCredit Banca MPS Banco BPM Erste Group Bank BBVA Raiffeisen Bank Int'l Caixa Geral BCP Allied Irish

10%

Fig. 1.10  Major European banks’  RWAs/total assets (%) at end-2017. Source: CreditSights

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1.3.5.7  I mpact on Banks’ CET1 Capital of New Basel IV and IFRS 9 The increase of RWAs is to come for the other European banks with the implementation of Basel IV. Basel Committee has undertaken the various reviews of risk weights and of the calculation of RWAs. Basel IV serves to limit the use of banks’ own models, in particular for assessing operational risks, securitisation exposures and risks in large exposures to corporates and financial institutions and equity exposures. An output floor is to be set at 72.5% of the banks’ RWAs calculated under the standardized approach, which will have the most material implications for banks that have set the RWAs on key asset classes such as residential mortgages to very low levels. The schedule for the changes to come into effect is 2022, with a five-year transition for the 72.5% output floor, starting at 50% in 2022, then rising 5% points each year until 2026 then moving to 72.5% as of 1 January 2027. The Basel IV with its 25% mortgage risk-weight floor will impact the most banks with large mortgage portfolios such as the Nordic ones. It has also been agreed to add a buffer to the leverage ratio for the G-SIBs and this is to be set at half of the G-SIB buffer added to their CET1 ratio. For example, if a bank’s CET1 buffer is 1%, then the buffer on the leverage ratio will be 50 bp, raising the minimum requirement (depending on the jurisdiction) from 3% to 3.5%. For Deutsche Bank the requirement would be 4% (3% + 1%) (Raymond et al., 2017). The EBA’s Cumulative impact assessment of the Basel reform package of December 2015 suggests that the Basel IV effects will be relatively modest. It reckons the reforms will increase the Tier 1 capital requirement for major European banks (‘Group 1’) by 14%, reducing the CET1 ratio by 70 bp on average, which translates into a CET1 shortfall of around €13 bn. However, the impact study is based on end-2015 capital, so this shortfall could have been largely eliminated in the three years since then. The regulators have specifically stated that their aim is not to increase the overall level of capital in the system. The Basel Committee’s impact assessment of December 201734 suggests large banks globally will see an uplift of 20 bp in CET1 capital. The aim is rather to remove outliers and achieve more consistency in the assignment of risk weights that will restore credibility. The banks will also have time to adapt to the new rules as the end of transition period is ten years away (Raymond et al., 2017).  Basel III Monitoring Report, Results of the Cumulative Quantitative Impact Study, Bank for International Settlements, The Basel Committee on Banking Supervision, December 2017. 34

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Most banks will report a decrease in equity when IFRS 9 (International Financial Reporting Standard ‘Financial Instruments’) is implemented (1 January 2018) because of the need to increase loan loss reserves. IFRS 9 ‘Financial Instruments’ was published in July 2014 by the International Accounts Standard Board and adopted by the European Union through Ruling 2016/2067 of 22 November 2016. This standard replaces IAS 39 (International Accounting Standards) and will be introduced from 1 January 2018. IFRS 9 represents a change from an incurred loss model to a forward-looking expected credit loss (ECL) model, that is, the carrying value of loans on the balance sheet should at any point in time reflect the amount of credit losses that are to be expected over 12 months or the lifetime of the loans. For financial assets where credit risk has not increased significantly since initial recognition (classified to Stage 1) entities are required to recognize 12-month ECL and recognize interest income on a gross basis—this means that interest will be calculated on the gross carrying amount of the financial asset before adjusting for ECL. Stage 2 is where credit risk has increased significantly since initial recognition. When a financial asset transfers to stage 2 entities are required to recognize lifetime ECL but interest income will continue to be recognized on a gross basis. Stage 3 is where the financial asset is credit impaired. This is effectively the point at which there has been an incurred loss event under the IAS 39 model. For financial assets in Stage 3, entities will continue to recognize lifetime ECL but they will now recognize interest income on a net basis. This means that interest income will be calculated based on the gross carrying amount of the financial asset less ECL. The EBA, in its Report on Results From the Second EBA Impact Assessment of IFRS 9 published on 13 July 2017 estimated an average impact on CET1 capital of 45 bp for European banks. So the impact on CET1 capital is relatively modest as new standard is phased in over five years and banks already make a deduction from regulatory capital for expected losses in excess of loan loss reserves, although the calculation of expected losses for regulatory capital purposes differs from under IFRS 9. The EBA’s 2018 EU-wide stress test takes into account the impact of the implementation of IFRS 9 (as of 1 January 2018). According to the 2018 stress tests results, the negative impact of IFRS 9 first implementation on banks’ aggregate CET1 capital ratio is −20 basis points (bps) on a fully loaded basis, −10 bps on a transitional basis.

1.3.5.8  EU Banks’ Capital Outlook As it was presented in Fig. 1.7 in Sect. 1.3.5.6 European banks’ CET1 ratio levels lie comfortably above the CoCo trigger level. The risk of CoCo triggering takes a backseat to other risks, mainly coupon cancellation and call

63

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e­ xtension risk. Under the Basel III regime (translated into EU law with CRR/ CRD IV having entered into force on 1 January 2014), all European banks have significantly improved their capital positions only with a few exceptions (of one Spanish and three Italian banks, described further in Sects. 2.7.4 and 2.8 of Chap. 2). According to EBA, CET1 ratio of the EU banks has increased in years 2014–2017 by 230 bps to a weighted average of 14.8%. All banks have a CET1 ratio above 11% (asset share of banks in 2014: 59%). The exact change of CET1 ratio with distribution to each EU member state is presented on Fig. 1.11. Increase in the ratio was mainly driven by the RWA decrease (which contributed to 57% of CET1 ratio increase since 2014). Since 2014 the CET1 increased by 7.3% and RWAs decreased by 9.2% (see Fig. 1.12). All RWA-components have declined in volume since 2014. The main driver of decreasing RWA is the reduction of credit risk. The biggest component, credit RWA, has declined by around 8%. Market and operational RWA have declined by 13.0% and 4.7%, respectively (see Fig. 1.13). This comes in parallel to a decrease in total assets (decline of about 3.2%). However, loans (gross carrying amount) have increased by about 11.6% during the same period. According to EBA data, NPL (non-performing loans) ratio decreased from 6.5% in 2014 to 4% in 2017 (see Fig.  1.14). In absolute terms the NPLs decreased from more than EUR 1.2 Tn to EUR 813 bn. In three years the

35% EU 30% 25% 20% 15% 10% 5% 0%

EE SE FI LV HR LU BG IE LT SI DK RO CZ GR BE MT NL DE PL NO SK GB FR AT CY HU PT IT ES

Fig. 1.11  CET1 ratio in EU countries at end-2017. Source: EBA

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110

CET1 +7%

108 106 104 102 100 98

RWAs -9%

96 94 92

Dec-17

Sep-17

Jun-17

Mar-17

Dec-16

Sep-16

Jun-16

Mar-16

Dec-15

Sep-15

Jun-15

Mar-15

Dec-14

90

Numerator: CET1 capital Denominator: Total risk exposure amount Fig. 1.12  CET1 ratio developments (numerator and denominator) from 2015 to 2017. Source: EBA

12.5 12.0 11.5 11.0 10.5 10.0 9.5 9.0 8.5 8.0 2014 Credit risk

2015 Securitisation

2016 Market risk OpRisk

Fig. 1.13  RWAs developments by type of risks (in EUR Tn). Source: EBA

2017 Other

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65

7% 6% 5% 4% 3% 2% 1% 0%

Non-performing - Unlikely to pay that are not past-due or past-due 90 days 1 year

Fig. 1.14  NPL ratio developments. Source: EBA

share of NPLs more than 90 days and less than 1 year past due decreased from 16% to 12% (explaining the lower inflow of NPLs). The share of NPLs more than 1 year past due slightly increased from 49% to 51%. The share of unlikely to pay (UtP) NPLs increased from 35% to 37%.

1.3.6 CoCos and the Cost of Capital From investors’ point of view, CoCo bonds provide the safety of bond during prosperous times capping the maximum possible payoff to the face value of the bond. In bad times, however, the payoff will decrease as the share price drops. As a result, CoCos predominantly expose investors to downside risk, while their maximum value is restricted to the face value and the coupons. The CoCos limited gain potential together with investor’s exposure for high losses result in relatively high coupons for investors (see Table 1.4), which is well visible comparing to cost of other bonds (see Figs. 1.15 and 1.16). The higher interest rate paid by the issuer on contingent capital may be deemed as an equivalent to ‘bank tax’ to offset bail-out costs (Coffee Jr, 2011). As far as an institution’s solvency is concerned, contingent convertibles deliver two counter effects. When things go wrong, CoCos are automatically

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Fig. 1.15  Yields* of Banco Bilbao (BBVA) euro-denominated international bonds as on 17 May 2016. *Yields quoted according to yield to maturity (YTM) convention. In case of bonds embedding call option, yield to first call date was used. Source: own analysis based on Cbonds data

Fig. 1.16  Yields* of Danske Bank euro-denominated international bonds as on 17 May 2016. *Yields quoted according to yield to maturity (YTM) convention. In case of bonds embedding call option, yield to first call date was used. Source: own analysis based on Cbonds data

converted into issuer’s common equity or just wiped out: in both cases debt is reduced. Much higher coupons of CoCos relative to straight bonds make CoCos issuers less resilient. Jaworski and Liberadzki (2017b) investigated when the CoCos’ loss-absorption capacity offsets higher cost of coupon in terms of reducing risk of bank’s insolvency. They proposed to measure the issuer’s default risk with a Value-at-Risk (VaR) method given alpha ­significance

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Fig. 1.17  Spreads (bp) of major eurozone banks’ selected bonds Aug 2012—Mar 2018. Source: EBA

level. Issuing CoCos makes sense (that is: improves issuer’s solvency) only if they are structured so that the probability of the triggering is more than the alpha significance level. This rule also holds when Expected Shortfall is used as default risk measure. The theorem is valid for any spread (the difference between coupon of CoCo and of straight bond) less than 100%. Apparently, the past and present spread values observed on the market do not exceed the value of 100% (see Fig. 1.17). The conclusion is that whenever the probability of contingent conversion is high enough, the issuer’s default risk will be reduced irrespective of cost disadvantage of CoCo bonds in comparison to straight bonds. However, the most important comparison is the one between AT1 and CET1 items. Since the AT1 CoCos are categorized as an own funds’ item, the main dilemma of every bank would be in what items should be a bank’s minimum TCR of 8% RWAs fulfilled. It would be either common shares (preferred shares only to limited extend—see Sect. 1.2.8) or AT1 perpetuals up to the filling of 1.5% bucket. The current practice shows that banks prefer CoCos to shares (see Fig. 1.6) and only a few major banks still have to fill the AT1 capital layer up to the 1.5% prescribed. At present, more and more medium-sized banks tap into AT1 market. The advantages of issuing AT1 capital are clear for banks: besides qualifying as regulatory capital, they offer better capitalization without dilution. As they form part of Tier 1 capital, they reduce bank’s leverage exposure both, for regulatory and credit rating purposes. At the same time, AT1s’ coupons are tax deductible, but this may soon

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change in view of EC’s pressure on Dutch authorities to change tax classification of CoCos. Investors in contingent capital facilities in turn, may prefer consistent and high coupon payments to equity stakes. In fact, they anticipate that the triggers will never be reached and therefore enjoy a relatively high coupon that embody the option to convert the bond into equity. Another argument pro CoCos is that, by setting a price for a contingent equity issue in advance, the issuer can reduce the Myers-Majluf effect of managers likely to issue new equity when they have adverse private information suggesting that the market has overvalued the stock of the company (Bolton & Samama, 2012). It is used to call the AT1 CoCos ‘the cheapest equity’. However, there is no clear evidence that perpetuals are definitely more cost-efficient solution than equity (Bundesbank, 2018). It may happen that AT1s rank ahead CET1 capital in hierarchy of absorbing losses on an ongoing basis. Suppose that there is a substantial possibility of CoCo 7% trigger breach before reaching the point of non-viability (PONV).35 In other words, a full and permanent write-down at a 7% CET1 ratio could effectively overturn the normal creditor hierarchy by imposing 100% losses on CoCos ahead of shareholders. These instruments would be therefore much higher risk than dated subordinated debt. The lack of ‘dividend stopper’ mechanism banned by CRR may deliver another proof for ‘subordination paradox’ in case a bank decides to pay share dividends out of its DIs ahead of AT1 coupon payments. The question is how much banks have to pay investors to take on these risks. On the basis that high-trigger CoCos are arguably higher risk than equity, suffering losses at an earlier stage and with no upside at least for write-­ down rather than convertible CoCos—the yield should be seen in the context of a bank’s return on equity (RoE), estimated by EBA for European banks to be around 6.1% at end-2017 (see Fig. 1.18).36 On the other hand, the risk on low-trigger CE CoCos would be substantially lower, not much different from ‘bail-inable’ Tier 2 issues. According to EBA, the AT1 CoCos yielded around 5.4–5.6% at Q1 2018 (see Fig. 1.20), which is slightly below banks’ end-2017 RoE. Besides, It must be noted that since the outbreak of the great financial crisis, the cost of equity (CoE) which denotes the rate of return on bank equity required by investors has been permanently lower than RoE (EBA, 2016).37 The European Banking Authority  For more on PONV trigger please refer to Sect. 2.6 of Chap. 2.  1. Risk Assessment of the European Banking System, European Banking Authority, November 2017. 2. Risk Dashboard. Data as of Q4 2017, European Banking Authority. 37  Risk Assessment of the European Banking System, European Banking Authority, December 2016. 35 36

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Fig. 1.18  Banks’ RoE (weighted average by country) at end-2017. Source: EBA

Fig. 1.19  Cost of capital assessment. European banks’ long-term sustainable profitability targets (left panel—July 2018 EBA questionnaire). ROE targets large euro area banks (right panel—2018–2021 horizon). Notes: left panel: The results are taken from the EBA’s Risk Assessment Questionnaire, which reports the responses from banks and market analysis. Right panel: Based on 21 large euro area banks. The targets have been collected from banks’ business and strategic plans. Source: EBA, individual bank disclosures and ECB calculations following the ECB (2018)

publishes on regular basis outcomes of survey regarding the level of RoE needed to operate on a longer-term basis. The European Central Bank reaches similar cost of capital estimates as the EBA (Fig. 1.19-right).38  ECB surveillance note on risk and vulnerabilities for the EU financial system, European Central Bank, Directorate General Macroprudential Policy and Financial Stability, 29 November 2018. 38

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Fig. 1.20  AT1 index (mid-yield in %). Source: EBA

Low bank profitability together with the increase of the CET1 capital (as the latter has been demonstrated in Sect. 1.3.5.8) leads to a dramatic decrease of bank profitability ratios. As the law forbids issuing new shares below nominal value to raise the RoE, it comes hard for the institutions to raise the required amount of own funds in CET1 instruments only. Another evidence for proximity of AT1s to equity in the creditor waterfall is the correlation between AT1 spreads and bank equities since the beginning of 2016 at 90% (excluding Banco Popular; fell to 83% if included) (Knepper & Adamson, 2017). Alternative for CET1 and AT1 instruments to improve banks’ capital position would be synthetic securitization. According to Regulation 2017/240239 Article 2(10) ‘synthetic securitisation’ means a securitisation where the transfer of risk is achieved by the use of credit derivatives or guarantees, and the exposures being securitised remain exposures of the originator. Neither CRR rules nor CRR II proposal (only with some exceptions) do not provide supervisory approval as requisite for use of synthetic securitization to reduce credit risk component of a banks’ capital requirement. The only case a supervisor can intervene is when the law has been applied incorrectly. There are hardly any data concerning cost of financing via synthetic securitization. The synthetic securitization market, once so huge, went almost into non-existence  Regulation (EU) 2017/2402 of the European Parliament and of the Council of 12 December 2017 laying down a general framework for securitization and creating a specific framework for simple, transparent and standardized securitization, and amending Directives 2009/65/EC, 2009/138/EC and 2011/61/EU and Regulations (EC) No 1060/2009 and (EU) No 648/2012. 39

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since 2009. To our best knowledge, there were 39 transactions across Europe in 2017, initiated by 19 entities. However, a revival of this form of financing is to be expected in the longer run: According to Regulation 2017/2402 Article 45(1), by 2 July 2019, the EBA, in close cooperation with European Securities and Markets Authority (ESMA) and European Insurance and Occupational Pensions Authority (EIOPA), shall publish a report on the feasibility of a specific framework for simple, transparent and standardized synthetic securitization, limited to balance sheet synthetic securitization. By 2 January 2020, the EC shall, on the basis of the EBA report submit its own report to the European Parliament and the Council, together with a legislative proposal, if appropriate (Regulation 2017/2402 Article 45[2]).

1.3.7 Offering CoCos The first CoCo issues were sold heavily to the private banks representing primarily Asian private investors, followed by hedge funds and private banks from Europe and the US.  Buyers today are mostly real money accounts— most of the large asset managers in Europe, the US and Asia. Banks do not buy CoCos as the CRR Article 56(1)(c) and (d) orders an institution to deduct from its own AT1 items ‘direct, indirect and synthetic holdings by the institution of the Additional Tier 1 instruments of financial sector entities’. It is not clear however if the European banks and insurers purchase AT1s via other entities, ex. foreign branches (Bunesbank, 2018). On August 2014, the UK Financial Conduct Authority (FCA) restricted the retail distribution of CoCos to sophisticated or high net worth investors. According to the FCA, ‘CoCos are risky, highly complex financial instruments. The FCA believes they are unlikely to be appropriate for ordinary retail investors’ (Selby, 2014). The FCA warned that investors might be drawn in by the ‘high headline returns’ available through CoCos but might find coupon payments ‘extremely difficult’ to properly assess because of the transition from debt to equity (Morris, 2014). In line with Directive 2014/65/EU40 (MiFID II) Article 25(10), ESMA in its Guidelines on complex debt instruments and structured products (ESMA /2015/1787) classifies both CoCos and callable bonds (together with convertibles and exchangeable bonds) as ‘complex’ debt instruments because they ‘embed a derivative’. Separately, ESMA sets out types of debt instruments that are deemed to be ‘complex’ by virtue of ‘structure making it difficult for the  Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU. 40

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client to understand the risk’. These are, inter alia: (1) subordinated debt instruments, (2) ‘debt instruments with issuer discretion’ (regardless of whether or not it may be deemed to embed a derivative), (3) perpetual bonds, and (4) debt instruments structured in a way that may not provide for a full repayment of the principal amount—this category is exemplified by ESMA as ‘debt instruments eligible for bail-in tool purpose’. ‘Issuer discretion’, emphasized by ESMA ‘Issuer discretion’, emphasized by ESMA in (ii), addresses instruments where under the terms and conditions an issuer enjoys the right to modify significantly the cash flows related to the security, for example the payment of interest (regardless of whether or not it may be deemed to embed a derivative). The latter category is exemplified by ESMA as a de facto PWD CoCo mechanism. It seems that this classification of CoCos is congruous with ESMA’s earlier assessment of risk associated with investing in CoCos  (statement on potential risks associated with investing in CoCos, ESMA/2014/944), where the following risks were identified: • Trigger level risk, associated with CET1 ratio trigger volatility; • Coupon cancellation (i.e. non-cumulative deferral with no dividend stoppers/pushers); • Capital structure inversion risk: as ESMA explains, contrary to classic capital hierarchy, CoCo investors may suffer a loss of capital when equity holders do not; • Call extension risk: the investor may not receive return of principal if expected on call date or indeed at any date; • Unknown risk: the structure of the instruments is innovative yet untested; • Yield/valuation risk. According to ESMA ‘Yield has been a primary reason this asset class has attracted strong demand, yet it remains unclear whether investors … have fully considered the risk of conversion or, … coupon cancellation’. With regard to CoCos, bank regulatory incentives partially clash with investor protection concerns. ESMA uses CoCos as an example of instruments being suitable only for a narrow target market under the MiFID II regime. The 2012 Liikanen Report to the European Commission on banking sector reforms strongly supported banks being required to issue bail-in instruments such as CoCos. To limit the interconnectedness of the banking system, it also recommended that these bail-in instruments be held by non-bank institutional investors, explicitly singling out life insurance companies as such investors alongside investment funds (Sui-Jim, 2015).

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1.4 Tier 2 CoCos 1.4.1 Tier 2 Capital Eligibility Items that qualify as Tier 2 financial instruments provide loss absorption as ‘gone-concern capital’ when the issuer is facing bankruptcy. Then, holders of such instruments will carry the burden of financial losses to a greater extent than other senior creditors. That is why Tier 2 items constitute a category of own funds. Simultaneously, these instruments possess less equity-like features in terms of maturity and deferral. It is worth noting that Tier 2 capital may consist of a broader list of items than AT1: subordinated loans are also potentially Tier 2 eligible, and—to some extent and in specified circumstances— general credit risk adjustments, gross of tax effects or positive amounts and gross of tax effects resulting from the calculation of expected loss amounts (CRR Article 62). Capital instruments and subordinated loans qualify as Tier 2 instruments if they have an original maturity of at least five years (CRR Article 63[g]) and any call options are exercisable at the sole discretion of the issuer or debtor, as applicable, subject to conditions specified in Article 77 and Article 78(4) CRR. Thus, an investor may not be granted with a put option, nor be accorded the right to accelerate the future scheduled payment of interest or principal, except in the case of an insolvency or liquidation proceeding (CRR Article 63[l]). Again, provisions governing the instruments or subordinated loans may not include any incentive for their earlier redemption or repayment. It should be noted that the nature and scope of such an incentive is not specified further, and there are no EBA regulatory technical standards on this matter. In particular, prohibited incentives set out in EC Delegated Regulation 241/2014 are applicable only for the purposes of AT1 instruments (see Sect. 1.3.3.1). Therefore, it remains unclear as to what extent one can rely on EBA findings regarding the nature and scope of AT1 instruments when structuring the Tier 2 instrument. Generally speaking, it is questionable whether the provision qualified as a prohibited incentive with regard to an AT1 instrument. Indeed, it may be qualified in a different manner when contemplated with regard to a Tier 2 instrument, as the nature and scope of discussed incentives seems to be homogenous for both instruments. On the other hand, the absence of detailed guidance from the EBA on this matter may imply that a more liberal approach is permitted when discussing Tier 2 instruments. This question remains ambiguous and unresolved, and the only conclusion may be that there is a significant probability that provisions

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­ rohibited under the AT1 regime would also be prohibited under the Tier 2 p regime, but it is impossible to exclude any exemptions. Finally, indications with regard to possible call, redemption or repurchase of the instruments are also limited (CRR Article 63[j]–[k]).

1.4.2 R  egulatory Amortization of Tier 2 Financial Instruments The absence of a perpetual maturity requirement means that Tier 2 instruments—and, of course, subordinated loans as well—will have a fixed maturity date. Therefore, the closer the maturity date is for a given item, the lesser the support for the calculation of the issuer’s own funds. Here is where the CRR mechanism of amortization of Tier 2 instruments or subordinated loans is put in place. Pursuant to Article 64, during the last five years of maturity only a calculated part of the nominal value of a given instrument is considered to be eligible for Tier 2 purposes. The model of calculation is simple: the nominal amount is divided by number of calendar days in the period of said five last years of the instrument’s maturity (that is, 1826 or 1827 calendar days), then multiplied by the number of remaining calendar days of contractual maturity. This means that in that period, the exact sum of own funds will be different each day. In case of a Tier 2 bond or subordinated loan with a maturity of only five years (the minimum maturity permitted under the CRR Article 63[g]), the amortization mechanism will start its work on the very day of the bond issue. It is also important to note that any call mechanism is irrelevant for amortization purposes, as it may not be certain that such a call is exercised by the issuer. There is no place for ‘synthetic maturity’, and that is why mechanism of amortization is not taken into account at all when it comes to AT1 financial instruments. To avoid the increasingly limited recognition through the amortization mechanism, the most common format of Tier 2 bonds is ‘10NC5’ which of course means that their maturity equals ten years, with an option for the issuer to call the notes after five years have passed.

1.4.3 Contingent Conversion (Write-Down) Instruments or subordinated loans that are eligible for Tier 2 purposes under CRR are not required to be convertible on a contingent basis. There is also no obligation for the write-down clause. Only Swiss regulations recognize separate Tier 2 CoCos category (see Sect. 4.2.1 of Chap. 4). The absence of

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the conversion clause seems to be natural, given that list of possible Tier 2 items is far broader than AT1 items and covers more items than financial instruments that could be potentially converted into CET1. Thus, all Tier 2 instruments may be issued on an indirect basis, provided that the issuer (SPV) will be consolidated and proceeds will be immediately available to the financial institution (Article 63[n]). The same applies to subordinated loans raised indirectly. Banks tend not to issue convertible CoCos as they restrict the number of potential buyers, with many fixed income investors unable to buy convertible securities. Banks are also inclined to avoid securities that might dilute their existing shareholders. Nevertheless, we may find many outstanding instruments labelled as Tier 2 CoCos. Some of Tier 2 CoCos were issued before publication of CRD IV or even before publication of Basel III. Instruments issued in a time of uncertainty over the regulatory treatment of AT1 securities and structured on the basis of draft standards have not been called by their issuers, simply because they met requirements of Tier 2-eligibility, finally set out in BaseI III and CRR. Therefore, issuers have reached their goal of meeting capital requirements, and today they are still not able to replace these Tier 2 CoCos with new Tier 2 bonds, stripped of a contingent conversion mechanism, because of a non-call period still pending. A contingent conversion mechanism is unnecessary because it is not required by the CRR. However, it may have been necessary at the time of issue, because it was required by national regulators providing financial institutions with public aid. ECNs issued by Lloyds in 2009 in exchange for existing hybrids serve as an example (see Sect. 1.2.6). They were in many ways the original CoCos, with what now looks like a very low trigger: a Basel 2 Core Tier 1 ratio of 5%. Different motivations stood behind the decision made by Danish mortgage lender, Nykredit, to issue Tier 2 rather than AT1 CoCos as a cheaper option. It prioritized the ratings benefits over the regulatory advantages—it obtained full equity credit from S&P.41 The absence of costly AT1-compatible provisions (as MDA and ADI restrictions) limited coupon to a 4.0% while YTC lay at merely 1.22% (see Table  1.5). The trigger is a CET1 ratio of 7% at either Nykredit Realkredit (unconsolidated and consolidated) or Nykredit Holding Group. The instrument will also be useful in meeting Danish Pillar 2 capital requirements. Table 1.5 presents outstanding Tier 2 CoCos issues at 5 April 2018.

41

 Most Tier 2 CoCos are rated in the BBB range while AT1s tend to be rated in the BB range.

1.22%

3.09% 0.83% 4.66% 1.07% 4.45% 1.97% 4.69% 1.56%

5.40%

8.125% 5.750% 6.500% 4.750% 7.625% 4.750% 5.125% 2.625%

7.625%

Source: Creditsights *YTC/YTM calculated for 05 Apr 2018

Crédit Agricole Credit Suisse Credit Suisse UBS UBS UBS UBS Zürcher Kantonalbank Barclays Bank

4.000%

Nykredit Realkredit Saxo Bank

14.400% 12.24%

Coupon

Bank

1000 1250 2500 2000 2000 1500 2500 500 3000

USD

50

600

USD EUR USD EUR USD USD USD EUR

EUR

EUR

First call

19-­Sep-­18 18-­Sep-­20 NA 12-­Feb-­21 NA 22-­May-­18 NA 15-­Jun-­22

14-­Apr-­20

21-­Nov-­12 NA

19-Sep-­13 18-Sep-­13 8-Aug-­13 13-Feb-­14 17-­Aug-­12 22-­May-­13 8-May-­14 8-Jun-­15

14-­Apr-­15

23-­May-­14 3-Jun-­21

Yield to Amount call/Mty* Crncy mn Issue date

Table 1.5  Outstanding Tier 2 CoCos at 05 Apr 2018

Maturity

Write-down Write-down Write-down Write-down Write-down Write-down Write-down Write-down

Conversion Full Full Full Full Full Full Full Full

Write-down Full

21-Nov-­22 Write-down Full

19-Sep-­33 18-Sep-­25 8-Aug-­23 12-Feb-­26 17-Aug-­22 22-May-­23 15-May-­24 15-Jun-­27

14-Apr-­25

3-Jun-36

Trigger

Perm

Perm Perm Perm Perm Perm Perm Perm Perm

Perm

Group

Nykredit Group Group & Bank CA Group Group Group Group Group Group Group Group

Conversion/ Partial/ Temp/ write-down full perm Entity

Write-down terms

CET1

7.000%

7.000% 5.000% 5.000% 5.000% 5.000% 5.000% 5.000% 5.000%

7.000%

7.000%

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1.5 Conclusions The CRR supplemented by the EBA’s RTS established the legal regime that governs EU’s contingent convertible bonds. Analysis of the CRD IV/CRR regime shows that this regulation is highly innovative yet controversial and very detailed. Back in 1988, the document we now know as Basel I contained just 30 pages. While this was no doubt an oversimplified attempt to regulate capital levels, it seems extraordinary that the Regulation and Directive that comprise CRD IV—the EU version of Basel III—run to over 1600 pages. And that’s not including the EBA technical standards that will determine how the new rules are implemented. This is a global trend. The Dodd Frank Act, a mere 848 pages, has grown into almost 9000 pages of associated rules and regulations. Since the inception of the AT1 market in late 2013, the structure of AT1 securities has become fairly standardized—they are all perpetuals with a first call and coupon reset date typically five to seven years after issuance, and they all include a CET1 capital ratio trigger. If this trigger is breached, the bond is written down or converted into equity. The conventional analysis of AT1 securities looks at the ‘cushion’ that banks have above the trigger level, in other words the difference between the trigger ratio and their actual CET1 ratio. The so-called Distance to trigger gives an idea of how much capital would have to be eroded, or how much risk-weighted assets would have to increase, in order to breach the trigger and invoke the automatic conversion or write-down. The risk of triggering CoCos has reduced greatly due to the strides made in bank regulation and deleveraging since the crisis. European banks are increasingly in a much better situation, with excess capital positions, while earnings have generally been solid. On top of this, regulators are continuing to demand that they set aside even more capital. The latest EBA EU-wide stress test proved the resilience of major EEA banks to a common set of adverse shocks. The great redeeming quality of the AT1 market, however, is that it is largely made up of national champions. After tumultuous year 2016, the following 2017 and 2018 were the most successful years when considering AT1 issuance volumes and the trend seems to continue, even as prices have soared to record highs. Uncertainty over banks’ future capital requirements and ratios surrounding so-called Basel 4 and IFRS 9 effects has little or no effect over AT1 spreads. As the yields have been pushed to all-time lows (see Fig. 1.17), investors’ focus has shifted from the ‘distance to trigger’ to coupon risk. And increasingly, pricing is also affected by extension risk, that is, the possibility

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that bonds will not be redeemed at their first call date because the reset spread is below the level at which the bank could issue a new AT1. With new AT1s, bankers calculate what is called a reset spread—or a back-end spread—often by looking at the difference between the coupon rate and the relevant mid-­ swaps rate. The AT1 issuer will have to pay investors this spread over the prevailing five-year mid-swaps rate, should it decide to extend the life of an instrument. To put it simply: is it cheaper for a bank to leave AT1s outstanding or refinance them? Bonds with higher reset spreads are therefore less likely to be extended than low coupon low back-end AT1s, especially with much talk that we are heading into a rising rate environment. While a bank’s decision on whether to call an AT1 or leave it outstanding will largely depend on its credit spreads at the call date it might not be a wholly economic decision. A bank might not need to refinance an AT1 security, or it might wish (or be required to) to replace it with an instrument that has different features, for example a higher write-down or conversion trigger, or a longer call date. Other elements that might be a factor include subsequent call dates or coupon reset dates, which range from one to ten years. This means that extension risk needs to be assessed on a bond-by-bond basis. Extension risk is the most likely but least serious of the three main risks. The main focus is therefore on (a) the MDA (maximum distributable amount) calculation and (b) the existence of available distributable reserves (DIs). The ability of banks to pay AT1 coupons out of distributable items has been so far most significant factor in the pricing of AT1 securities. The risk is that DIs could be wiped out by a bank reporting an annual loss—for example because of a one-off litigation charge—which would prevent it from paying coupons. Most AT1 issuers have a comfortable level of DIs (which are essentially retained profits), although there have been banks standing out as having relatively small distributable reserves with Deutsche Bank serving as the most prominent example. The uncertainty surrounds the level of available distributable items rather than banks’ ability to meet their MDA threshold not at least because most banks have stated in their AT1 roadshows that, in an MDA scenario, they would prioritize AT1 coupons over share dividends. The issuers’ determination to pay the coupons whichever the MDA and DIs are to meet the investors’ requirements is against the capital character of the instruments. The non-cumulative coupon deferral should be treated as a ‘first defence line’ against losses. On a contrary to that, the investors wish the AT1s were solely fixed income dated debentures. The truth is the other way round: In fact, AT1s are capital—not debt—instruments with no maturity, devised with the primary aim to absorb an institution’s losses on an ongoing basis. In fact, they belong to a separate class called ‘hybrid securities’ and are

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placed somewhere in-between debt and equity (in ‘debt to equity continuum’ as rating agencies call it). They behave like fixed incomes only if issuer is financially sound. In practice, however, investors tend to perceive the AT1 sector as an opportunity to buy high yielding securities from strong issuers, with implicit commitment from issuers that coupons will be paid and calls will be exercised. The best evidence for bondholders seeing perpetuals as dated instruments (first call date marks so-called synthetic maturity) is that the AT1 market has swung from trading on a yield-to-perpetual basis to trading on a yield-to-call basis. What is more, the three main worldwide rating agencies assign their notch-down for the coupon deferral risk which widens the gap between issuer’s and issue rating. As a result, the one-off loss reduction comes at a price of sustainable rise of refinancing costs. In view of the above, there is a rising concern about rationale for the MDA and ADI rigors. On the one hand, these requirements are a direct response to the loss-absorbing deficiencies of the Basel II instruments. On the other hand, they substantially increase the cost of the bank’s refinancing. As presented in Sect. 1.4, the existing Tier 2 CoCos with CET1 ratio trigger, not bounded by either MDA nor ADI restrictions, are of substantially lower cost to the issuer. What’s more, the rising concern about Deutsche Bank’s ability to pay AT1s coupons out of its DIs put on edge the whole AT1 market at beginning of the 2016. The increased volatility put in question the stability the CoCos should bring in themselves. Then the question arises as to what extent AT1s offer a real protection against losses on a going-concern basis. AT1 CoCos may fill banks’ own funds up to 1.5% RWAs and their prevailing coupons range between 3.8%–8.8% per  annum. Pure arithmetic shows that coupon ­cancellation may bring a one-off relief to the issuer of merely 0.13% RWAs. This modest gain comes at a high price to the issuer in the form of difficulties in its ability to tap the bond market in future, as the bank’s reputation will often be tarnished by this kind of event. The restrictions on coupon distributions made more sense in the light of original BCBS proposals to build the capital buffers of AT1 instruments as well, which would increase their admissible share in RWAs even up to 13%. The first real test of the AT1 market however were not turbulences caused by concerns about available distributable items for Deutsche Bank in January/ February 2016 but the cancellation of Banco Popular AT1s on 7 June 2017 in a resolution process. It was hailed as a success by the European regulatory bodies, and there has been surprisingly little contagion to the broader AT1 market. The fate of Banco Popular’s AT1s is woven into its resolution process, which will be described in detail in Sect. 2.7.4 of Chap. 2.

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The main CoCos’ loss-absorbing capacity comes out not of coupon cancellation but lies in their mechanism of conversion into issuer’s equity or principal write-off. Some banks prefer the write-down structure as it would not dilute existing shareholders, while many fixed income investors are not able to buy convertible instruments. Unlisted banks such as Rabobank have no choice—they are unable to issue convertible bonds. However, the attraction for investors of a convertible is the potential upside from owning shares, compared with a full and permanent write-down. However, CRR allows AT1 securities to have a temporary write-down and write-up structure (similar to instruments such as German Genusscheine) and such a structure is viewed more positively by investors making existing CoCos with a permanent write-­ down much less attractive. At first glance, the least risky CoCos seem to be therefore (a) low-trigger issues that are less likely to be breached, and (b) issues by banks with relatively small trading books or investment banking operations, where RWA volatility might be lower. The way a CoCo is structured (which includes such factors as whether it has a PWD or an equity conversion clause; the value of its conversion ratio; and bondholders’ equity share after conversion) may have an impact on the risk-taking incentives of stockholders. Hilscher and Raviv (2014) conclude that a high conversion ratio significantly reduces the risk propensity of stockholders and issuers’ management. In practice however, CoCos almost exclusively entail weak dilution of the original equity holders’ stakes. As German Bundesbank baldly states in its monthly report (2018), ‘the current design could thus tend to result in perverse incentives leading bank to take on greater risk’. Contingent capital might curb shareholder pressure on corporate managers for risk and leverage throughout substantial dilution. Coffee Jr (2011) proposes a legal structure of contingent capital to counterbalance equity shareholders. In this approach, the debt security would convert into a fixed return preferred stock with cumulative arrearages and significant voting rights. The interest of the new preferred stock would be limited and fixed, and thus aligned with the firm’s debt holders. These preferred shareholders would be rationally risk-averse and could offset the voting power of risk-tolerant common shareholders, thereby disciplining them and deterring excessive risk-taking. The main motivation to create AT1 capital was to strengthen the resilience of the banks. The common view is that contingent capital provides a form of buffer capital, like common stock but at a lesser cost. CoCo bonds are the most cost-effective recapitalization vehicle to provide buffer capital to a bank at a time of limited or no access to the capital markets due to its weakened capital position. Therefore, it is possible to recapitalize the bank from debt to

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equity without infusing new cash into the bank. Contingent capital allows banks to avoid paying the extra cost of an equity issue. Instead, a bank purchases a capital line commitment—a sort of guarantee that is drawn only when necessary (Bolton & Samama, 2012). CoCos are even more than a capital buffer—PWD CoCos and their coupon deferral clauses with no dividend stopper shaped a mechanism of wealth transfer from bondholders to shareholders (Roggi, Giannozzi, & Mibelli, 2013). From this perspective, such CoCos may in fact be evaluated as being junior to equity. This creates an incentive for excessive risk-taking by bank shareholders and management and needs regulatory involvement (Berg & Kaserer, 2014). Contingent capital replaces the bankruptcy process and thus does not depend on regulators properly exercising their resolution authority. During the great financial crisis governments injected capital to rescue from failure a select group of large banks commonly referred to as ‘too big to fail’ or systemically important financial institutions (SIFIs). The others were left to survive or fall on their own. CoCos can be designed to provide for remote government intervention and leave the fate of all banks to the domain of the capital markets. It builds loss absorption into a firm’s capital structure instead of drawing down funds form the bail-out fund, making the whole industry less exposed to contagion risk. Then the higher interest rate paid by the issuer on contingent capital may be deemed as an equivalent to a bank tax that offsets bail-out costs (Coffee Jr, 2011). More attention should be paid to cross-bank risks posed by AT1 perpetuals. The crucial aspect is the CoCos increasing interconnectedness of banks as well as of credit institutions and institutional investors. Additionally ‘information-­based contagion effects’ are possible: a trigger event occurring at one bank could produce a negative effect on other banks and beyond (Bundesbank, 2018). Therefore, the German Bundesbank (2018) suggests that supervisors should monitor to extend the buyer side of the AT1 market more. To make the final remark, one has to take into account that such CET1 ratio trigger event is not the only factor that may result in the contingent conversion or write-down of an AT1 bond. The CRR preamble explicitly states that ‘all additional Tier 1 and Tier 2 instruments of an institution should be capable of being fully and permanently written down or converted fully into Common Equity Tier 1 capital at the point of non-viability of the institution. Necessary legislation to ensure that own funds instruments are subject to the additional loss-absorption mechanism should be incorporated into Union law as part of the requirements in relation to the recovery and resolution of institutions’

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(Recital 45). There is still room for a regulatory trigger that is regulated by the  EU’s Bank Recovery and Resolution Directive (BRRD). This strongly emphasizes the interconnected nature of the CRD IV/CRR package and the BRRD. An in-depth analysis of contingent conversions and write-downs triggered by regulators will be presented in Chap. 2 adding the ‘point of non-­ viability’ (PONV) trigger. At this point, it is enough to mention that the BRRD regulatory trigger has a strong impact on contingent conversion and write-downs under CRR.

2 CoCo Bonds and Bail-in Mechanism

2.1 O  verview of EU Recovery and Resolution Regime 2.1.1 General Remarks Contingent conversions and write-downs of contingent convertible (CoCo) bonds under Capital Requirements Regulation (CRR) regime lie at the intersection of recovery and resolution regime governed by the European Union (EU) Bank Recovery and Resolution Directive (BRRD),1 both regimes spilling over into each other. As it was mentioned in the very end of Chap. 1, the CRR preamble explicitly states that ‘all additional Tier 1 and Tier 2 instruments of an institution should be capable of being fully and permanently written down or converted fully into Common Equity Tier 1 capital at the point of non-­ viability of the institution. Necessary legislation to ensure that own funds instruments are subject to the additional loss-absorption mechanism should be incorporated into Union law as part of the requirements in relation to the recovery and resolution of institutions’ (Recital 45). It means that irrespective of CoCos’ contractual Common Equity Tier 1 (CET1) ratio trigger event, the contingent conversion or write-down of an AT1 bond can be triggered by regulators

 Directive 2014/59/EU of the European Parliament and of the Council of 15 May 2014 establishing a framework for the recovery and resolution of credit institutions and investment firms and amending Council Directive 82/891/EEC, and Directives 2001/24/EC, 2002/47/EC, 2004/25/EC, 2005/56/EC, 2007/36/EC, 2011/35/EU, 2012/30/EU and 2013/36/EU, and Regulations (EU) No 1093/2010 and (EU) No 648/2012, of the European Parliament and of the Council. 1

© The Author(s) 2019 M. Liberadzki, K. Liberadzki, Contingent Convertible Bonds, Corporate Hybrid Securities and Preferred Shares, https://doi.org/10.1007/978-3-319-92501-1_2

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on reaching the so-called point of non-viability (PONV). Thus the CRR trigger is supplemented by so-called regulatory trigger governed by the BRRD. The BRRD was passed in May 2014 when CRR had already come into effect. Since this is a directive rather than an automatically binding regulation of the EU, it had to be implemented through national legislation in each country—a process which was originally supposed to have happened by the beginning of 2015 and was delayed in a number of countries. Nevertheless it is now complete and each banking system has a resolution fund and resolution authority to oversee the process if a bank reaches this point. And for this purpose the eurozone countries, in which the major banks are all supervised directly by the European Central Bank (ECB), are treated in principle as one system under a single resolution mechanism (SRM), with its own fund and board. These countries are governed by a directly applicable SRM regulation.2 Nevertheless, individual countries do retain their national resolution authorities, which interact with the SRM in different ways, depending on the size and complexity of the banks or situations that they are dealing with. In terms of chronology, the BRRD comes after the fourth Capital Requirements Directive (CRD IV) package, so it is logical that it also adopts its terminology and definitions. The coherence of the terminology of these legal acts is of crucial importance. The BRRD often refers directly to the terminology of the CRR as regards CET1, AT1 and T2 instruments (Article 2[1] [62] BRRD). Besides, certain sections of BRRD rules (Chapter V of Title IV) refer to AT1 and T2 instruments collectively as ‘relevant capital instruments’ (Liberadzki and Liberadzki, 2016). However, these two acts focus on different aspects of banking reform. While the CRR establishes a tier-based structure of prudential capital requirements to strengthen pre-bankruptcy loss-absorption capacity (‘make failure less likely’), the BRRD focuses rather on how this structure works in case of non-viability establishing the procedure of loss sharing between shareholders and creditors (‘make failure less harmful’) with the aims of avoiding the disruption caused by insolvency procedures, minimizing losses by avoiding a fire-sale of assets and giving authorities more discretion than they would have in an insolvency, especially over how losses are distributed. The use of public funds to finance the implementation of resolution tools may only be considered as a last resort (BRRD Recital 1, BRRD Article 56). Once a bank is formally declared to be in resolution, an EU resolution authority can (1) transfer a portion of its assets and liabilities into a bridge  Regulation (EU) No 806/2014 of the European Parliament and of the Council of 15 July 2014 establishing uniform rules and a uniform procedure for the resolution of credit institutions and certain investment firms in the framework of a Single Resolution Mechanism and a Single Resolution Fund and amending Regulation (EU) No 1093/2010. 2

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bank, so that they can be protected there (the bridge institution tool); (2) it can sell off parts of the business or separate some of the assets out into a special-­purpose vehicle for wind-down (the sale of business tool and the asset separation tool) as well as it can unilaterally impose write-down or converting into shares bank ‘eligible liabilities’ or to require an institution in resolution to issue new shares or other capital instruments (bail-in tool) all of which are enumerated in BRRD Article 37(3) and detailed further in BRRD. Resolution authorities may apply the resolution tools individually or in any combination, only the asset separation tool must be applied together with another resolution tool (BRRD Article 37[4] and [5]). Additionally, regulatory capital instruments can always be converted or written down by regulatory authorities if they deem a bank to be at the PONV, even if they are not putting it formally into resolution yet (BRRD Article 59). As the bail-in tool together with write-down or conversion of ‘relevant capital instruments’ affect most the AT1s characteristics shaped by the CRR, only this resolution tool and power will be described in detail further in this chapter.

2.1.2 General Resolution Principles Resolution tools and measures may be applied by resolution authorities to the resolution objectives in a manner tailored to the individual circumstances of a given case. These objectives are (1) to ensure the continuity of critical functions, (2) to avoid a significantly negative impact on the financial system (in particular by preventing the contagion effect), (3) to protect public funds by minimizing the use of extraordinary public financial support, (4) to protect retail depositors and investors, and finally (5) to protect client funds and client assets. The resolution authority is also obliged to minimize the cost of resolution and allow for the destruction of value only when it is necessary to achieve these objectives (BRRD Article 31[1]–[2]). The protection of investors and depositors, along with the treatment of public financial resources as a tool of last resort, clearly implies that shareholders and creditors would have to face losses in the event of a resolution. However, protection against the contagion effect will also have to be taken into account when determining the size of the losses that shareholders and creditors will have to bear. This is because the significant exposure of one institution to the risk connected with another institution would also increase the threat of contagion (Liberadzki and Liberadzki, 2016). The resolution authority applies resolution tools and exercises its resolution powers only if all detailed conditions set out in BRRD Article 32 or 33 are met,

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depending on the character of the financial institution. Generally speaking, these conditions are met when it has been determined by a ‘relevant authority’3 that an institution (or its parent consolidated undertaking, if applicable) is failing or is likely to fail, and relevant circumstances, for example, the timing of the individual case, leave no room for any alternative private sector measures, in which case a resolution action is necessary and in the public interest. Necessary, that is, for the achievement of objectives set out in BRRD Article 31 that would not be met by the winding-up of an institution in a normal insolvency proceeding (Liberadzki and Liberadzki, 2016). Measures to determine whether an institution is failing or is likely to fail are detailed further in BRRD Article 32(4) and will be referred to further in Sect. 2.6. BRRD Article 34 delineates the order of the loss-sharing ‘rating’ in a similar manner as BRRD Recital 46, and also provides some detailed regulations applicable to that matter. The shareholders of the institution will bear the first losses, as a result of the application of resolution tools or the exercise of resolution powers by the resolution authority, and the creditors will bear losses afterward. Any non-equitable treatment of creditors of the same class must be provided for in the directive, and no creditor should incur greater losses than in the course of a normal insolvency proceeding (BRRD Article 34[1][g]). This is referred to as the NCWO principle—no creditor worse off. It is important to note that the NCWO principle does not mean that all pari passu creditors will be treated the same as each other in a resolution. As BRRD Article 34(1)(f ) stipulates, creditors of the same class should be treated equitably, not equally (Schillig, 2016). There can be substantial differentiation among them, for example if the resolution authority wishes to keep corporate transaction deposits whole in order to protect the wider economy, even if senior debt holders at the same bank are having haircuts imposed on their claims, in a regime where the two classes of creditor still rank equally. The senior debt holders would only have a claim under NCWO if they can demonstrate that the haircut they are suffering is greater than their own loss would have been in a hypothetical liquidation. The NCWO principle requires an independent valuer to come up with a ‘counterfactual’ estimate of what each class would have lost if the bank—as it existed at the time of resolution—had been put through a judicial insolvency process (BRRD Article 71[1]). If any class of creditors is eventually deemed to be worse off than in liquidation, this is the main purpose for which resolution  ‘Relevant authority’ is either the competent authority (i.e. supervisory authority—see CRR Article 4[1] [40]) or the resolution authority of the EU member country where the institution has been authorized or, in the group context, has been established, of the member state of the consolidating supervisor. Under SRM it is either the ECB or the SRB (Schillig, 2016). 3

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funds can be used once 8% of the original balance sheet has been bailed-in: to compensate those creditors up to the level of recoveries that they would have received in liquidation (and not up to 100% of their original claims). The resolution fund contribution for these purposes cannot exceed 5% of the bank’s original balance sheet (BRRD Article 44[5][a]). Senior debt holders have partial protection up to the level of their liquidation recovery rate. In extraordinary circumstances after the 5% resolution fund contribution limit has been reached, the resolution authority may seek further funding from alternative financing sources (including state aid), but only after ‘all unsecured, non-preferred liabilities, other than eligible deposits, have been written down or converted in full’ (BRRD Article 44[7]).4

2.2 Recovery Planning and Early Intervention Recovery and resolution planning and early intervention constitute an integral part of an enhanced and strengthened framework for regulation and supervision with a focus on resolvability (Schillig, 2016). ‘Recovery plans should include possible measures which could be taken by the management of the institution where the conditions for early intervention are met’ (BRRD Recital 20). Financial institutions must maintain recovery plans that set forth measures aimed at restoring their deteriorated financial position (BRRD Article 5). If it is likely in the near future that the financial position of an institution will deteriorate to the extent that it affects the regulatory requirements on capital set out in CRR and CRD IV, the ‘competent authority’5 may, inter alia, require the management of the institution to implement measures set out in the recovery plan or to prepare a plan for negotiating the restructuring of the debt with some or all of its creditors (BRRD Article 27[1][e]). Any restructuring of debt under this Article is not linked to the contingent conversion or write-down of AT1 instruments, as these negotiations may be conducted only on a voluntary basis. Of course, possible future mandatory write-downs may be used by an institution as a point in these negotiations (Liberadzki and Liberadzki, 2016). In order to preserve financial stability, it is important that competent authorities are able to remedy the deterioration of an institution’s financial and economic situation before that institution reaches a point at which authorities  There is one more situation in which state aid can still be used in the EU, potentially for full protection of remaining creditors once 8% of the balance sheet has been bailed-in. But it would not apply to a single bank or a small group of banks. It could apply only ‘in the very extraordinary situation of a systemic crisis’, as laid out in BRRD Article 37(10). 5  ‘Competent authority’ means supervisory authority under CRR Article 4[1][40]). 4

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have no other alternative than to resolve it. To that end, competent authorities should be granted early intervention powers, including the power to appoint a temporary administrator, either to replace or to temporarily work with the management body and senior management of an institution. Early intervention measures may be taken by the competent authorities where an institution infringes or is likely to infringe in the near future the prudential and conductof-business requirements set out in CRR, CRD IV, Directive 2014/65/EU (MiFID II)6 or Regulation (EU) No 600/2014 (MiFIR). These likely ‘infringements in the near future’ are indicated by, inter alia, a rapidly deteriorating financial condition, including deteriorating liquidity situation, increasing level of leverage, non-performing loans or concentration of exposures, as assessed on the basis of a set of triggers, which may include the institution’s own funds requirement plus 1.5 percentage points (BRRD Article 27[1]). The own funds requirement trigger plus 1.5 percentage points is therefore to be set as total capital ratio (TCR) of 8% risk-weighted assets (RWAs) increased by additional own funds requirements under Pillar 2 requirements (P2R—see Sect. 1.2.7 of Chap. 1) plus 1.5%. The measures provided for in CRD IV Article 104 are supplemented by a range of new powers. In particular, supervisory authorities may require the institution’s management (1) to implement measures set out in the recovery plan, (2) to examine the situation and to draw up a programme of action to overcome problems, (3) to convene a shareholders’ meeting, (4) to draw up debt restructurings plans, (5) to require one or more members of the management body or senior management to be removed or replaced, (6) to require changes to the institution’s business strategy and the legal or operational structures, and finally (7) supervisor must have power to acquire the information necessary to prepare for the possible resolution of the institution including through on-site inspections (BRRD Article 27[1]). If these measures are not sufficient to reverse ‘a significant deterioration in the financial situation of an institution or where there are serious infringements of law, of regulations or of the statutes of the institution, or serious administrative irregularities’ competent authorities may require the removal of the senior management or management body of the institution, in its entirety or with regard to individuals (BRRD Article 28). Where replacement of the senior management or management body as referred to in Article 28 is deemed to be insufficient by the competent authority to remedy the situation, supervisor may appoint one or more temporary administrators to the institution (BRRD Article 29[1]). The appointment of a temporary administrator shall not last more than one year (BRRD Article  Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU. 6

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29[7]). The temporary administrator has no powers to override existing shareholders’ rights. Thus, for instance, upon increase in capital, the temporary administrator may issue shares out of authorized capital to the extent that the institution’s management could have done so. He may not create new shares (when authorized capital has been exhausted), because this would require shareholders’ resolution. Also, the temporary administrator may not suspend any pre-emptive rights of shareholders (Schillig, 2016). This means that under temporary administrator’s rule it is impossible for bank to issue new CoCos.

2.3 W  rite-Down and Conversion of Capital Instruments Pursuant to BRRD Article 59(2), resolution authorities shall have the power to write-down or convert relevant capital instruments, that is, AT1 and T2 hybrids (BRRD Article 2[1][74]), into shares or other ‘instruments of ownership’7 of institutions and entities referred to in Article 1(1)(b)–(d). A write-­ down of capital instruments may occur independently of a resolution action or as a part of a resolution (BRRD Article 59[1]). If resolution authority does not commence a resolution process at the same time then CoCo holders, both in the AT1 and T2 capital will be in worst position since the instruments have to be written down in full or converted first, before any resolution action is taken. BRRD does not make clear if NCWO principle applies to CoCos converted or written down under the PONV powers. Creditors in bail-in are entitled to the safeguards provided in BRRD Article 73(b) that they not incur greater losses than they would have incurred had their bank been wound up under normal insolvency proceedings. Although BRRD Articles 73–75 refer only to shareholders and creditors, not specifically to holders of capital instruments, and to the application of the bail-in tool, it would be very odd that holders of capital instruments would not be covered by this safeguard (Cahn & Kenadjian, 2016). European Banking Authority (EBA) in its Single Rulebook Q&A answered to the question 2015_2181 that NCWO is not restricted to resolution tools only and applies to write-down and conversion as well. Interestingly, EBA also stated that if CoCos existed at the time of the resolution decision and they were converted, because the contractual event  ‘Instruments of ownership’ means shares, other instruments that confer ownership, instruments that are convertible into or give the right to acquire shares or other instruments of ownership, and instruments representing interests in shares or other instruments of ownership (BRRD Article 2[61]). For further discussion on instruments of ownership other than shares please refer to Liberadzki (2016) Section 7.1.2 of Chapter 7. 7

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triggering their conversion had occurred, the NCWO principle did not apply to the CoCo holders. Pursuant to BRRD Article 59(3), resolution authorities exercise their write-­ down or conversion power when one or more of the following circumstances apply: (1) it has been determined that conditions for resolution specified in Articles 32 and 33 have been met but no resolution action has been taken yet; (2) it has been determined that unless these powers are exercised the institution (or its parent undertaking) will no longer be viable; (3) where the relevant capital instruments are issued by a subsidiary to meet CRR capital requirements, it has been jointly determined by the competent authorities (for the consolidating supervisor and the subsidiary) that unless these powers are exercised the group will no longer be viable; (4) where the relevant capital instruments are issued by the parent undertaking for purposes of CRR own funds requirements, and it has been determined by the competent authority that unless these powers are exercised the group will no longer be viable; and finally (5) extraordinary public financial support is required by the institution except for any situation set out in the BRRD Article 32(4)(d)(iii). According to BRRD Article 60(1), the normal priority of claims in an insolvency proceeding shall be the principal exercising the referenced power: CET1 instruments—essentially common shares (see Sect. 1.2.8)—are reduced firstly in proportion to the losses incurred and to the extent to their capacity. Hence, this reduction may be to zero, if the amount of losses is higher than the amount or capacity of the own funds of the CET1. The resolution authority takes one or both of the actions provided for in BRRD Article 47(1): (1) it cancels existing shares or other instruments of ownership, or transfers them to bailed-in creditors; or (2) it dilutes the existing shareholders and holders of other ownership instruments as a result of the conversion into shares or other instruments of ownership of (a) AT1 or T2 hybrids or (b) eligible liabilities. The conversion scenario is possible only when valuation carried out under BRRD Article 36 demonstrates that the institution has positive net value. In the next step, if the reduction of the CET1 to zero does not completely resolve the problem and the objectives of BRRD Article 31 have yet to be achieved, the principal amount of the AT1 is either written down, converted to a CET1, or both. Again, the write-down or conversion is conducted to the extent of the capacity of the instruments; therefore, a write-down to zero or a conversion of the entire principal amount may be exercised. It is explicitly affirmed that the bottom line is the lower of (1) the extent required to achieve objectives of BRRD Article 31, and (2) the extent of the capacity of the AT1 instrument. It is striking that AT1 instruments may be written down, or converted, or both. In the end, the same write-down or conversion is performed

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with regard to T2 instruments (Liberadzki and Liberadzki, 2016). One must note that ability to perform a partial conversion and a partial write-down reflects how the BRRD regime prevails over the CRR regime when a conversion is carried out. In essence, it seems to be of minor importance whether a certain AT1 hybrid is structured for the purpose of a CRR, a CE CoCo or a principal write-down (PWD) CoCo, because the resolution authority may chose a conversion or write-down tool on a discretionary basis. Thus, a PWD CoCo may be converted regardless the contractual trigger event set out in terms of the issue, or written down, or partly converted and partly written down. Of course, the same applies to a CE CoCo. This ‘going-up’ structure of capital may work where the former Basel II Tier structure failed. In Basel II, T2 capital and non-deferrable coupons were absorbing losses only on a gone-concern basis, so in times of financial stress, even if a bank possessed significant stock of subordinated debt in T2, it had to issue new equity to remain solvent anyway. The BRRD aims to remedy this by placing all own funds on the ‘in-line’ of loss absorption. Losses will be consumed by CET1 items in the first, but subsequently AT1 holders will be next in line, as their instruments may be converted to CET1 instruments or simply written down. If their investment also has to be used to absorb losses, T2 instruments may come into play and also be converted into CET1 instruments (Liberadzki and Liberadzki, 2016).

2.4 Bail-in Tool A ‘bail-in tool’ is a mechanism for effecting the exercise of the write-down provisions by a resolution authority and the application of conversion powers in relation to liabilities of an institution under resolution (BRRD Article 2[1] [57]). The bail-in tool is very broad in its scope: it applies to all liabilities of an institution that are not excluded (BRRD Article 44[1]). Excluded liabilities are (1) covered deposits; (2) secured liabilities up to the amount of the value of the collateral, including covered bonds, and liabilities in the form of financial instruments used for hedging purposes, which form an integral part of the cover pool and which are secured in a way similar to covered bonds under the national law; (3) liabilities to institutions, excluding entities that are part of the same group, with an original maturity of less than seven days; (4) liabilities to employees and to crucial commercial or trade creditors; (5) tax and social security claims, provided they are treated as preferential under national insolvency law; and finally (6) contributions owed to a deposit guarantee scheme. Therefore, when it comes to financial instruments, it appears that only secured

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liabilities are beyond the scope of the bail-in tool. That clearly corresponds to the prohibition of AT1 or T2 instruments to be secured, as set forth by the CRR. A bail-in tool has a broader scope of options than the write-down of AT1 or T2 instruments. Correspondingly, bail-in bonds have a broader scope than AT1 CoCos and T2 bonds. However, when exercised, the bail-in tool also applies to AT1 and T2 instruments. It is explicitly affirmed in Article 59(1) that the power to write-down or convert relevant capital instruments like CET1 instruments or AT1 and T2 hybrids may be exercised either independently of or in combination with the resolution action (Liberadzki and Liberadzki, 2016). In exceptional circumstances, where the bail-in tool is applied, the resolution authority may exclude or partially exclude certain liabilities from the application of the write-down or conversion powers where: it is not possible to bail-in that liability within a reasonable time; where the exclusion is strictly necessary and is proportionate to achieve the continuity of critical functions and to avoid giving rise to widespread contagion; or where application of the bail-in tool would cause losses to other creditors higher than if those liabilities were excluded from bail-in (BRRD Article 44[3]). Where a resolution authority decides to exclude an eligible liability or class of eligible liabilities the level of write-down or conversion applied to other eligible liabilities may be increased to take account of such exclusions, provided that the level of ­write-­down and conversion applied to other eligible liabilities complies with NCWO principle (BRRD Article 44[3]). The BRRD and SRM regulation establish a hierarchy for exercising the bail-in tool. Pursuant to BRRD Article 47(1)(a), shares or other instruments of ownership may be cancelled or transferred to bailed-in creditors. In addition, as a result of a bail-in, relevant AT1 and T2 capital instruments may be converted into shares or other instruments of ownership (BRRD Article 47[1] [b]). This may happen only if a valuation has proved that the institution has a positive net value. If this condition is met, the resolution authority may also implement both these actions. It is very important to note that conversion may also be performed with regard to AT1 instruments that embed write-­ down instead of contingent conversion, as well T2 instruments that are not required to incorporate contingent conversion mechanisms. Perhaps more importantly, this action may also be performed with regard to eligible liabilities (BRRD Article 63[1][f ]). The sequence of reduction—that is, write-down or conversion—is set out in BRRD Article 48, wherein the first losses are absorbed by CET1 items, while the subsequent losses are absorbed by AT1 and T2 items, until the required reduction is complete. However, the bail-in tool has a wider scope than the write-down or conversion of AT1 and T2 instruments, and if these

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own fund items are insufficient to restore the viability of the institution, the resolution authority will proceed with the reduction of subordinated debt that is not AT1 or T2. Here, the hierarchy of normal insolvency proceedings applies. In the end, even if the reduction of the principal amount of such subordinated debt is not enough, the resolution authority may reduce the rest of the eligible liabilities using the same normal hierarchy of claims. These two final steps address the new class of ‘non-preferred senior’ debt, so-called Tier 3, discussed further in detail in Sect. 2.9. Losses have to be absorbed equally among financial instruments of the same rank. Before the last class of eligible liabilities may be reduced, the resolution authority shall first reduce instruments embedded with contingent conversion or write-down provisions on the occasion of the occurrence of any event that impacts the financial situation, solvency or levels of the institution’s own funds. Of course, this principle applies only when such instruments have not been already reduced (BRRD Article 48[3]). Legislators are clearly aware of the difficulties that may arise in practice, as provisions of the BRRD will ­postpone any contingent conversion or write-down mechanism of the CRR. To ensure that absorption of losses by capital instruments is effective, and that resolution authorities and other stakeholders have a clear understanding of how this sequence should be applied, Article 48(6) of the BRRD mandates the EBA to issue guidelines clarifying the interrelationship between the provisions of the BRRD and the provisions of the CRR and CRD, as far as this affects the write-down sequence. EBA guidelines of 05 April 2017 (EBA/ GL/2017/02) clarify that when applying the bail-in tool or the PONV conversion power, the resolution authority should treat capital instruments which belong to the same category of the sequence established by BRRD Article 48 or BRRD Article 60 and which rank equally in insolvency in the same way, whatever their other qualities. As EBA exemplifies it, issued AT1 instruments which fully meet the conditions of Article 52 of CRR and instruments grandfathered according to CRR Article 486 (see Sect. 1.3.3.4 of Chap. 1) with the same ranking in the creditor hierarchy are subject to the same treatment for the purposes of the sequence of the write-down and conversion. They should be written down to the same extent or subject to the same terms of conversion. In order to ensure respect for the creditor hierarchy, the resolution authority should treat all AT1 instruments which rank equally in insolvency in the same way without considering other differences between the loss-absorbing capacity of these AT1 instruments resulting from their contractual clauses. Therefore, in case of application of the bail-in tool or the write-down or conversion power at PONV, the resolution authority should treat equally new-style AT1s and grandfathered AT1 instruments. With regards Tier 2 instruments, EBA states

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that the resolution authority should apply the same treatment to instruments which are partially included in the calculation of own funds as to instruments which are fully included. This rule is applied to the case of Tier 2 instruments subject to the amortization regime of the CRR. For Tier 2 instruments with less than five years of residual maturity, the amount which can be included in own funds is reduced to zero on a straight-line basis. The guidelines clarify that the amortized amount of such instruments should be treated in the same way as the amount included in own funds. That means that T2 instruments under the amortization regime should be subject to the same treatment as T2 instruments fully included in own funds. At this point, we must answer an important question: what happens next after losses have been absorbed in abovementioned manner? After the AT1 items (or, if necessary, AT1 items and T2 items) replace the CET1 items (that have fully absorbed losses but in exchange been reduced to zero), the tier or tiers may be left undercapitalized or even absolutely empty of any financial items. Without any remedy for such a situation, there would be little improvement under BRRD: T2 instruments would be capable of absorbing losses on a going-concern basis, but in practice such absorption could work only once, and the institution would be left in poor capital condition, without the required amount of own funds in place. To address the problem of inadequate own funds after the write-down or conversion of relevant capital instruments, BRRD Article 63(1)(i) equips resolution authorities with the resolution power to request the management of a financial institution to issue new shares, other ownership instruments or other capital instruments, including preference shares and contingent convertible instruments. It is explicitly reaffirmed that both preferred shares and CoCos may be categorized as AT1 instruments (Liberadzki and Liberadzki, 2016). BRRD Article 123 proposes to amend Directive 2012/30/EU by requiring that member states disapply a number of provisions of this directive, among them Article 33 on the right of pre-emption (see Sect. 1.3.5.3 of Chap. 1) with respect to, inter alia, CoCos that are issued upon of request of a resolution authority. Besides, the BRRD addresses to some extend the question of high conversion price offering bondholders low equity share after conversion, which was discussed in Sect. 1.3.5.3 of Chap. 1. Article 47 provides that a conversion of capital instruments shall be conducted ‘at a rate of conversion that severely dilutes existing holdings of shares’. BRRD does not make any further specifications it his respect, one may note however that the severity and impact of dilution depend not only on the percentage of shares issued upon conversion but also on the size of the current stakeholders’ stakes and their investment strategies. While retail investors and most institutional investors are usually not interested in exercising their corporate rights and

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will, therefore, be indifferent to a decrease of their relative voting power, strategic investors may well seek to maintain their relative share in the company so as to be able to influence shareholder decisions and management (Cahn & Kenadjian, 2016). It must be pointed out however that BRRD provisions on disabling pre-emptive rights and dilution of control rights do not refer to CoCos that a bank issues under its own discretion.

2.5 P  ersonal Scope of Financial Institutions Covered by Write-Down or Conversion of Capital Instruments Mechanism The write-down or conversion of AT1 and T2 Cocos within a PONV powers and bail-in tool can be inflicted upon institutions and entities established in the EU referred to in Article 1(1)(b)–(d). These are: 1. Financial holding companies (defined in BRRD Article 2(1)[9]), mixed financial holding companies (defined in BRRD Article 2[1][10]) and mixed-activity holding companies (defined in BRRD Article 2[1][11]); 2. Parent financial holding companies in a member state (defined in BRRD Article 2[1][12]), Union parent financial holding companies (defined in BRRD Article 2[1][13]), parent mixed financial holding in a member state (defined in BRRD Article 2[1][14]), and EU parent mixed financial holding companies (defined in BRRD Article 2[1][15]); and 3. Institutions established in the EU that are subsidiaries of the aforementioned entities, financial institutions or investment firms, provided that they are covered by the supervision of the parent undertaking on a consolidated basis in accordance with CRR Articles 6–17. It is unnecessary to analyse the details and personal scope of every definition. But it is sufficient to state what type of entities will not be covered by the discussed powers of the resolution authorities: financial institutions established in EU that are not subsidiaries of the aforementioned entities and their branches established outside the EU, that are generally covered by the BRRD. This conclusion explicitly results from the very aim of the BRRD, which is to deal with financial conglomerates whose failure may cause the contagion effect to spread through the financial system in a cross-border, even pan-European manner. Financial institutions that are not financial conglomerates, namely small family-owned banks or otherwise closely held banks, are also subjects of concern in BRRD policy, but under another regime (BRRD Articles 32 and 33). The

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absence of capital instruments and write-down mechanisms with regard to such independent financial institutions is an example of the varied approach that may be taken with different types of financial institutions. For example, institutions referred to in BRRD Article 1(1)(a) are covered by the CRR regime, so any contingent conversion of its AT1 will take place only under the CRR mechanism (Liberadzki and Liberadzki, 2016). Some T2 instruments may also incorporate contingent conversion mechanisms set off by an accounting trigger, although this is not required under CRR (see Sect. 1.4 of Chap. 1).

2.6 P  oint of Non-Viability (PONV) and Resolution Triggers 2.6.1 PONV Trigger Key among the BRRD provisions directly affecting CoCos are those which relate to the point at which a resolution authority may use write-down or conversion power on the grounds of BRRD Article 59 or the bail-in tool to convert or write-down outstanding securities as the part of resolution framework. The crucial answer is which one out of both: a resolution tool or PONV power should a resolution authority use as first? The Recital 81 of BRRD gives some guidance by stating that ‘Member States should ensure that Additional Tier 1 and Tier 2 capital instruments fully absorb losses at the point of non-­ viability of the issuing institution. Accordingly, resolution authorities should be required to write down those instruments in full, or to convert them to Common Equity Tier 1 instruments, at the point of non-viability and before any resolution action is taken’. That means that member states are directed to insure that AT1 and T2 instruments fully absorb losses at the PONV and ‘before any resolution action is taken’. That said, ‘the point of non-viability should be understood as the point at which the relevant authority determines that the institution meets the conditions for resolution or the point at which the authority decides that the institution would cease to be viable if those capital instruments were not written down or converted’ (Recital 81 of BRRD). This reading is reinforced by the BRRD Article 59(1) which states that power to write-down or convert relevant capital instruments may be exercised independently of resolution action and that resolution authorities exercise this power ‘without delay’ when they determine that (1) conditions for resolution have been met8 before any resolution action is taken, or (2) that unless that power is exercised in relation to the AT1s and  Specified in BRRD Articles 32 and 33.

8

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T2s, the institution will no longer be viable, or (3) extraordinary public financial support is required by the institution (BRRD Article 59[3]). An institution or an entity referred to in point (b), (c) or (d) of BRRD Article 1(1) or a group shall be deemed to be no longer viable only if both of the following conditions are met (BRRD Article 59[4]): 1 . is failing or likely to fail, and 2. having regard to timing and other relevant circumstances, there is no reasonable prospect that any action, including alternative private sector measures or supervisory action (including early intervention measures), other than the write-down or conversion of capital instruments, independently or in combination with a resolution action, would prevent the failure of the institution or the entity referred to in point (b), (c) or (d) of Article 1(1) or the group within a reasonable timeframe. Therefore, to determine whether institution (or group) is ‘viable’ a ‘failing or likely to fail’ criterion set out in Article 32(4) must be fulfilled. Essentially, ‘an institution is no longer viable’ means conditions for resolution minus the public interest requirement (Schillig, 2016). In line with BRRD Article 59(6) a group shall be deemed to be failing or likely to fail where the group infringes or there are objective elements to support a determination that the group, in the near future, will infringe its consolidated prudential requirements in a way that would justify action by the competent authority including but not limited to because the group has incurred or is likely to incur losses that will deplete all or a significant amount of its own funds.

2.6.2 Resolution Trigger Resolution trigger may be understood as the point at which the relevant authority determines that the bank meets conditions for resolution. Conditions for resolution are set out in BRRD Article 32(1) and must be met collectively: (1) the determination that the institution is failing or is likely to fail and (2)  there is no reasonable prospect that any alternative private sector measures, or supervisory action, including early intervention measures or the write-down or conversion of relevant capital instruments in accordance with Article 59(2) taken in respect of the institution, would prevent the failure of the institution within a reasonable timeframe, and a resolution action is necessary in the public interest. While BRRD prescribes that the determination that an institution is failing or likely to fail should be made by the competent

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authority after consulting with the resolution authority, member states may also permit this determination to be made by the resolution authority after consulting the competent authority, provided that the resolution authority has the necessary tools and in particular adequate access to the information required (BRRD Article 32[2]). As discussed in previous section resolution should be preceded by write-­ down or conversion of relevant capital instrument. However, the previous adoption of early intervention measures is not a condition for taking a resolution action (BRRD Article 32[3]). An institution is considered to be failing or likely to fail in one or more of the following circumstances: (1) when it infringes or is likely in the near future to infringe the requirements for continuing authorization, (2) when the assets of the institution are or are likely in the near future to be less than its liabilities, (3) when the institution is or is likely in the near future to be unable to pay its debts as they fall due, or (iv) when the institution requires ­extraordinary public financial support (BRRD Recital 41, Article 32[4]).9 BRRD Article 32(4)(a) deems institution to be failing or likely to fail if it is in breach or will be in breach of capital and other requirements for continuing authorization including, but not limited to, having incurred or being likely to incur losses that will deplete all or a significant amount of its own funds. Pursuant to the CRR Article 72 own funds of a bank consist of its Tier 1 capital and Tier 2 capital and should be no less than 8% (CRR Article 92[1]). Nonetheless, as EBA points out in its ‘Guidelines on the interpretation of the different circumstances when an institution shall be considered as failing or likely to fail’ of 26 May 2015 (EBA/ GL/2015/07), when assessing whether the institution will comply in the near future with the own funds requirements, additional own funds requirements (P2R) should be added to minimum own funds requirements of 8%. In other words, breaching the TSCR (total SREP capital requirement) set individually by the supervisor may result in triggering resolution process. In these guidelines EBA clearly states that the competent authorities should base their determination that an institution meets ‘failing or likely to fail’ criterion primarily on the outcomes of the supervisory review and evaluation  The Recital 41 of BRRD states that ‘The resolution framework should provide for timely entry into resolution before a financial institution is balance-sheet insolvent and before all equity has been fully wiped out. Resolution should be initiated when a competent authority, after consulting a resolution authority, determines that an institution is failing or likely to fail and alternative measures as specified in this Directive would prevent such a failure within a reasonable timeframe’. This should be read together with recital 49: ‘The resolution tools should therefore be applied only to those institutions that are failing or likely to fail, and only when it is necessary to pursue the objective of financial stability in the general interest. In particular, resolution tools should be applied where the institution cannot be wound up under normal insolvency proceedings without destabilising the financial system and the measures are necessary in order to ensure the rapid transfer and continuation of systemically important functions’. 9

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process (SREP) as described in CRD IV Article 97 and as further specified in the EBA Guidelines on common procedures and methodologies for the SREP (EBA SREP Guidelines).10 For the purposes of making a determination that an institution is failing or likely to fail, the competent authority should assess the objective elements relating to (1) the capital position of an institution, (2) the liquidity position of an institution, and (3) any other requirements for continuing authorization in a way that would justify the withdrawal of its authorization by the competent authority pursuant to CRD IV Article 18. The assessment of these objective elements will usually be carried out by the supervisory authority in the course of the SREP performed in accordance with EBA SREP Guidelines. Competent authorities should determine the institution’s viability, defined as its proximity to a point of non-viability on the basis of the adequacy of its own funds and liquidity resources, governance, controls or business model or strategy to cover the risks to which it is or may be exposed. The overall SREP assessment should be reflected in a viability score based on the above specified considerations (see Table 2.1). Pursuant to the outcomes of the SREP assessment the competent authority should base its determination that an institution is failing or likely to fail on the following (EBA/GL/2015/07): 1. An overall SREP score of ‘F’ assigned to an institution based on the considerations stipulated in the EBA SREP Guidelines; or 2. An overall SREP score of ‘4’ assigned to an institution based on the considerations stipulated in SREP Guidelines and failure to comply with the supervisory measures applied in accordance with CRD IV Articles 104 and 105, or early intervention measures (see Sect. 2.2). Table 2.1  Interpretation of the overall SREP score SREP score

1

2

3

4

F

The The risks The risks The risks Supervisory The risks institution identified identified identified view identified pose a high is pose a pose a pose low level of risk considered medium-­ level of risk medium-­ to be to the low level of high level to the ‘failing or viability of of risk to risk to the viability of likely to the viability the viability of the fail’. institution. of the the institution. institution. institution. Source: EBA SREP Guidelines

10

 EBA/GL/2018/03.

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When determining that an institution is failing or likely to fail, as reflected by an overall SREP score of ‘F’, competent authorities should engage with the resolution authorities to consult on findings following the procedure specified in Article 32 of BRRD. In addition, when assessing the conditions for reaching ‘failing or likely to fail’ point, the competent authorities should take into account the results of the application of supervisory and early intervention measures, recovery options applied by institutions, and the results of the valuation of an institution’s assets and liabilities (EBA/GL/2015/07).

2.7 C  oCo PONV and Resolution Triggers Versus Contractual Triggers 2.7.1 General Remarks A CoCo was thought to absorb losses on a ‘going-concern’ basis which means that contingent convertibles are to allow a recapitalization to occur automatically prior to or at the point of insolvency upon the occurrence of a predefined event indicating that the financial health of a bank has deteriorated to a point where it needs more capital. The CoCo contractual trigger in form of the CET1 capital ratio lie at the centre of investigations in Chap. 1. This concept must be distinguished from discretionary or point of non-viability (PONV) trigger activated by supervisor’s judgement: the decision to convert CoCos into equity or to write-down its value lies in the hands of a public authority that determines at which point it should pull the trigger. The good question is, which comes first: PONV or high-trigger event stipulated in the terms and conditions of the issue (that is CET1 ratio of 7% of RWAs)? The idea is that high-trigger event should occur before issuer becomes failing or likely to fail marking its PONV has been reached. Only in such a case the recapitalization will occur at a point when the issuer is still a ‘going-concern’ without the need for public authority intervention. Consequently, low triggers should activate at close to the PONV (Cahn & Kenadjian, 2016). Otherwise CoCos would have become ‘gone-concern’ rather than ‘going-concern’ instruments.

2.7.2 L evels of Regulatory Capital Triggering CoCo-­ Specific Events Below presented divagations are to verify if this expectation is met in practice, with help of Figs. 2.1 and 2.2. Looking at Fig. 2.1 top to bottom, the bar on

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P2G

101

P2G systemic risk buffer G-SIB buffer

0 - 2%

1-3.5% 0 - 2.5%

0 - 5%

D-SIB buffer countercyclical risk buffer

2.5%

capital conservation buffer

1.5%

BRRD Art. 27(1)

P2R

P2R

2%

T2

1.5%

AT1

4.5%

CET1

MDA bar recovery trigger / PONV trigger - TSCR + 1.5% CoCo high trigger - 7 % (in CET1 items only) resolution trigger - TSCR level. Overall SREP score of "F" CoCo low trigger - 5.125% (in CET1 items only) TCR - withdrawal of authorization Fig. 2.1  Levels of regulatory capital triggering CoCo-specific events

the very top separates Pillar 2 capital guidance (P2G) capital level sitting at the top of capital layers (see Sect. 1.2.7 of Chap. 1) from the combined buffer requirement (CBR). As P2G is positioned above CBR, a failure to meet P2G does not trigger automatic restrictions on distributions provided for in Article 141 of CRD IV. As discussed extensively in the Sect. 1.3.4.3 of Chap. 1, when institution fails to meet its CBR, it is prohibited from discretionally distributing inter alia AT1 coupon payments more than MDA (maximum distributable amount). Therefore the breaching of MDA trigger may result in AT1 CoCos coupon cancellation. Where an institution fails to meet its CBR, it shall prepare a capital conservation plan and submit it to the supervisor no later than five working days after it identified that it was failing to meet that requirement (CRD IV Article 142). If, in spite of capital conservation plan implementation, the financial position of a bank further deteriorates to the extent that it affects the regulatory requirements on capital then the supervisor may require the management

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12.0% 10.5% 9.0% 7.5% 6.0% 4.5% 3.0% 0.0%

Erste Group Bank Raiffeisen Bank Int'l Belfius Bank KBC Group Danske Bank Nykredit Group BNP Paribas BPCE Crédit Agricole Group Crédit Agricole S.A. Société Générale Commerzbank Deutsche Bank Allied Irish Bank of Ireland Banca MPS Banco BPM Intesa Sanpaolo UniCredit ABN AMRO ING Group Rabobank DNB BCP Caixa Geral Banco Sabadell Bankia BBVA CaixaBank Santander Nordea SEB Svenska Handelsbanken Swedbank Barclays HSBC Holdings Lloyds Banking Group Nationwide Royal Bank of Scotland Group Santander UK Group Holdings Standard Chartered

1.5%

base CET1

P2R

1,5% - BRRD Art. 27(1)

7%

5, 125%

Fig. 2.2  PONV trigger level* and resolution trigger level*** in CET1 capital only versus contractual CoCo trigger levels for 41 major EEA banks at the end of 1Q2018. *base CET1 + P2R + 1.5%; **base CET1 + P2R

of the bank to implement measures set out in the recovery plan or to prepare a plan for negotiating the restructuring of the debt with its creditors. If these measures don’t put a hold on deteriorating financial condition, then a supervisor may take early intervention measures towards the ailing bank in proper order. The regulatory capital trigger of BRRD Article 27(1) is set as TCR of 8% RWAs increased by P2R plus 1.5% RWAs (see Sect. 2.2). This bar level is marked on Fig. 2.1 as ‘recovery trigger’. As set out in Sects. 2.3 and 2.6.1, no reasonable prospect that any action, including alternative private sector measures or supervisory action (including early intervention measures) would prevent the failure of the bank, marks a point at which a bank may deemed to be no longer ‘viable’. This is a condition for the resolution authority to order a write-down or conversion into shares of AT1 CoCos. As BRRD does not exactly parameterize the conditions for such an action, we marked PONV trigger at the same level as recovery trigger (see Fig. 2.1). Only when all the supervisory (and private) measures including early intervention are exhausted and the regulatory capital level still not rebounds above TSCR + 1.5% bar (recovery trigger) is resolution authority entitled to exercise their write-down or conversion power. As presented in Sect. 2.6.1, CET1, AT1 and T2 instruments should absorb losses at the PONV and before any resolution action is taken. One of the main conditions for deeming a bank to be failing or likely to fail is a

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depletion or possible depletion of ‘significant’ amount of banks own funds including additional own funds requirements (P2R). With respect to this we set a resolution trigger at TSCR that is slightly below PONV (see Fig. 2.1). Finally, as subject to CRR Article 92 ‘institutions shall at all times satisfy’ TCR, own funds of level below that bottom bar (see Fig. 2.1) mean infringement the requirements for continuing authorization. Figure 2.1 shows that capital level seeming to be a reasonable PONV trigger indicator lies above CoCo high-trigger level of 7% RWAs. Figure  2.2 directly compares CoCo high-trigger level to that of PONV trigger. Unlike what Fig. 2.1 presents, to make view more readable this comparison is made of CET1 capital items only, which means that AT1 and T2 capital layers are taken out. Figure  2.2 clearly shows that in case of the 41 major European Economic Area (EEA) banks, CoCo trigger of 7% RWAs was situated in-­ between PONV and resolution triggers at the end of 1Q2018. As mentioned earlier, supervisors impose additional own funds requirements individually on each bank throughout SREP process. Therefore P2R capital level for this population ranged between 1.2% RWAs (Nykredit Group of Denmark) and 5.2% RWAs (Nordea of Sweden). Contractual CoCo low trigger of 5.125% RWAs lied below resolution trigger. Of course, it is practically impossible to indicate exact regulatory capital level below which a bank may been deemed failing or likely to fail. As it was shown earlier many different drivers stay behind such a determination made by the competent and resolution authority. However the observation that PONV trigger will be hit well before 7% CET1/RWA trigger is activated is confirmed by calculating so-called implied PONV level with use of AT1s market quotations and ECB stress-test volatility parameters, which will be shown in detail in the next chapter.

2.7.3 Why Actually 5.125%? Contrary to the original intentions the CoCo contractual triggers lie below PONV. Neither CRR nor BCBS (the Basel Committee on Banking Supervision) papers provide direct explanation for the introducing a minimum low 5.125% of RWAs trigger for AT1 CoCos. An answer can be found in Basel III text only indirectly (Jaworski et al., 2019). Namely, provision 131 of Basel III introduces capital conservation ratio, that is, a requirement for a bank to conserve a certain fraction of its earnings in the subsequent financial year depending on its CET1 ratio. A bank with a CET1 ratio below 5.125% RWAs (i.e. minimum of 4.5% RWAs stipulated in provision 50 of Basel III plus 0.625% RWAs) must retain all of its distributable profits. When a bank

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Table 2.2  Individual bank minimum capital conservation standards CET1 ratio

Minimum capital conservation ratios (expressed as a percentage of earnings)

4.5%–5.125% >5.125%–5.75% >5.75%–6.375% >6.375%–7.0% >7.0%

100% 80% 60% 40% 0%

Source: Basel III

has CET1 ratio exceeding 7% is free from any constraints on capital distributions (see Table 2.2). This calculation excludes any additional CET1 needed to meet the 6% Tier 1 and 8% TCR. For example, a bank with 8% CET1 and no Additional Tier 1 or Tier 2 capital would meet all minimum capital requirements, but would have a zero conservation buffer and therefore be subject to the 100% constraint on capital distributions. Looking at the Table 2.2, one notch is exactly 0.625% RWAs. This value is the same as initial size of capital buffers in the first year of Basel III (CRR) adoption. These values would then rise by 0.625% annually. This means that high-trigger CoCos are instruments that absorb losses (by virtues of conversion or write-down mechanism embedded) immediately when the capital conservation regime sets in, that is, when CET1 ratio falls below 7%. This value can be formulated as minimum CET1 ratio (4.5%) increased by 2.5%, that is, fourfold of the initial size of capital buffer. In addition, it corresponds also to maximum size combined capital conservation and countercyclical buffers could be of in 2017. Low-trigger CoCos in turn are instruments, that absorb losses when a bank would have to conserve 100% of its earnings, that is, when its CET1 ratio falls below absolute minimum (4.5% RWAs) plus 0.0625% of capital buffer size. Simultaneously it equals the size of combined capital conservation and countercyclical buffers for 2016. This means that CoCo trigger levels do not reflect neither the rise of capital conservation and countercyclical buffers size in years 2018–2019, nor other existing buffers, in particular systemic risk buffer imposed as early as 2014 (Jaworski et al., 2019). One may formulate a hypothesis that EU lawmakers intended to calibrate AT1s to phasing-in base capital requirements only for initial period of 2013–2017. Beyond 2017, the capital requirements relating to the abovementioned buffers have been increasingly exceeding the CET1 ratio trigger levels thus reducing the probability of AT1s being triggered contractually. This makes PONV trigger become more and more prominent. The five-year

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time horizon seems to coincide with the AT1s minimum non-call period of five years (see Sect. 1.3.3 of Chap. 1). AT1s issued in years 2013–2015 will have their first calls in 2018–2020 at the earliest. However to be granted a regulatory permission for redemption a bank must replace its AT1s with own funds instruments of no worse quality in terms of loss absorption (see Sect. 1.3.3.2 of Chap. 1). A possible explanation maybe that it was assumed that by this time CRR would have been amended to adopt CoCo triggers to the growing capital requirements. Anyway, this didn’t happen, and the CRR II proposal does not provide for increasing CoCo trigger level (Jaworski et al., 2019).

2.7.4 Resolution of Banco Popular The first incident of any sort of coupon or principal loss in the AT1 CoCos asset class was writing down to zero all the AT1s of Banco Popular Español S.A. in June 2017. On 6 June 2017, the ECB determined that Banco Popular was failing or likely to fail in accordance with Article 18(1) of the SRM regulation. As ECB stated in its press release of that day: ‘The significant deterioration of the liquidity situation of the bank in recent days led to a determination that the entity would have, in the near future, been unable to pay its debts or other liabilities as they fell due. Consequently, the ECB determined that the bank was failing or likely to fail and duly informed the Single Resolution Board (SRB), which adopted a resolution scheme entailing the sale of Banco Popular Español S.A. to Banco Santander S.A’. Although Banco Popular’s chronic problems were asset quality and solvency, the immediate catalyst for resolution was a liquidity crisis. FROB, the Spanish restructuring fund and resolution authority (Fondo de Reestructuración Ordenada Bancaria), disclosed that Banco Popular’s total deposits had declined to around €60 bn by 5 June 2017, from almost €80 bn at the end of March 2017. A resolution scheme was adopted by the Single Resolution Board (SRB)  and executed by the FROB.  The SRB transferred all shares of Banco Popular including the entire business of Banco Popular and its subsidiaries to Banco Santander. This means that Banco Popular operated under normal business conditions as a solvent and liquid member of the Santander Group with immediate effect. As part of the execution of the resolution scheme, (1) all the shares of Banco Popular outstanding and all the shares resulting from the conversion of the AT1s issued by Banco Popular were totally cancelled and (2) all the Tier 2 bonds issued

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by Banco Popular were converted into newly issued shares of Banco Popular, all of which were acquired for a price of one euro having regard to the results of the valuation of the bank.11 In fact Santander did not acquire any of the common shares that existed prior to the subordinated debt conversion, they were simply cancelled along with the AT1. Moreover, as part of the transaction, Banco Santander carried out a share capital increase of approximately € 7 bn which covered the capital and the provisions required to reinforce the balance sheet of Banco Popular so that the impact on the CET1 capital of the Banco Santander Group remained neutral. The first and the only so far resolution process combined sell of business tool for transferring shares to a purchaser with write-down and conversion of capital instruments. As no bail-in tool was used the senior debt remained protected. The AT1 wipeout had little spillover into the rest of the market, with most other AT1 securities soon trading at higher levels – even for debt issued by Spanish banks. This calm stands in stark contrast to the chaos in the market in February 2016, when jitters around whether Deutsche Bank could continue to pay coupons on its AT1s triggered a broad selloff, closing the primary market for such securities entirely. The resolution trigger was bank’s illiquidity not a capital position. All of the € 1.25 bn AT1s issued by Banco Popular were written down (see Table 1.2 in Sect. 1.3.3.5) long before their contractual triggers were hit. Banco Popular issued both: low triggers and high triggers which turned out to be of no meaning in terms of either loss-absorption sequence or different rates of recovery. Table 2.3 gives some idea about the capital position of the bank at the end of last full quarter of its normal functioning. Looking at the Table 2.3, on 31 March 2017 Banco Popular CET1 level was above MDA threshold, P2G however was not fully met. Had the bank’s capital remained stable by the resolution date, the PONV would have been then 10.02% RWAs. More predictive value has perhaps the comparison of Banco Popular capitalization with that of other major European banks at that time (see Table 2.4). Banco Popular lies at the bottom of the Table 2.4, followed only by Banca Monte dei Paschi di Siena (MPS), another troublesome bank.

 The ex-ante valuation (BRRD Article 36) revealed the base scenario economic value of Banco Popular of € minus 2 bn, in adverse scenario the economic values fell to € minus 8.2 bn. 11

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Table 2.3  Regulatory capital of Banco Popular at end-1Q2017 Banco Popular Transitional Fully loaded 31.03.2017 Common Equity Tier 1 (CET1) ratio Tier 1 ratio Total capital ratio AT1 CoCos important parameters CET1 high trigger Transitional/fully loaded Distance to trigger (%) Distance to trigger (€ mn) ADI at end-2016 (€ mn)

10.02% 10.87% 11.91%

7.33% n.a. n.a.

7.000% Transitional 3.02% 1838 3832 2017 MDA threshold in CET1 only 7.88% MDA threshold 9.482% Base Common Equity Tier 1 4.50% Capital conservation buffer 1.25% Countercyclical buffer 0.00% Systemic risk buffer 0.00% D-SIB buffer 0.125% Pillar 2 requirement 2.00% AT1 shortage to 1.5% of RWAs 0.65% Other shortage in capital other than CET1 vs. 3.5% RWA 0.96% CET1 cushion above MDA requirement % 0.54% CET1 cushion above MDA requirement (€ mn) 326 Pillar 2 Guidance (estimated) 1.25% SREP requirement (incl. Pillar 2 Guidance) 10.732%

7.000% Fully loaded 0.33% 201 3832 Fully loaded 9.25% 12.75% 4.50% 2.50% 0.00% 0.00% 0.25% 2.00% 1.50% 2.00% −5.42% −3300

Source: CreditSights Table 2.4  The best and worst capitalized major EEA banks at end-1Q2017 CET1 ratio Country

Bank

The best capitalized banks UK Nationwide Sweden Swedbank Sweden Sv Handelsbanken Denmark Nykredit Realkredit Sweden SEB Sweden Nordea Netherlands ABN AMRO (…) The worst capitalized banks Spain BBVA Italy Banco BPM Spain Santander Spain Banco Popular Italy Banca MPS Source: CreditSights

Transitional

Fully loaded

25.43% 24.24% 23.81% 19.49% 18.91% 18.78% 16.87%

25.43% 24.24% 23.81% 19.46% 18.91% 18.78% 16.86%

11.64% 11.50% 12.12% 10.02% 6.46%

11.01% 10.93% 10.66% 7.33% 6.04%

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2.8 C  onversion and Write-Down of Capital Instruments of Italian Banks in 2017 2.8.1 Banca Monte dei Paschi di Siena On 22 December Monte dei Paschi announced the failure of its attempt to raise capital from the private sector. On 1 June 2017 EU Competition Commissioner Margrethe Vestager and Pier Carlo Padoan, Italy’s Minister of Economy and Finance reached an agreement in principle on the precautionary recapitalization of MPS (EC Statement 17/1502). The BRRD Article 32(4)(d) offers a possibility for the state to inject capital into a solvent bank, provided that certain criteria are met (so-called precautionary recapitalization). The BRRD recital 42 matches MPS’ position closely: the provision of extraordinary public financial support should not trigger resolution where, as a precautionary measure, a member state takes an equity stake in an institution, including an institution which is publicly owned, which complies with its capital requirements. This may be the case, for example, where an institution is required to raise new capital due to the outcome of a scenario-based stress test or of the equivalent exercise conducted by macroprudential authorities which includes a requirement that is set to maintain financial stability in the context of a systemic crisis, but the institution is unable to raise capital privately in markets.

The Italian State injected the capital worth €5.4 bn, in return for shares in MPS (bought at a discounted price). In line with ‘burden-sharing principles’ under EU state aid rules, subordinated bondholders and shareholders have contributed €4.3 bn, that is from the conversion of T2 bonds (many retail-held) into equity and the dilution of existing shareholders (EC Statement 17/1502). MPS was neither being put into resolution nor declared at the point of non-viability. Instead, the power to convert subordinated debt into equity was created by means of the Decree Law and the equity support (meaning in fact bail-out) was provided under the precautionary recapitalization terms of Article 32 of the BRRD.

2.8.2 Veneto Banca and Banco Popolare di Vicenza On 23 June 2017 the ECB deemed Veneto Banca and Banco Popolare di Vicenza failing or likely to fail. The banks had exceptionally high levels of non-performing loans and did not fulfil their Pillar 2 and combined buffer requirements. Later that day, the SRB decided that resolution was not war-

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ranted for the two banks as neither of these banks provided critical functions, and their failure was not expected to have significant adverse impact on financial stability. The two Italian regional banks were effectively deemed to be not big or important enough to be of public interest. On 25 June the European Commission approved state aid for the two banks. Following day, Intesa Sanpaolo confirmed it would acquire assets and liabilities of both banks. The decision of the SRB not to put these two banks into resolution allowed them to get access to state aid as part of an orderly wind-down under national ­insolvency law.12 The Italian government provided a cash injection of €4.8 bn and up to €12 bn in state guarantees to facilitate the orderly wind-down and support Intesa’s acquisition. By using state aid, the Italian authorities protected deposits and senior bonds (many of which were retail-owned) as they were part of the liabilities transferred to Intesa. Shareholders and T2 bondholders were, however, written down as part of state aid ‘burden-sharing’ rules.

2.9 Senior Non-Preferred Securities 2.9.1 TLAC and MREL Requirements On 9 November 2015, the Financial Stability Board (FSB) published the ‘Total Loss-Absorbing Capacity (TLAC) Term Sheet’, to develop requirements for loss-absorbing capacity at global systemically important banks (G-SIBs) which was endorsed by the G20 in November 2015. In a parallel process, the European Commission (EC) proposed a similar standard— MREL (minimum requirement for own funds and eligible liabilities) – for all EU banks within the BRRD framework. Both TLAC and MREL are designed to maintain critical economic functions in the event of failure, without recourse to public funds, by ensuring there is sufficient capital and other bail-­ inable liabilities to absorb losses and, in the case of systemically important banks, to recapitalize them. The main difference between MREL and TLAC is that MREL applies to much bigger number of banks than TLAC. In addition, TLAC establishes a common minimum requirement for all G-SIBs, while MREL is to be set on a case-by-case basis. Thus the minimum TLAC requirements for G-SIBs are included in the amended CRR (Article 92a) so it applies directly to banks without having to be transposed into national law.

 Many controversies aroused whether liquidation was carried out under ‘normal insolvency proceedings’ as defined in BRRD Article 2(10(47)). 12

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It must be stressed that TLAC/MREL eligibility is not the same as bail-­ inability. Eligibility focuses on creating a layer of reliably bail-inable liabilities which excludes a number of liabilities that are deemed bail-inable under the BRRD. Although the BRRD contains a bail-in tool that allows regulators to write down senior liabilities if a bank is put into resolution (see Sect. 2.4), regulators have been concerned about the practical implications. In particular, resolution authorities appeared reluctant to contemplate the bail-in of liabilities such as corporate deposits, structured notes and derivatives, mainly for a NCWO principle reason. However, traditionally these liabilities have ranked pari passu with senior unsecured debt at European banks, and the prospect of bailing in senior unsecured debt but no other senior liabilities raises the possibility of legal challenge by creditors. As majority of banks don’t have sufficient Tier 1 and Tier 2 instruments to meet TLAC/MREL requirements, a different class of bail-inable TLAC-eligible senior unsecured debt appeared to cover this shortfall. This whole group of different kinds of debt in Europe have had only recently official term of ‘senior non-preferred’. Sometimes they used to be called ‘Tier 3’; however, it doesn’t form a regulatory capital category as non-preferred senior can only be bailed-in under a formal resolution process, the same as other senior liabilities. The difference is that holders of senior non-preferreds would first bear losses, before the resolution authority moved on to bailing in other senior creditors if necessary.

2.9.2 MREL Subordination Requirement At all times, financial institutions must meet minimum requirements with respect to own funds and eligible liabilities, as determined by the resolution authority on an individual basis (BRRD Article 45[1]) so as to be able to absorb losses and restore their capital position. Details on how to calculate MREL are to be found in the EU Delegated Regulation 2016/1450. The individually set MREL level must be achieved by 1 January 2023. MREL requirement refers to both recovery and resolution. MREL is expressed as a percentage of the total liabilities and own funds of the institution, not its RWAs (BRRD Article 45[1]). The ‘eligible liabilities’ are instruments (1) that are fully paid up; (2) that are not owed to, secured by or guaranteed by the institution itself; (3) whose purchase was not funded directly or indirectly by the institution; (4) that have remaining maturity of at least one year; (5) that do not arise from a derivative; and (6) that do not arise from certain privileged deposits (BRRD Article 45[4]). MREL can be met with regulatory capital and other long-term liabilities which can feasibly and credibly bear losses in a resolution: regulatory capital plus the

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portion of Tier 2 that is under regulatory amortization (lasts five years), but has more than one year left to maturity as well as basically all senior unsecured debt with a maturity of over one year including deposits not covered by the Deposit Guarantee Fund with a maturity of over one year. That means eligible instruments do not necessarily have to be subordinated, but the resolution authority may require that part of MREL be met with ‘contractual bail-in instruments’ within so-called subordination requirement, which basically dictates what instruments can be eligible for MREL purposes, and in particular, how much preferred senior can count towards it. National regulators have been given considerable discretion over what securities and how much preferred senior they will allow banks to count towards their MREL requirements. It is assumed that overall MREL requirement should be no less than 8% of balance sheet: under the terms of Article 44(5) BRRD resolution funds can be used once 8% of the original balance sheet has been bailed-in to compensate creditors that are eventually deemed to be worse off than in liquidation (to restore the NCWO principle). The resolution fund contribution for these purposes cannot exceed 5% of the bank’s original balance sheet. In extraordinary circumstances after the 5% resolution fund contribution limit has been reached, the resolution authority may seek further funding from alternative financing sources (including state aid), but only after ‘all unsecured, non-­preferred liabilities, other than eligible deposits, have been written down or converted in full’ (BRRD Article 44[7]). There is one more situation in which state aid can still be used in the EU, potentially for full protection of remaining creditors once 8% of the balance sheet has been bailed-in. But it could apply only ‘in the very extraordinary situation of a systemic crisis’, as laid out in Article 37(10)(a) of BRRD. Accordingly, the SRM Regulation Article 27(7) provides that contribution of eurozone-dedicated Single Resolution Fund (SRF) must be preceded by bail-in of at least an amount not less than 8% of the original balance sheet. The SRB, after consultation with national supervisors (and ECB), lays out indicative MREL calculation for the majority of biggest and most complex eurozone banks including all G-SIBs, the bulk of them being CoCos issuers. The current SRB calculation (as for December 2017) is as follows:13

13

MREL = Loss Absorption Amount ( Pillar 1 + Pillar 2 + CBR [ combined buffer requirement ] ) + Recapitalisation Amount ( Pillar 1 + Pillar 2 ) + the market confidence buffer ( CBR minus the market confidence charge [ MCC] of 1.25% of RWAs ) .  MREL – SRB Policy for 2017 and Next Steps, Single Resolution Board, 20 December 2017.



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E.  Koenig (2018) in her publication to be found on the SRB website, explained that ‘As a new feature, some bank-specific adjustments were introduced for the recapitalisation amount and the market confidence charge, by referring to the effect of balance sheet depletion, the use of recovery options, or restructuring plan divestments and sales’. Such a general statement does not help to precisely calculate an individual bank-specific adjustment. Besides, SRB introduced ‘subordination benchmark’ under which the minimum for subordinated instruments (including non-preferred or holding company senior debt14) has been set at 13.5% of RWAs + the CBR for G-SIBs, and 12% of RWAs + the CBR for D-SIBs. Since for European G-SIBs, MREL must be set consistently with the TLAC requirements 13.5% subordination requirement for G-SIBs should be compared to subordination requirement calculated for the purposes of meeting TLAC requirement, described in the following section.

2.9.3 TLAC Subordination Requirement The minimum TLAC requirements for G-SIBs are the greater of 16% of RWAs or 6% of leverage exposure from 1 January 2019, rising to 18% and 6.75% from 1 January 2022. While MREL is denominated as a percentage of bank’s total assets, the calculation of TLAC is based mainly on RWAs. Tier 1, Tier 2 and other TLAC-eligible debt instruments must amount to at least 33% of the minimum TLAC requirements. Unlike with MREL, regulatory capital buffers do not count into TLAC RWA-based minimum. Regulatory capital may not be used to meet both TLAC requirements and the combined buffer requirements. Another crucial distinction between TLAC and MREL is that currently the BRRD does not stipulate a subordination requirement for MREL, although this may be required on a case-by-case basis by national regulators. Certain countries such as the UK, Germany and Sweden want MREL to be covered entirely by subordinated liabilities, but other countries such as France, Italy and Spain believe that banks should also be able to include nonsubordinated senior (preferred senior) debt. The higher relative cost of issuing subordinated debt compared with preferred senior is likely to put some banks at a funding disadvantage, although, this can be offset by tighter spread their preferred senior should trade at as there is a larger bail-inable layer ­sitting underneath.  See Sect. 2.9.6.

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While most of the TLAC requirement is to be met with some form of subordinated instrument, senior unsecured debt that ranks pari passu with excluded liabilities but which is otherwise TLAC-eligible may be included (at the discretion of the regulator) up to 2.5% of RWAs when the overall requirement is 16%, rising to 3.5% when the overall requirement moves to 18%.15 The 13.5% subordination proposal for MREL (see previous section) is just a different way of expressing what TLAC demands on the 2019 basis, that is, an 8% minimum total capital requirement, plus another 8% for recapitalization, minus the 2.5% preferred senior allowance. In 2022 the minimum TLAC requirement rises by two percentage points from 16% to 18% of RWAs, partially offset by a rise in the preferred senior allowance from 2.5% to 3.5%. The net effect is an increase in the overall subordination requirement by one percentage point, from 13.5% to 14.5%. The FSB in its ‘Principles on Loss-absorbing and Recapitalization Capacity of G-SIBs in Resolution’ of 9 November 2015 gives a guidance how ensure that eligible TLAC absorbs losses prior to liabilities that are excluded from TLAC-eligible instruments. Primarily, this can be achieved in three ways: 1. Debt is contractually subordinated to other liabilities (‘contractual subordination’). 2. Laws of a given jurisdiction prefer or subordinate certain types of liability (‘statutory subordination’). 3. Senior unsecured debt is issued by holding companies (‘structural subordination’).

2.9.4 Contractual Subordination In December 2016, France passed a law to allow a contractually lower ranking for a new class of debt called non-preferred senior (so-called Loi Sapin 2).16 The creditor ranking is determined by this legislation, which states that losses are taken in the order of CET1 first, then AT1, then Tier 2, then in any of the new ‘non-preferred senior’ and finally by the existing or ‘preferred’ senior bonds and other senior unsecured liabilities. Immediately after the Loi Sapin 2 had been passed Crédit Agricole mandated a ten-year euro-denominated non-preferred senior deal. Crédit Agricole was soon followed by the rest of  Principles on Loss-absorbing and Recapitalisation Capacity of G-SIBs in Resolution, Financial Stability Board, 9 November 2015. 16  Loi n° 2016–1691 du 9 décembre 2016 relative à la transparence, à la lutte contre la corruption et à la modernisation de la vie économique. 15

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four France’s major banks (BPCE, Société Générale and BNP). So far, Italy, Spain, Belgium, the Netherlands, Sweden and Austria have followed France in changing their banking legislation to allow the issuance of non-preferred senior. The EU Directive 2017/239917 amending BRRD envisages all EU countries adopting by 29 December 2018 the French solution of issuing ­non-­preferred senior instruments that will ensure TLAC/MREL compliance by ranking in insolvency junior to existing senior debt but senior to own funds instruments and subordinated liabilities that do not qualify as own funds instruments (Directive 2017/2399 Recital 10). The European legislator puts a strong emphasis on disclosing the lower ranking of this new instrument class under normal insolvency proceedings in terms and conditions of an issue. Besides, Article 7 of Regulation 2017/1129 (Prospectus Regulation)18 requires to describe in prospectus a subordination as the material risk factor. What is new under the BRRD amendment however, is that lack of such a reference prevents issuance from getting a ‘non-preferred senior’ status (Article 108[2] of amended BRRD). Moreover, the new BRRD Article 108(2) sets the criterion of ‘original contractual maturity’ of the debt instruments of at least one year without providing for regulatory amortization schedule similar to that of Tier 2 instruments set in CRR Article 64. Therefore it seems that senior non-­ preferred debt issued to meet BRRD Article 45 criteria (see Sect. 2.9.2) will nonetheless count as MREL till its maturity rather than one year before ‘remaining maturity’ passes as Article 45[4] stipulates it (Jaworski et al., 2019). Besides the debt instruments must neither contain embedded derivatives nor be derivatives themselves (Article 108[2][b]  of amended BRRD). However, under amended BRRD, debt instruments with variable interest derived from a broadly used reference rate, such as Euribor or Libor, and debt instruments not denominated in the domestic currency of the issuer, provided that principal, repayment and interest are denominated in the same currency, should not be considered to be debt instruments containing embedded derivatives solely because of those features (Directive 2017/2399 Recital 11; amended BRRD  Article 108[6]). Thus floating rate Eurobonds may be counted to MREL. This meaning a derivative is narrowed down in relation to the wide yet not exhaustive catalogue of the MiFID II Annex 1 Section C (Jaworski et al., 2019).  Directive (EU) 2017/2399 of the European Parliament and of the Council of 12 December 2017 amending Directive 2014/59/EU as regards the ranking of unsecured debt instruments in insolvency hierarchy. 18  Regulation (EU) 2017/1129 of the European Parliament and of the Council of 14 June 2017 on the prospectus to be published when securities are offered to the public or admitted to trading on a regulated market, and repealing Directive 2003/71/EC. 17

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2.9.5 Statutory Subordination In Germany, from 1 January 2017, the status of tradable senior unsecured bonds (excluding structured bonds and securities with original maturity of less than one year) was changed to subordinate it to other senior unsecured liabilities under the revised German banking law (KWG). Making existing and future senior debt TLAC-eligible favoured Deutsche Bank (the only G-SIB in Germany) as it eliminated its need to issue new subordinated debt. The reclassification of existing senior debt to be TLAC and MREL-eligible was widely criticized as it enlarged for existing senior bondholders the loss-­given-­bail-in because of the smaller pool of pari passu securities. Besides, statutory subordination of all outstanding long-term senior debt (over one year) deprives banks of the option of continuing to issue higher-ranked senior debt that remains pari passu with operating liabilities. For these reasons the contractual subordination solution was preferred EU-wide over Germany’s pattern. In order to harmonize the rules with the rest of Europe, Germany passed new legislation with effect from July 2018. Any senior unsecured bonds issued under new regime have to be contractually subordinated to other senior ­liabilities—with an explicit statement to that effect in the terms and ­conditions—in order to count as non-preferred senior debt.

2.9.6 Structural Subordination The UK and Swiss regulators’ preference is for TLAC/MREL to be met at the holding company (HoldCo) level with capital and debt instruments downstreamed to operating subsidiaries (OpCo). This model assumes that HoldCo senior debt is bail-inable and TLAC/MREL-eligible. The HoldCo eventually downstreams (on-lends) capital and debt to its operating subsidiaries in internal TLAC/MREL form, that is, in a form that is contractually subordinated to existing senior unsecured debt at the OpCo. As a result, holders of senior unsecured debt issued by the OpCo rank ahead of the downstreamed sub-­ senior debt from the HoldCo. In this model, resolution tools and powers are applied at the holding company level by a single resolution authority; the subsidiaries remain operational and can be transferred on a going-concern basis. This simplifies the resolution process and, at least theoretically, reduces the need for international co-ordination (Schillig, 2016). Where the OpCo experiences capital and liquidity shortages, funds can be downstreamed from the recapitalized holding company. When losses arise in an operating subsidiary, to the extent that it is no longer viable the intragroup liabilities will be

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written down or converted, passing the losses up to the HoldCo. Initially, Belgian KBC and ING in the Netherlands used a holding company structure. Eventually these countries switched to the contractual subordination pattern.

2.9.7 TLAC and MREL Harmonization On 25 May 2018 the European Council adopted EC proposals for changes to the key pieces of capital and resolution legislation for EU banks: BRRD, CRR, CRD IV and SRM regulation. The amendments proposed are often referred to as BRRD II, CRR II, CRD V and SRMR II. The amendments aim, inter alia, to provide harmonized rules for TLAC and MREL.  For European G-SIBs, MREL will need to be set consistently with the TLAC requirements and will be set by the resolution authority on a bank-by-bank basis. Integration of the TLAC standard into the existing MREL rules is to ensure that both requirements are met with largely similar instruments. Among other measures, this integration brings the MREL calculation more into line with TLAC by changing the base of the requirements, from total liabilities and own funds, to RWAs and leverage exposure (BRRD II Article 45). The proposal introduced the notion of ‘top-tier bank’ in order to capture financial institutions other than G-SIBs, of total assets of more than €100 bn. With regard to non-G-SIB top-tier banks the resolution authorities will have a large amount of discretion in setting the subordination requirement. The BRRD II allows regulators to set the subordination requirement for of at up to 8% of total liabilities and own funds (less 3.5% of RWAs if agreed). So, non-G-SIB top-tier banks could have a subordination requirement as low as 13.5% of RWAs or as high as almost the full MREL requirement.

2.9.8 The Protection Retail Holders of MREL Instruments The forced wipeout of subordinated and bail-inable senior bonds held by retail investors poses a practical and political problem. Some member states as Italy forbad offering MREL-eligible instruments to retail clients while implementing BRRD into their laws. The UK Financial Conduct Authority (FCA) banned offering CoCos to retail investors in its Conduct of Business Sourcebook (COBS 22.3.) ‘Restrictions on the retail distribution of contingent convertible instruments and CoCo funds’ recommendations within the FCA Handbook.19 The German supervisory authority, BaFin  https://www.handbook.fca.org.uk/handbook/COBS/22/?view=chapter.

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(Bundesanstalt für Finanzdienstleistungsaufsicht) warns on its website, that CoCo instrument are not proper for retail investors and as such should not be offered to them.20 In Poland and Croatia a principal of a single T2 bond should be no less than domestic currencies €100,000 equivalent. The Austrian supervisor sees the high stake of retail-owned MREL-eligible instruments as potential ‘substantive impediments to the resolvability of an institution’ with consequences provided for in BRRD Article 17 (Jaworski et  al., 2019). Paradoxical though it may seem, there are no such restrictions with regard to holders of instruments the most exposed to the risk of forced loss-absorption under new resolution regime—namely the shares. It is the shareholders who first bear losses with much less prospect for bail-out comparing to what they could have expected had the bank faced insolvency in pre-BRRD times. After all however, it lies in the nature of shares to be the first in the loss-sharing ranking this way or another. Own funds AT1 and T2 instruments in turn, are usually labelled as bonds (not to mention the bail-inable debt) which falls under wider ‘fixed income’ instruments category. Here the general understanding of fixed incomes is rather deceivable than explanatory and the nonprofessional investors may simply not be able to go through tortuous and full of indecipherable paragraphs and multiple cross references EU legislation to read the exact nature of CoCo, T2 and bail-in bonds.

2.9.9 TLAC and MREL in a Group Resolution The AT1 CoCo issuers are almost exclusively large banks or banking groups that operate on an international, if not global, basis. In general, three models of banking groups can be identified: (1) holding company model, (2) ‘big bank’ model, and (3) global multi-bank model. Under holding company model, a holding company (HoldCo) holds separate commercial bank and investment bank subsidiaries. The banking and investment business are conducted out of the respective subsidiaries (OpCo). It is the predominant form of a bank ownership in the US (Schillig, 2016). Under the ‘big bank’ model, all activities are conducted out of a single legal entity with a large balance sheet. The German Grossbanken are representative for this model. Global multi-bank model means a holding company owning a number of banks incorporated in different jurisdictions. External funding may be raised to some extent at the level of the holding company, at the same time some of the bank subsidiaries may issue their own senior debt. HSBC Holdings plc, the UK parent company 20  https://www.bafin.de/SharedDocs/Veroeffentlichungen/DE/Fachartikel/2014/fa_bj_1410_coco-­ bonds.html.

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that owns a number of subsidiaries covering different regions of the world, serves as a good example of this model (Schillig, 2016). The organizational structure born out of mixture of legal environment, tradition and business strategies determines to much extend the adopted resolution strategy. On an entity-centric basis, there may be distinguished SPE (single point of entry), MPE (multiple point of entry) resolution strategies and, combination of both, hybrid SPE/MPE model (Regulation 2016/1075 Recital 23). Under SPE strategy, the HoldCo or parent company of a group would be the resolution entity, and the OpCo would not be put into resolution if possible. This can be achieved in a way that losses arising in the OpCo would initially have to be absorbed by the OpCo’s own capital and subordinated debt. If the losses arise to the extent that it is no longer viable, the intragroup liabilities will be written down or converted. That would merely transmit the losses to the HoldCo as the owner of these instruments. In this model, the senior debt issued by the HoldCo is to be downstreamed in a form that is subordinated to other senior liabilities in the OpCo. Usually OpCo don’t have much, if any, externally issued senior debt. To be viable, this approach requires sufficient capital and bail-inable debt to be issued by the holding company in order that it can be written down and converted to equity. For TLAC/MREL and resolution planning purposes, externally issued CET1, AT1, T2 and senior instruments are at the HoldCo level. HoldCos downstream senior debt to the OpCo as internal TLAC/MREL, that is, in a form that is contractually subordinated to existing senior unsecured debt at the OpCo (‘sub-senior’), and with language that would allow it to absorb losses at the PONV, before the group is placed in resolution. As a result, holders of senior unsecured debt issued by the OpCo rank ahead of the downstreamed sub-senior debt. G-SIBs with ‘material sub-groups’—subsidiaries that are not separate resolution entities and that are located in a different country21—need to meet internal TLAC requirements (i.e. TLAC issued to, or downstreamed from, the parent) at a level of 75%–90% of where their external TLAC requirement are. The home authority is also permitted to impose internal TLAC requirements on domestic subsidiaries. Regulators in the UK and Switzerland have indicated that major banks should meet TLAC/ MREL and resolution/bail-in requirements at the HoldCo level. Under MPE resolution strategy, banking groups would be resolved at the entity that is experiencing problems. Each resolution authority would apply the resolution tools in its local jurisdiction, following the local resolution  A material sub-group is a subsidiary, whose RWAs leverage exposure or operating income amount to 5% or more of the group’s. 21

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regime. Parent support would be voluntary and normally conditional upon home authority approval. Each subsidiary (resolution entity) in the group should have the capacity to absorb losses (TLAC), and requirements at the consolidated level should essentially be the sum of all the individual ­requirements. This is the model currently favoured by most European regulators, largely because not many European banks have HoldCo structures. The SPE strategy is mainly confined to the UK and Switzerland. If banking groups consist of more than one resolution entity, the location of TLAC might be as important as the overall quantity. For example, in a group such as Santander, MPE resolution would involve intervention at whichever entity was in trouble, such as its UK or its Latin American subsidiaries, rather than at the parent bank level. As an example, in the UK its resolution entity will be its holding company, Santander UK Group Holdings, which needs not only enough external TLAC and but also has to downstream capital and debt securities as internal TLAC to its operating subsidiary, Santander UK. So-called hybrid SPE/MPE models may be deemed for decentralized groups such as HSBC or Santander that operate through intermediate HoldCos. It would comprise of (1) an SPE scheme when dealing with subsidiaries in the Europe (or Eurozone which falls under SRM) and (2) an MPE scheme when dealing with subsidiaries in third countries. Apart from G-SIBs there are O-SII entities (like BBVA in Spain) that are subject to the MREL rules, not TLAC, following MPE strategy. The BRRD adopts a ‘top down’ approach to the determination of the MREL within a group. In consequence, resolution action is applied at the level of the individual legal person, and that it is imperative that loss-absorbing capacity is located in, or accessible to, the legal person within the group in which losses occur (BRRD Recital 80). Recital 80 of the BRRD further states that ‘resolution authorities should ensure that loss-absorbing capacity within a group is distributed across the group in accordance with the level of risk in its constituent legal persons. The minimum requirement necessary for each individual subsidiary should be separately assessed’. Each Individual entity’s MREL in the group is strictly connected with resolution strategy adopted. The Commission Delegated Regulation (EU) 2016/1075 sets out detailed criteria how to assess the resolution strategy is appropriate. In November 2016 the European Commission proposed that, in compliance with the TLAC term sheet, banks have external MREL (applicable to resolution entities), and internal MREL (applicable to subsidiaries). The notion of internal MREL is not well established in BRRD. On 16 January 2019 SRB published its ‘2018 SRB Policy for the second wave of resolution

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plans’ where it announced to start issuing binding MREL targets at the individual level to subsidiaries of banking groups. From the bondholder standpoint, it seems that there is not much difference between owning bail-inable instruments issued by the HoldCo and to holding the same securities in a European bank without a holding company. This is because debt at the HoldCo would be bailed-in at the same time as debt in a European operating bank, only after the OpCo’s capital and subordinated debt has been wiped out. Of course, the important thing is how big would the failing OpCo be in relation to the HoldCo and whether or not all debt issued by the holding company has been downstreamed to its operating bank subsidiary or subsidiaries.

2.10 Conclusions According to the EU recovery and resolution framework practically all debt instruments of an institution should be capable of being fully and permanently written down or converted fully into Common Equity Tier 1 capital at the point of non-viability (PONV) of the institution. As explained in Chap. 1, coupon risk is a less severe threat to AT1 bondholders but is a more likely event than principal write-down or conversion. The main risk to principal for AT1 bondholders is that the bank is put into resolution, or the resolution authority declares it to be at the PONV. In these circumstances, holders are likely to be wiped out, given that AT1s are deeply subordinated and rank only just above equity. The determination that a bank is no longer viable has not been undoubtedly defined, but the PONV obviously occurs before a bank’s CET1 ratio falls to the CoCo trigger level. This was a case of Banco Popular in June 2017. A necessary of public intervention well before CoCo contractual triggers activated means they turn out to be ‘gone-concern’ rather than intended ‘going-concern’ instruments. A risk of breaching the CoCo contractual trigger before bank reaches its PONV seems even more remote in case of AT1s with a CET1 trigger of 5.125%. Therefore, the risk of low-trigger CoCos being converted into CET1 or written down is little different from that of a plain vanilla Tier 2 bond. This means that getting paid a premium over a straight Tier 2 for little extra risk is attractive. With some regulators already setting the bar at 7% (most notably, the UK, Sweden and—as presented further in Sect. 4.2.1—Switzerland) it seems that banks will gradually move towards issuing high trigger instruments instead of low-trigger ones. The Bundesbank, in its March 2018 monthly report put in question the rationale for low-trigger CoCos on the grounds

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that they are not able to absorb losses on an ongoing basis. It recommended that the capital ratio trigger should be looked at to see how high it needs to be considered effective which means that even CET1 trigger of 7% is argued. It is possible that national ad hoc legislation might be passed instead of using PONV powers. Not putting Veneto Banca and Banco Popolare di Vicenza into resolution allowed Italian State to wind them down under national insolvency law and avoid bailing in senior bondholders. However, this would likely have the same implications for AT1 holders if any of these Italian banks were AT1 CoCos issuers. What we learned from the abovementioned restructurings is that bail-in of CET1, AT1 (as with Banco Popular) and T2 instruments alone did not bring banks back over their PONV levels. It must be accompanied either by the sale of business tool or bail-out. Surprisingly, the Banco Popular AT1 wipeout had no contagion over the rest of AT1 market which stays in contrast to the spillover caused by rumours over Deutsche Bank’s inability to pay its AT1s coupons less than one and half year earlier. However, many Banco Popular investors, among them AT1 holders, have filed lawsuits against EU regulators over their handling of the failure of Banco Popular, marking one of the largest legal challenges yet to the EU. The limitation on the amount of preferred senior debt to fall within a range of ‘eligible liabilities’ reflects concerns over the bail-inability of senior unsecured debt that ranks pari passu with other senior liabilities that would not be MREL-eligible, thereby raising the risk of legal challenges based on the NCWO principle. Recently a legislation has been passed to allow European banks to designate certain liabilities as eligible to take the first hit in the form of plain vanilla senior non-preferred bonds. The new layer in the liabilities stack ranks above subordinated debt but below traditional senior debt. The rise of a new assets class of non-preferred senior reduces to minimum probability of more radical CoCos to be designated as ‘contractual bail-in instruments’, thus expanding their role in bank capital beyond that envisaged in CRR. The senior non-preferreds lessen the chance that bank’s other liabilities will be bail-in and thus are expected to lower its overall cost of debt funding.

3 The Contingent Convertibles Pricing Models: CoCos Credit Spread Analysis

3.1 T  he Impact of Conversion into Equity Mechanism on CoCo Pricing. An Introduction At first glance convertible (CB), reverse convertible (RC) and contingent convertible (CoCo) bonds are quite similar debt securities. All of them are based on a straight fixed coupon bond. All are additionally equipped with an equity conversion mechanism. Let us ignore at the moment a write-down, coupon deferral and bond call/put options (giving the right for the issuer/bondholder to initiate premature redemption at a predefined call price) and solely concentrate on the impact of different conversion mechanisms on the bond characteristics. Convertible bond holder is entitled at specified dates to choose between converting into a fixed number of issuer’s shares or not converting thus go on receiving CB coupons and principal. Equivalently the CB investor has got a two-element portfolio of a straight bullet bond and a long call stock option. The option strike price is equal to future convertible bond value divided by the number of shares received at conversion. Therefore the CB holder has a limited loss potential to straight bond value (called investment value), and an unlimited profit potential when the underlying shares price upsurges (see Fig. 3.1 left hand exhibit). The CoCo equity conversion is triggered automatically when the issuer’s regulatory capital ratio (CET1 ratio) drops below a specified level. In effect, the bondholder receives a predetermined number of issuer’s shares and the bond ceases to exist. This distress scenario would be almost for sure accompanied by the share price drop, say below a level of S ∗. Therefore the CoCo © The Author(s) 2019 M. Liberadzki, K. Liberadzki, Contingent Convertible Bonds, Corporate Hybrid Securities and Preferred Shares, https://doi.org/10.1007/978-3-319-92501-1_3

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Fig. 3.1  Theoretical value (prior to maturity) of a convertible bond and of a contingent convertible (CoCo) versus the price of the underlying share. Source: Liberadzki and Liberadzki (2016)

bondholder has got a position equivalent to holding a straight (dated or perpetual) bond and short put stock option (see also Sect. 3.3.3). With the result, the CoCo value range is capped by the straight bond value and floored at zero (see Fig. 3.1),with strong sensitivity to the underlying stock price downturn.1 Very similar conversion mechanism to CoCo is built into reverse convertible bond. This structured bond pays off interest and principal unless the underlying share price (or basket of selected stocks value) drops below a specified strike level at bonds maturity. If so, the RC bondholder receives payoff, being exclusively an equivalent of the underlying shares depreciated value. As a result, the RC value versus the price of the underlying shares is practically identical to the one of the CoCo. Structured products were a popular investment in particular in Germany and Switzerland, where they accounted for 6–8% of all invested assets. In the US, the market growth used to be of around 30% annually (Rieger, 2012). There are no clear data on these instruments’ historical performance. As a structured note, the reverse convertibles were traded over the counter and marketed to selected individuals by some brokerage firms. In the year 2010, according to Bloomberg, an average loss on sold in the US in previous year  In fact, due to short position in equity put option, the CoCo bondholder has got both negative option delta and gamma. 1

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1481 reverse convertibles was 1%, while the S&P 500 stock index returned 8% and corporate bonds gained 11.1% (Faux, 2011). There were occasionally some rumours about the poor RCs performance and the structures were even named ‘toxic investment’. To sum up: a convertible bond offers the investors the safety of fixed income security during distress periods while an equity offers profitability at prosperous times. On the contrary, CoCos and RCs are high risk investments because of the short put option embedded. Thereby the risk is set off by relatively higher coupon (see Sect. 1.3.6 of Chap. 1).

3.2 T  he Credit Spread Definition and Key Formulas In case of perpetuals with built-in options, the YTM (yield to maturity) spread is calculated only accounting for fixed coupons up to the first call date and the bond nominal value, thus their yield will be calculated on the yieldto-call (YTC) basis. If the YTM denotes the yield for the reference instrument, the credit spread should be defined as following:

Spread = YTC − YTM.

Credit spreads are always quoted relative to reference discount factors or their equivalent yields. If the reference values are extracted from swaps or treasury bonds, then Z-spread (zero volatility spread) name is used. However, the spreads relative to treasuries, are called T-spreads. It is worth recon, that credit default swaps (CDS) are bilateral arrangements that allow one party (protection buyer or originator) to transfer credit risk of a reference asset, which it may or may not own, to one or more other parties (the protection sellers). In exchange, the CDS seller receives periodical spread (premium) expressed as basis points of a CDS notional value. CDSs are usually triggered on the occurrence of so-called credit event. What constitutes a credit event is defined specifically in the credit derivative contract. CDS may be paid out under both technical as well as actual default. A technical default refers to the delay in timely payment of an obligor, which does not have to be necessarily a prelude to actual default, but may be caused by operational reasons or short term cash shortage. CDS is triggered in case a credit event on the reference issuer occurs: the protection seller pays then a pre-­ arranged amount to CDS buyer.

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Following events may be specified as a credit event between counterparties (Choudhry, 2008): (1) downgrade in S&P and/or Moody’s and/or Fitch credit rating below a specified grade; (2) financial or debt restructuring; (3) bankruptcy or insolvency of the reference asset obligor; (4) default on payment obligation; (5) technical default; (6) a change in credit spread payable by the obligor. CDS Index on Tier 2 instruments issued by the bank X, is an arrangement, where the payoff depends on the occurrence of credit event on the Tier 2 bond. If the credit event does not occur, the payer is obliged to pay regularly (let’s say: quarterly) the amount of sN / 4 (where the s denotes the CDS spread and N stands for CDS Nominal) so the seller receives the total of sNT in altogether 4 T instalments ( T denotes the arranged CDS tenor in years). If the credit event occurs at the moment τ , 0 < τ ≤ T , the buyer has already paid the total amount of τ sN (payments due in the end first m quarters, 4m ≤ τ , plus the accrued interest paid at the moment τ ), the CDS seller is obliged at τ to pay the amount of LN , 0 < L < 1. The L rate value is agreed in the terms of CDS contract. The CDSs are among those instruments, which enable directly quoting the probability of default relating to specified issuer or a debt issue. They deliver clear message on market’s view about the individual default probability. Simultaneously CDS credit spreads are directly market-quoted. Arbitrage free pricing must respect for the relation between CDS spread, bonds spread and thus between credit spread and probability of default. Let us illustrate that on a simplified example, based on martingale derivatives pricing approach, flat interest rate term structure and exponential probability of default (Jaworski et al., 2019). We will discount all the cash flows by using the flat term structure of discount factor B ( t ) = exp ( −δ t ) ,δ > 0. According to the martingale rule of pricing, the expected values in martingale measure Q of discounted payoffs regarding both the buyer and the seller shall be equal:

EQ ( PVbuyer ) = EQ ( PVseller ) .



Note, that the Present Value of buyer’s payments might be approximated by the discounted continuous stream of cash flow:

exp (δ / 4 ) PVbuyer > PVcontinuous > PVbuyer > exp ( −δ / 4 ) PVcontinuous .



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Let us denote by τ the moment of default: τ

PVcontinuous (τ ) = ∫s e −δ t dt =



0

s 1 − e −δτ . δ

(

)



If the τ is exponentially distributed E xp ( λ ) , λ > 0 . EQ ( PVcontinuous ) = EQ ( PVcontinuous (τ )1τ T ) = T



(

)

s s s − λ +δ T 1 − e −δ t λ e − λ t dt + 1 − e −δ T e − λT = 1− e ( ) . δ δ λ +δ 0

=∫

(

)

(

)



From the seller’s perspective: T



EQ ( PVseller ) = L ∫ e −δ t λ e − λ t dt = L 0

λ − λ +δ T 1− e ( ) . λ +δ

(

)



After matching both expected values, we get:

s ≈ Lλ

(3.1)

If the spread s is known, so basing on model assumptions the probability of default until the moment T in martingale measure Q is approximately equal to 1 − exp ( −sT / L ) :

Q (τ ≤ T ) = 1 − exp ( −sT / L ) .



The model (theoretical) price of zero-coupon Tier 2 bond paying in moment T 1 if the bond does not default, or 0 in case of default, equals:

P = exp ( − sT / L − δ T ) .



3.3 Classification of CoCos Pricing Models 3.3.1 Overview Analysing defaultable corporate bonds, one may generally classify their pricing models into structural and intensity approach.

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According to structural approach, a default results from the change of issuer’s assets value, referring thus to celebrated (Merton, 1974) theory. By applying widely used Black-Scholes stock option pricing formula, the credit spread as well as issuer’s default probability may be estimated. It requires further inputs: issuer’s leverage level, maturity and seniority of his debt and indirectly—assets market value volatility approximated basing on stock price volatility (Liang & Giang, 2012). When market value of assets drops below some definite threshold, there is a default. This threshold is usually determined by nominal debt value. Of course, there are many variations on this theory, either by modifying threshold specification (Black & Cox, 1976) or by adding other processes, for example, stochastic interest rates (Longstaff & Schwartz, 1995). Intensity models ignore the endogenous factors causing default (Duffie & Singleton, 1999), using rather external inputs, mainly default intensity (Jarrow & Turnbull, 1995) or credit spread. It is a useful approach regarding those hybrids in which main characteristics suddenly change upon a distress event; CoCos are main representatives for this hybrid bonds category. Prices are strictly related to issuer’s financial condition and simultaneously—to default intensity. CoCos pricing models correspondent generally with the dafaultable bond pricing models taxonomy. Respecting the division between structural (Penacchi, 2011) and intensity approach (market implied models), the latter category includes credit derivatives and equity derivatives models (De Spiegeleer & Schoutens, 2012). CoCos are complicated securities so an applicable model seems to be tradeoff between (Wilkens & Bethke, 2014): (1) capability of capturing numerous CoCo characteristics (deferrals, callability, coupon revaluation); (2) respecting realistically trigger event; and (3) simplicity to calibrate model to market data and quote model parameters. It seems that the structural models excel as far as the first criterion is concerned, while credit derivatives and equity derivatives approach are relatively better in the third aspect (Liberadzki and Liberadzki, 2016).

3.3.2 Credit Derivatives Method In previous sections, the relationship between default intensity λ and default probability has been described. Equation 3.1 represents a credit triangle which is an approximated relationship between credit spread, default intensity and recovery rate. Note, that this conjunction was derived taking on fixed interest rates and default intensities.

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The credit derivatives method forged by De Spiegeleer and Schoutens (2012) uses this relation to approximate CoCo’s value. Keeping up to CoCo terminology, the link between contingent convertible bond credit spread ( sCoCo ) , recovery rate ( RCoCo ) , the trigger intensity λtrigger satisfies: sCoCo = (1 − RCoCo ) ∗ λtrigger .





(3.2)

CoCo triggering results in either conversion into shares or a CoCo principal write-down. If the C p denotes CoCo conversion price, N is a CoCo nominal value, Cr is the number of shares the bond is converted into while S ∗ is a market share price at conversion2: Cp =

N . Cr



Hence, in case of conversion the CoCo holder will incur loss of: lossCoCo

 S∗ = N − Cr S = N  1 −  Cp  ∗

  = N (1 − RCoCo ) . 

(3.3)

S∗ quotient is tantamount to CoCo recovery rate. The Cp recovery rate strictly depends on write-down degree: if for instance, 100% of a CoCo principal is written-down, then, RCoCo = 0 . The next step is an approximation of trigger intensity. The catalogue of possible trigger events has already been presented in detail in Chaps. 1 and 2. Among them, there is a forced conversion at regulatory authority’s discretion. It is impossible to properly assess a real probability of such event. Similar problems crop up while specifying a process for CET1 ratio, which is a typically accountancy-type coefficient. To avoid confusion caused by these immeasurable random variables, it is the issuer’s share price ( S ) which is a proxy for trigger events, while a CoCo is being triggered by reaching specified threshold share price level S ∗. To put it simply—the level S ∗ corresponds to the value of underlying share on the moment when CET1 ratio fails to stay above the minimum trigger level. Note that the

2

 See Sect. 1.3.5.3 of Chap. 1 for more on different conversion mechanisms.

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The probability ( p ) of hitting the S ∗ barrier within the lifetime T of a contingent convertible is:



  S∗  log    − µT  S   p =Φ  σ T  

   S∗  2µ log     + µT 2 ∗  S   +  S σ Φ       S  σ T    

  ,   

(3.4)

while:



µ =r −q−

σ2 , 2

q : continuous dividend yield, r : continuously compounded risk-free interest rate, σ : stock return volatility, T : maturity of the contingent convertible (in years), S : current market CoCo issuer’s stock price, Φ (x)—cumulative distribution function of normal distribution random variable ( X ), hence, probability of the random variable being larger or equal for x : P ( x ≤ X ) . The formula above stems directly from widely used Black-Scholes approach for barrier equity option pricing. Therefore, Black-Scholes assumption on share price geometric Brownian motion process with fixed drift µ and volatility σ parameters is valid. At this point, one may calculate for CoCo trigger intensity using formula:



λtrigger = −

log (1 − p ) T

.

(3.5)



Putting the right side of the above equation into Eq. (3.2) one gets the formula for CoCo spread: sCoCo = −

log (1 − p )  S∗ ∗ 1 −  Cp T 

  . 

(3.6)

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Employing Black-Scholes approach and using threshold share price as an equivalent trigger event bring many practical advantages for CoCo market participants. By reversing formula 3.4 one gets an implied threshold share price Simpl∗. This is a market estimation of share price level triggering CoCo conversion and/or a write-down.

3.3.3 Equity Derivatives Method The equity derivative model is another market-based approach proposed by De Spiegeleer and Schoutens (2012). Starting with CDS spreads, CoCo price and share price together with their implied volatilities market quotations, we find for the threshold stock price value ( S ∗ ), corresponding with the issuer’s CET1 ratio trigger level. CoCo is decomposed into a straight corporate bond and exotic stock options components. The embedded straight bond pays off regularly k coupons of ci at ti moments and nominal value N at maturity T. The CoCo issuer’s share price value drop below S∗ barrier triggers a contingent conversion and the bondholders lose their claim to receiving bond coupons and nominal. This is equivalent to short position in in a series of binary down-­ and-­in barrier options expiring at consecutive moments where the CoCo coupons and nominal are due. At forced conversion, the bondholder receives Cr shares, which is in fact a binary asset or nothing down-and-in option (De Spiegeleer, Hoecht, Marquet, & Schoutens, 2016). The formula for CoCo pricing is following; P = straight corporate bond − N binary down &in options − ∑ci ∗ binary down&in + Cr ∗ binary asset − or i



− nothing down&in stock option.



Using a binary stock option Black-Scholes pricing methodology (as given by Haug (2007)) we finally get:

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M. Liberadzki and K. Liberadzki k

P = N exp ( r − ( T − t ) ) + ∑ci exp ( −r ( ti − t ) ) i =1

(

) ( ) Φ ( y − σ T − t ) ) ( ) Φ ( y − σ t − t ) 

2 − N × exp ( −r ( T − t ) ) Φ − x1 + σ T − t + S ∗ / S  − ∑ci × exp ( −r ( ti − t ) ) Φ − x1i + σ ti − t + S ∗ / S  i

(

 S ∗  + Cr × S ∗    S 

a+b

 S∗  Φ (z) +    S 

a+b

λ −2

1

2λ −2

1i

i

 Φ z − 2bσ T − t  

(

)

(3.7)

while: q : continuous dividend yield, r : continuously compounded risk-free interest rate, σ : stock return volatility, T − t : maturity of the contingent convertible (in years), S : current market CoCo issuer’s stock price, Φ ( x ) —cumulative distribution function of a normal standard distribution, hence probability of the random variable X being larger or equal x : P ( x ≤ X ) , with: z =

(

log S ∗ / S

) + bσ

T −t

σ T −t 1 r −q− σ2 2 a = σ2

x1 =

y1 =

(

log S / S ∗

σ T −t

) + λσ

T −t

) + λσ

T −t

) + λσ

ti − t

) + λσ

ti − t

(

log S ∗ / S

σ T −t

2

b =



1 2  2  r − q − 2 σ  + 2rσ   2 σ

r − q +σ 2 / 2 λ = σ2

x1i = y1i =

(

log S / S ∗

σ ti − t

(

log S ∗ / S

σ ti − t

Assuming a full write-down CoCo, the Cr value is 0.



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3.3.4 The Implied CET1 Volatility Market Model The idea how to modify the credit derivatives model was proposed by De Spiegeleer, Höcht, Marquet, and Schoutens (2017). It is based on the concept to get back to CET1 dynamics modelling and then applying similar pricing methodology as described in Sect. 3.3.2. (Credit derivatives method) using barrier option pricing approach. To remain consistent with the Black-Scholes framework, the CET1 ratio evolution is modelled as a continuous geometric Brownian motion in the absence of any drift:



dCET1t = σ CET1dWt CET1t t

(3.8)

where the dWt stands for Wiener process increment and σ CET1 is a CET1 volatility. The probability p∗ that the ratio hits a trigger during time horizon T is equal to



2   Trigger  σ CET1  + T  log  CET1  2  ∗   p =Φ   σ CET1 T     2   Trigger  σ CET1 + T log −1   CET1  2  Trigger     +  Φ σ CET1 T  CET1   

     

(3.9)

with the notation retained as in Eq. 3.4, completed by:



Trigger – CET1 Trigger level; σ CET1– volatility of the CET1 ratio; CET1 – current CET1 ratio.

Starting with the CoCo price- or equivalently spread quotation using 3.2 and 3.9, we get implied CET1 volatility: σ CET1implied. Computation becomes

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easier in case of full write-down CoCos as the recovery ratio is equal to 0 then. In case of equity conversion CoCos, the recovery rate must be taken into account in accordance with Eq. 3.3 as follows:



sCoCo = −

(

log 1 − p∗ T

) ∗ 1− R (

CoCo

)



Where the RCoCo is a recovery rate resulting from CoCo forced conversion into equity. The more elaborate approach is to develop the equity derivatives method in a similar manner as presented in this section. The embedded exotic options are switched off if the CET1 ratio drops below the contractual level D . Hence, analogically to Eq.  3.7, the price of a CoCo (P) at the moment t equals:

(

)

P = Nexp ( −r (T − t ) ) × 1 − p∗ + ∑ci exp ( −r ( ti − t ) )

(

)

i =1

(

)

× Φ xi − σ CET1 ti − t − D Φ yi − σ CET1 ti − t   

where: xi =

log ( D )

σ CET1 ti − t

yi = −

log ( D )

σ CET1 ti − t

+

σ CET1 ti − t 2

+

σ CET1 ti − t 2





The starting point for the analysis while applying the model is the quoted CoCo market value (or equivalently the CoCo spread), which in turn enables calculation of the implied CET1 volatility: σ CET1implied. This market volatility level mirrors the market participants’ assessment of CET1 ratio volatility.

3.3.5 The Structural CET1 Model The analysis of CoCos features in a regulatory context conducted in previous chapters shows that the distance to trigger ratio (the difference between the

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issuer’s reported CET1 ratio and the trigger level of 5.125% or 7%)3 may not necessarily explain the CoCo price well as the so-called regulatory trigger (the point of non-viability, PONV) exists. However, it may be assumed that this specific regulatory capital cushion over the contractual CET1 level that initiates the principal write-down/forced conversion explains to some extent the valuation of a hybrid. Such an assumption is somehow supported by the logic of the implied CET1 volatility marked model (see the previous section), where the AT1 security is replicated, inter alia, by the exotic option on the CET1 ratio. The following section shows the use of implied CET1 volatility to build the risk adjusted distance to trigger ratio. Unadjusted distance to trigger (DsT) coefficient defined in relative values is a simple relation between the reported CET1 of a CoCo issuer and the CoCo contractual trigger: DsT =

CET1 Ratio contractual trigger

Apparently, the write-down or conversion into equity effects if the DsT level drops below the value of 1 before the instrument’s maturity. As Marquet (2017) found out, the unadjusted distance to trigger poorly explains the risk of contractual CoCo write-down/conversion. The regression analysis results in fit quality described by the R 2 coefficient of merely 2.3%. The CET1 ratio is obviously a kind of a ‘snapshot’—it reflects only the static situation of the bank, whereas the dynamic of CET1 ratio would explain more the processes taking place within the bank, like change and expectation of the bank financial results, non-performing loans (NPL) ratio and other factors. The risk-adjusted distance to trigger measure should more significantly impact on CoCo spread. Let’s take the marked implied CET1 volatility ( σ CET1implied ) as a proper risk measure. The σ CET1implied can be assessed using the CET1 volatility model. De Spiegeleer et al. (2017) propose the following CET1 volatility adjusted distance to trigger specification:

 See Sect. 1.3.5.6 of Chap. 1.

3

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DsTσ =

log ( DsT )

σ CET 1implied

(3.10)

The regression of AT1 spread versus the DsTσ Risk adjusted ratio allows for the R 2 significant increase to 50% (Marquet, 2017). Analogically, the estimation of market CET1 implied volatility values could be also applied for determining the capital cushion before coupon deferral, as the coupon deferral is triggered by the CET1 ratio reaching the maximum distributable amount (MDA) barrier (see Sect. 1.3.4.3 of Chap. 1). The CET1 structural model may deliver another useful analytical output, namely it may become a tool for assessing the risk of reaching PONV. For the comprehensive explanation of the PONV concept, please refer to Chap. 2. De Spiegeleer et al. (2017) made use of the European Central Bank (ECB) 2014 stress test results for the PONV evaluation. It was a comprehensive stress test exercise conducted with respect to the banks under the supervision of Single Supervisory Mechanism (SSM). The stress test assessment comprised of two components: • the Asset Quality Review (investigation of asset valuation on the balance sheet as of December 31, 2013); • Stress Test—the bank resilience check under two scenarios: a baseline scenario and an adverse scenario, conducted for the three-year horizon (2014–2016). The adverse scenario was forged by the European Systemic Risk Board (ESRB) together with the ECB, while the European Banking Authority (EBA) was responsible for coordination of the exercise (see Sect. 1.3.5.6 of Chap. 1). The minimum required CET1 ratio under adverse scenario was 5.5%. Assuming that the dynamics of the CET1 ratio is described by Eq. (3.8), one may use the concept of Itō integral for solving Itō differential equations.4 Finally, the value increment of CET 1t process within the time period t is:



 σ2 t  CET1t = CET10 exp  − CET1 + σ CET1 Z t  2  

(3.11)

 For more on solving stochastic differential equations: see Liberadzki (2016), Chapter 16, Section 16.2.2.

4

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137

whereas: Z —normally distributed variable Z ~ N ( 0,1) CET1t —the CET1 ratio resulting from the adverse scenario in years 2014–2016. Taking the CET1t values resulting from the stress test exercise for consecutive years, one can calculate the corresponding Z parameter value using Eq.  3.11. Note that the input CET1 ratio market volatility is obtained by applying the implied CET1 volatility method. It turns out, that the average Z value is lower than 1. If we assume that the ECB adverse stress test scenario corresponds to a 2.58 sigma event (there is a 0.5% probability that the drop in the CET1 ratio will be larger than what is accounted for in the ECB stress test scenario), we have to set the Z parameter to −2.58 . As this value is different from the one obtained using market implied volatilities, it is necessary to recalculate the CET1 volatilities by applying Eq. 3.11. This new adjusted implied CET1 volatility level would be called now the ECB CET1 implied volatility. Taking the ECB CET1 volatility level, it is possible to calculate implied point of non-viability embedded in the CoCos price, by simply matching the model and market prices. As a result, the average PONV trigger equals 9.37% (De Spiegeleer et al., 2017), which is significantly higher than the contractual level of 5.125% or 7%. What is noticeable is that the implied PONV level corresponds to the one deduced from the EU regulations as presented in Sect. 2.7 of Chap. 2: it lies clearly above the CoCo high-trigger level of 7% CET1 ratio.

3.4 C  ontingent Convertibles Credit Spread Empirical Analysis 3.4.1 General Remarks As presented in Sect. 3.2, credit spreads are always quoted relative to reference discount factors or their equivalent yields. If the reference values are extracted from swaps or treasury bonds, then Z-spread (zero volatility spread) name is used; alternatively, the spreads relative to reference treasuries are called T-spreads. The CoCo credit spread may be decomposed accordingly to all the clauses embedded in this security, as it has been shown on the Fig. 3.2. While analysing the AT1 securities’ credit spread, instead of using Z-spread it might be more useful to apply the difference between the Z-spread and the

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Fig. 3.2  CoCo spread decomposition. Source: Credit Suisse

spread on the CDS Index contract for the Tier 2 bonds (‘CDS spread sub’). Such a spread will be later denoted as the ‘Spread to Tier 2′. The rationale for this is that the spread to Tier 2 rewards the investor for all features unique to AT securities, namely the deep subordination, coupon deferral, call option and both regulatory and contractual contingent conversion.

3.4.2 The Model Data Our analysis comprises AT1 CoCos issued by the 33 major European banks: • Seven British banks: Barclays; HSBC Holdings; Lloyds Bkg Group; Nationwide; Royal Bank of Scotland Group; Santander UK Group Holdings; Standard Chartered; • Five Spanish: Banco Sabadell; Bankia; BBVA; CaixaBank; Santander; • Four Swedish: Nordea Bank; SEB; Svenska Handelsbanken; Swedbank; • Three French: BNP Paribas; Crédit Agricole; Société Générale; • Three Dutch: ABN AMRO Bank; ING Groep; Rabobank; • Two Austrian: Erste Group Bank; Raiffeisen Bank International; • Two Irish: Allied Irish Banks; Bank of Ireland; • Two Italian: Intesa Sanpaolo; UniCredit; • Two Swiss: Credit Suisse Group; UBS Group; • One Danish: Danske Bank; • One German: Deutsche Bank; • One Norwegian: DNB Bank.

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The financial data used for the analysis come from the annual financial reports for year 2017 (the reports were disclosed in 2018). The data and pricing parameters were taken from issuance prospectus or memorandum or were delivered by Bloomberg and CreditSights as on three different time moments: 13 March 2018, 5 April 2018 and 19 April 2018. Total of 351 data records were analysed, which covers approximately 90% of AT1 securities issued by the European banks. Two linear regression models were calibrated, specified as follows:

Y = b1 X1 + …+ bk X k +  .



(3.12)

The first of models was inspired by the credit spread decomposition approach while the other one by the martingale method for Index CDS spread pricing (see also Sect. 3.2).

3.4.3 The Model #1 3.4.3.1  The Input Data The model was forged by Jaworski and K.&M. Liberadzki (Jaworski et al., 2019). The dependent variable Y (see Eq. 3.12) is a difference between the CoCo bond ‘Z-spread’ calculated on the CoCo bond yield-to-call basis, and the CDS Index spread on Tier 2 instruments of the same AT1 issuer with the maturity ­corresponding with the first call date of the CoCo (see Sect. 1.3.3.2). Referring to the CoCo spread decomposition method (see Fig. 3.2) such a spread is a premium for embedded call option, coupon deferral and both regulatory and contractual loss absorption mechanism. After eliminating statistically less significant regressors, 12 of them were finally left in the model. The minimum value for the t-ratio (t-student statistic) is 3.24. The regressors left are as follows: X1 —AT1 instrument coupon increase in basis points (bp) after the first reset, if the issuer does not exercise the call option. The so-called implied coupon, shows what the all-in coupon cost would be to the banks if they were to leave any security outstanding beyond the first call and reset date, based on today’s floating-rate benchmark (i.e. current mid-swaps rate + reset spread for each issue—see Sect. 1.3.3.5 of Chap. 1); X 2 —the surplus over the average rating of 10.4 for the AT1 instrument issue scored by the agencies Moody’s, S&P i Fitch (the Table 3.1 explains our rating valuation method);

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Table 3.1  Rating valuation method (the rating agencies’ grades are associated with the relevant ‘weights’) Moody’s

S&P

Fitch

weight

Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Caa Ca Ca C

AAA AA+ AA AA− A+ A A− BBB+ BBB BBB− BB+ BB BB− B+ B B− CCC CC C D

AAA AA+ AA AA− A+ A A− BBB+ BBB BBB− BB+ BB BB− B+ B B− CCC CC C D

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

X 3 —product of multiplying the CoCo coupon by the CDS Tier 2 Index spread; X 4 —the surplus of the bank CET1 ratio over the MDA requirement, so-­ called MDA cushion (see Sect. 1.3.4.3 of Chap. 1). X 5 —the bank ‘Leverage ratio’. The leverage ratio must be calculated compulsorily by the institution (CRR Article 429[1]). The composition of the leverage ratio is following: the Tier 15 capital/leverage exposure. The leverage exposure is the sum of the exposure values of all assets and off-balance sheet items not deducted when determining the capital measure (CRR Article 429 [2] and [3]). It is usually a slightly lower value than the total asset value. Exceeding the maximum value for leverage ratio as recommended by the Basel III may have an impact on making decision on bank resolution (see Sects. 2.2 and 2.6.1 of Chap. 2), generally does not however result in imposing any supervisory sanctions. X 6 —time (in years) to the first call day; X 7 —the squared time (in years) to the first call day;

 Total of CET1 + AT1.

5

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X8 , X 9 and X10 —zero-one nature variables, receiving value of 1 when the quotation data falls on 13.03.2018, 19.04.2018 and 05.04.2018; X11 —dummy variable, taking the value of 1 when the CoCo bond is GBP denominated; X12 —dummy variable, taking the value of 1 when the New York State law is applicable for the CoCo issuance. Our empirical analysis confirmed that the ‘distance to trigger’ regressor is statistically unimportant (see also Sect. 3.3.5). It may be explained by the fact, that the European Economic Area (EEA) banks are well capitalized and the risk of contractual trigger event occurrence seems to be immaterial as presented in detail in Chap. 1. Rather the PONV trigger seems to be of higher impact (see Sect. 2.7 of Chap. 2). This is the reason why we do not differentiate in the analysis between the high-trigger and low-trigger CoCos. The regressors used in our model are dependent on three parameters: CoCo bond quotation date; issuing bank and the bond series. Respecting that, we may divide the regressors into four sets (Jaworski et al., 2019): Regressors X 4 (‘MDA cushion’) and X 5 (‘leverage ratio’ ) are dependent only on the bank; X1 (‘coupon increase’), X11 (‘GBP’) i X12 (‘New York law’) are characteristic strictly to the issue itself; The indicators X8 , X 9 i X10 are dependent exclusively on the quotation date; Finally the X 2 (‘rating’), X 3 (‘product of coupon and CDS spread’), X 6 (‘time to First Call’) and X 7 (‘squared time to First Call’) depend on the bank, the issue itself and the quotation date. It is worth noting that the only regressor dependent on market fluctuation is the X 3 , as its value is conjunct with the relevant CDS Tier 2 Index spread quotation.

3.4.3.2  The Results: Model #1 The computational results are following: The dependent variable Y : Spread to Tier 2; Value unit: bp; Mean: 173.97;

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Table 3.2  Regressors and structural parameters (Model #1) Regressor i 1 2 3 4

5 6 7 8 9 10 11 12

Structural parameter

name

Unit

Mean

Coupon increase Ratings Cpn*T2 CDS CET1 cushion above MDA restrictions Leverage ratio FirstCall -T0 (FirstCall -T0)^2 Date, 13.03.2018 Date, 19.04.2018 Date, 05.04.2018 Crncy, GBP Law, New York

bp pts bp pp

523.2 128.2 1.30 1.28 6.87 4.12 5.62 2.49

pp year year^2 1 1 1 1 1

5.39 4.53 26.56 0.32 0.33 0.34 0.10 0.23

Std. dev. Error

0.98 2.47 26.62 0.47 0.47 0.48 0.30 0.42

−0.15 28.11 −4.32 −2.73

Std error t-ratio p-value 0.02 2.21 1.06 0.82

7.06 12.71 4.09 3.33

9.25E-­12 1.56E-­30 5.37E-­05 9.74E-­04

−6.84 2.11 35.04 3.45 −2.58 0.28 198.47 18.22 210.73 17.90 220.15 17.63 24.64 6.89 −19.83 4.80

3.24 10.17 9.37 10.89 11.77 12.48 3.58 4.13

1.30E-­03 2.23E-­21 1.09E-­18 6.75E-­24 4.72E-­27 1.09E-­29 3.98E-­04 4.54E-­05

Source: Jaworski et al. (2019)

Standard deviation: 54.45. The table below presents mean and standard deviation of regressors and estimated values for structural parameters using the least sum of squares method, their standard error, t-ratio and p-value (Table 3.2).

3.4.3.3  Evaluation of the Model #1 The main parameters are as follows: Mean squared error: 1227; Estimator of residual standard deviation: 35.6; The correlation coefficient between the model variable 12



Yˆ = ∑bi X i i =1



and the dependent variable Y : 0.765 ; Determination coefficient R 2 : 0.585 . The signs of structural parameters are in accordance with the economical intuition regarding the modelled items. Among the factors reducing the difference between CoCo bond ‘Z -spread’ and the Tier 2 CDS Index spread are

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those evaluating the ‘condition’ of the bank—high rating (low values for the X 2 ), high MDA cushion ( X 4 ) and high leverage ratio ( X 5 ), significant increase of coupon after the reset (it reduces the non-call risk— X1 ), and the New  York law as applicable (presumably in favour of the CoCo bond holder— X12 ). The estimated structural parameters adequate to variables X 4 , X 5 , X1 and X12 are negative, and the parameter referring to the variable X 2 remains positive. The GBP denomination ( X11 ) increases the spread difference. The structural parameter is positive then. It might be so because of relatively lower GBP denominated instruments liquidity (comparing to the USD or EUR currencies), not to mention the ‘Brexit effect’. It is remarkable, that the dependency on the time to first call remains non-linear. The chart below presents the fit of empirical dependent variable value (vertical axis) with the model variable value (horizontal axis) for the quotation dates as on 13 March, 05 April and 19 April 2018 (Fig. 3.3).

Fig. 3.3  The empirical dependent variable (vertical axis) versus model variable (horizontal axis) as on 13 March, 5 April and 19 April 2018. (Model #1). Source: Jaworski et al. (2019)

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3.4.4 The Model #2 3.4.4.1  The Input Data This model was forged by Jaworski and K.&M. Liberadzki (Jaworski et al., 2019). Within the Model#2 framework, the dependent variable Y is a quotient of the CoCo bond ‘Z-spread’ calculated on the CoCo bond yield-to-call basis, and the CDS Index spread on Tier 2 instruments of the same AT1 issuer with the maturity corresponding with the First call date of the CoCo. It is worth recalling that the Z-spread is a difference between the CoCo bond YTC and the YTM of the relevant risk-free instrument. According to the default intensity-martingale method (see Sect. 3.2), the CDS spread on the Tier 2 instrument is proportional to the default probability intensity in the martingale measure λ . However, the Z-spread of a CoCo bond depends on three unobservable risk factors: • intensity of default (or resolution) probability in martingale measure λ ; • intensity of coupon deferral probability also in martingale measure; • probability in martingale measure of non-exercising the CoCo bond call option on the first call date. The model is founded on the hypothesis, that by the selection of proper independent variables we may reduce the impact of the second and the third risk component on the Z-spread. So that it remains more or less proportional to the first factor λ . Dividing the Z-spread by the Tier 2 CDS Index spread, we may also eliminate the λ factor. The excellent fit of the Model#2 confirms the above hypothesis. After eliminating the statistically less significant regressors, there are 11 remaining of them. The minimum value of the t-ratio (t-student statistic) equals 2.13. X1 —increase of the CoCo bond coupon (bp) after the first coupon reset; X 2 —quotient of the CoCo bond coupon increase (bp) after the first coupon reset and the relevant CDS Tier 2 Index spread; X 3 —quotient of the average Moody’s, S&P i Fitch rating (see Table 3.1) and the relevant CDS Tier 2 Index spread; X 4 —CoCo bond coupon.

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X 5 —quotient of the maturity (in years) to the first call day and the relevant CDS Tier 2 Index spread; X 6 —quotient of the squared maturity (in years) to the first call day and the relevant CDS Tier 2 Index spread; X 7 —quotient of the bank CET1 ratio surplus over the MDA requirement (‘MDA cushion’) and the relevant CDS Tier 2 Index spread; X8 —quotient of the bank Leverage ratio and the relevant CDS Tier 2 Index spread; X 9 —quotient of dummy variable, taking the value of 1 when the CoCo bond is GBP denominated and the relevant CDS Tier 2 Index spread; X10 —quotient of dummy variable, taking the value of 1 when the New York State law is applicable for the CoCo issuance and the relevant CDS Tier 2 Index spread; X11 —dummy variable, taking the value of 1 when the CoCo bond is GBP denominated. The minimum value of the t-ratio (t-student statistic) equals 2.13. Analogically as in the case of the Model#1, we may order the regressors into three sets. Regressors X1 (‘Coupon increase’), X 4 (‘Coupon’ ) and X11 (‘GBP’) are characteristic strictly to the specific issue parameters itself; Regressors X 7 (‘CET1 cushion above MDA restrictions %/T2 CDS’) and X8 (‘Leverage ratio/T2 CDS’) dependent only on the bank and the date of price quotation; Regressors X 2 (‘Coupon increase/T2 CDS’), X 3 (‘Ratings/T2 CDS’), X 5 (‘(FirstCall-T0)/T2 CDS’) and X 6 (‘(FirstCall-T0)/T2 CDS’), X 9 (‘Crncy, GBP/T2 CDS’) and X10 (‘Law New York/T2 CDS’) dependent only on the issue parameters itself and the quotation date (Jaworski et al., 2019).

3.4.4.2  The Results: Model#2 The computational results are following: The dependent variable Y: Multiple of Tier 2; Unit: 1; Mean: 3.17; Standard deviation: 1218.

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The Table 3.3 presents mean and standard deviation of regressors and estimated values for structural parameters using the least sum of squares method, their standard error, t-ratio and p-value.

3.4.4.3  Evaluation of the Model#2 The main parameters are as follows: Mean squared error: 0.268; Estimator of residual standard deviation: 0.527; The correlation coefficient between the model variable 11



Yˆ = ∑b1 X i + b 12 i =1



and the dependent variable Y : 0.905 ; Determination coefficient R 2 : 0.819 . Extraordinary high fit of the model variable with the dependent variable Y is an evidence for the hypothesis, that both analysed spreads (CoCo bond Z-spread and the relevant Tier 2 CDS spread) depend on the same risk factor—the bank resolution probability intensity ( λ ). By taking the quotient of the abovementioned spreads, this risk factor λ is being simply ‘eliminated’. It is worth mentioning, that the variables that do not have influence on Tier 2 securities and hence on the CDS Index, like ‘coupon’, or ‘coupon increase’ or New York law as applicable, play a similar role in the Model#1 and #2. High values of the regressors based on them ( X1 , X 3 i X12 in the first and X 2 , X 4 i X10 in the second model) reduce the difference or quotient between the spreads respectively. The Fig. 3.4 illustrates the fit of empirical dependent variable value (vertical axis) with the model variable value (horizontal axis) for the quotation dates as on 13.03, 05.04 and 19.04.2018. As discussed in Chap. 2, resolution authority has wide discretion as to when the contingent conversion or write-down of AT1 instruments (and T2 instruments as well) should take place. Conditions for such action (i.e. the likelihood of institutional failure) bring one to the conclusion that if an institution faces financial stress, contingent conversion or write-down will be forced by the resolution authority under Bank Recovery and Resolution Directive (BRRD) long before the CET1 capital ratio falls below CRR-given

1 2 3 4 5 6 7

name

Coupon increase Coupon increase/T2 CDS Ratings/T2 CDS Coupon (FirstCall-T0)/T2 CDS FirstCall-T0)/T2 CDS CET1 cushion above MDA restrictions %/T2 CDS Leverage ratio/T2 CDS Crncy, GBP/T2 CDS Law New York/T2 CDS Crncy, GBP Residual

Source: Liberadzki et al. (2019)

8 9 10 11

i

Regressor

1 1/bp 1/bp 1 1

bp 1 pts/bp pp year/bp year^2/bp 1

Unit

7.3074 0.0011 0.0030 0.1026

523.17 7.0767 0.1532 6.63 0.0464 0.2263 7.9457

Mean

Table 3.3  Regressors and structural parameters (Model#2) Std. dev.

4.7325 0.0043 0.0066 0.3038

128.23 4.8519 0.0936 1.05 0.0172 0.1713 6.8787 0.0675 −24.037 −12.156 0.487 0.539

0.00195 −0.327 21.812 −0.109 32.654 −2.553 −0.0143

Error

0.0205 11.263 4.550 0.160 0.339

0.0005 0.032 1.717 0.043 3.199 0.374 0.0064

Std error

Structural parameter

3.29 2.13 2.67 3.04 1.59

3.76 10.1 12.7 2.54 10.2 6.82 2.23

t-ratio

p-value

1.10E-­03 3.36E-­02 7.92E-­03 2.55E-­03 1.13E-­01

1.97E-­04 2.55E-­21 1.67E-­30 1.15E-­02 1.64E-­21 4.08E-­11 2.67E-­02

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Fig. 3.4  The empirical dependent variable (vertical axis) versus model variable (horizontal axis) as on 13 March, 5 April and 19 April 2018. (Model #2). Source: Jaworski et al. (2019)

(Capital Requirements Regulation) levels, whether it be a high-trigger ( > 7.0% ) or—especially—a low-trigger ( 5.125% ). Thus, these parameters have lost much of their importance, which is mirrored by their pricing: both types are priced as high-triggers. As discussed in previous chapters, a possible incentive for issuers to call low-triggers to replace them with high-triggers is not currently priced into spreads from what we can see. In essence, under BRRD all AT1 hybrids may be deemed high-triggers.

4 Non-EEA Banks’ and Insurers’ CoCos

4.1 Overview Financial hybrids issued by EEA financial institutions in order to meet Basel III capital requirements are the main subject of this study. These instruments, regulated in detail under Capital Requirements Regulation (CRR) and Bank Recovery and Resolution Directive (BRRD), were discussed in previous chapters. In this chapter, we exceed the scope of our study and also focus on the financial hybrids, issued by ‘third’, that is, non-EEA, countries’ issuers for the same purposes of Basel III regulatory capital. To a large extent, non-EEA financial hybrids will be similar to EEA financial hybrids. The minimum requirements that make CoCos eligible as Tier 1 capital are governed by the globally applicable Basel III accord. However, countries implementing Basel III have discretion to impose some additional requirements, with regard to regulatory capital and requirements which have to be met by financial hybrids eligible to be classified under the regime that governs regulatory capital. We may call this practice ‘gold-plating’. In the next sections, we will briefly present the main differences between EEA and selected non-EEA CoCos. Interestingly, regulators have the power to force write-offs or conversion into equity at point of non-viability (PONV) in the case of both Additional Tier 1 (AT1) and Tier 2 (T2) instruments; so, all Basel III-compliant countries have developed (or are currently developing) legislation to the same effect as the European Union’s BRRD. We may assume that this will be a major area of differentiation between legal systems: even in EEA, regulatory conversion/write-down is regulated ‘only’ in a directive.

© The Author(s) 2019 M. Liberadzki, K. Liberadzki, Contingent Convertible Bonds, Corporate Hybrid Securities and Preferred Shares, https://doi.org/10.1007/978-3-319-92501-1_4

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It means that non-EEA countries might not implement identical solutions to fulfil Basel III requirements. In Switzerland, we will show that the legal system also used ‘gold-plating’ when determining higher capital standards for financial institutions. The US banks’ AT1 capital in form of preferred stock lacks contingent conversion/write-down loss-absorbing capacity and will be discussed separately in Sect. 5.3.2.5 of Chap. 5. In Sect. 4.3 we present insurers’ Tier 1 Solvency II regulatory package compliant CoCo bonds. Like banks, insurers are part of regulated industry. Insurers’ and banks’ CoCos present very similar characteristics under EU Solvency II and Basel III regulatory regime. Most notably, they both have a loss-absorbency mechanism on a going-concern basis, which is based on a regulatory capital ratio trigger event. We then compare Tier 2 bonds issued by insurers to those issued by banks. Tier 2 bonds are plain vanilla bonds subordinated to senior unsecured debt, similar to those issued by European banks.

4.2 Non-EEA Banks’ CoCos 4.2.1 Switzerland Unlike with the EU countries, the Swiss regulator (FINMA) imposed additional capital buffer requirements to be fulfilled with CoCos. The Swiss Federal Council has published the Ordinance (Verordnung) implemented on 1 July 2016 phased-in over four years, with banks having to comply by end-­ 2019. The minimum ‘going-concern’ leverage ratio is set at 5% of leverage exposure, which translates into 14.3% of risk-weighted assets (RWAs). Common Equity Tier 1 (CET1) capital will have to be at least 3.5% of leverage exposure and 10% of RWAs. AT1 securities may account for the remaining 1.5%/4.3%, but only if they are ‘high-trigger’ instruments (i.e. written down or converted to equity if the CET1 ratio falls below 7%). The figure below (Fig. 4.1) shows the previous an the latest Swiss banks’ capital adequacy and leverage limits, with a split between ‘high-trigger’ and ‘low-trigger’ ­instruments; the latter have triggers of 5% (Tier 2 CoCos) or 5.125% (AT1s). For the selected Swiss banks’ AT1s issues please refer to Table 1.4. With regard to the grandfathering rules, existing low-trigger AT1s are grandfathered to ensure Tier 1-equivalent treatment until maturity or their first call date. Tier 2 CoCos (both low- and high-trigger) are grandfathered as ‘going concern’ until their first call date, their maturity or end-2019, w ­ hichever

4  Non-EEA Banks’ and Insurers’ CoCos  Leverage Ratio

151

Risk-weighted requirements 28,60%

19,00%

10,00%

4,56%

4.30 HT-Cocos (T1)

5% Ball-in instruments

1.44% LT-Cocos (T1/T2) 0.72% HT-Cocos (T1/T2)

1.50% HT-Cocos (T1)

2.40% CET1

3.50% CET1

OLD

6.00 % LT-Cocos (T1/T2) 3.00% HT-Cocos (T1/T2)

14.30% Ball-ininstruments

10.00% CET1

NEW

OLD

10.00% CET1 NEW

> Going concern Gone concern

Fig. 4.1  Swiss banks’ capital and leverage requirements. LT low trigger, HT high trigger

is earliest. If they no longer count as ‘going concern’, they are eligible as ‘gone concern’ (until one year before maturity).1 As presented in Chap. 1, the EU CRD IV (fourth Capital Requirements Directive) framework narrowed the scope for use of CoCos to effectively 3.5% RWAs which is far from original Basel Committee on Banking Supervision (BCBS) proposals to build the capital buffers above AT1 and T2 of CoCos as well, which would increase their admissible share in RWAs even up to 13%. In the name of ‘maximum harmonization’ and ‘single rule book’ (CRR Recital 9) Member States are not able to require higher levels of capital than it is stipulated in CRR (Cahn & Kenadjian, 2016). The rare exception to this rule comes from ‘Pillar 2 add-on’ powers that national supervisors have to add up to a particular bank’s capital requirements (see Sect. 1.2.7 of Chap. 1). In contrast, as presented above, the FINMA added supplementary requirements for meeting additional buffers with CoCos in excess of the Basel. By putting the capital rules in the CRR applicable directly, rather than in Directive, the EU cut off  Because they have a higher loss-absorbing capacity than senior debt, banks may receive a rebate on their required ratios, of up to 1% (leverage) or 2.86% (RWAs), if they are included in ‘gone concern’. 1

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any possibility for a wider use of CoCos such as had been made by the Swiss FINMA (Cahn & Kenadjian, 2016). Contrary to the EU, the Swiss regulator views Basel III as minimum standards that can always be supplemented by national authorities imposing additional buffers. In addition to ‘going-concern’ leverage ratio described above, the Federal Council set a ‘gone-concern’ leverage ratio, which is effectively the Swiss implementation of total loss-absorption capacity (TLAC). This includes any AT1 and Tier 2 instruments not included in the going-concern ratio plus TLACeligible senior debt issued by the holding company. It is set at twice the going concern requirements, that is, 10% of leverage exposure and 28.6% of RWAs.

4.2.2 Asia-Pacific 4.2.2.1  Asia-Pacific Banks Each Asia-Pacific country has implemented Basel III in its own way which results in some significant distinctions. The full Basel III capital requirements have been phased-in over a five-year transitional period and for most banks, this came to an end in 2018; so the capital ratios are no longer ‘transitional’ but ‘fully loaded’. An exception is India where the transition period continues until 2019. Besides, India is the only jurisdiction in Asia where some sizeable banks are not meeting their regulatory capital requirements. Australian banks are posting Basel III capital ratios that are adequate under Australia Prudential Regulation Authority’s (APRA) rules, which are stricter than the Basel Committee guidelines. The conservatism with which it implemented the Basel rules has led to a large and growing gap between the CET1 ratios reported by the banks under APRA’s rules, which look low, and their much higher ‘internationally comparable’ ratios. Additionally, APRA has adopted an accelerated implementation with all the regulatory adjustments applying in full from 2013, including reporting fully loaded CET1 ratios on a fully loaded basis. With regard to Chinese banks, the China Banking Regulatory Commission (CBRC) implemented the ‘Measures for the Management of Capital Adequacy Ratios of Commercial Banks’ (further referred to as the ‘2004 Management Measures’) in 2004. It formally initiated a regulatory review of commercial banks’ capital. On 7 June 2012, The CBRC issued ‘Administrative Measures for the Capital of Commercial Banks (for Trial Implementation)’, further referred to as ‘2012 Trial Measures’. Today, in terms of calculation of capital adequacy ratio of China’s commercial banks, most banks mainly refer to the more rigorous 2012 Trial Measures.

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However, there are also parts of them that not only refer to 2012 Trial Measures, but also adopt relevant rules in 2004 Management Measures in some ratios’ calculations (Li & Lin, 2017). Under the rules, commercial banks are categorized into four levels of capital adequacy (see Table 4.1). They are also attributed with different regulatory capital requirements. The lowest, first-level, requirements concern the CET1 capital adequacy ratio of 5% (so-­ called CCAR1), the T1 capital adequacy ratio of 6% (so-called CAR1) and the capital adequacy ratio of 8% (so-called CAR). Hence, we see room for AT1 instruments of up to 1% RWAs and for T2 instruments of up to 2%. Compared to Basel III requirements (CET1 of 4.5% and AT1 of 1.5% RWAs), the CBRC’s approach is slightly more conservative (CET1 of 5% and AT1 of 1% RWAs). Hence, it seems that Chinese banks will be able to rely less on AT1 CoCos than EEA financial institutions. The Hong Kong Monetary Authority (HKMA) set the same minimum capital requirements as recommended by the BCBS, that is, a minimum CET1 ratio, Tier 1 ratio and total capital ratio (TCR) of 7%, 8.5% and 10.5% respectively, after taking into account the 2.5% capital conservation buffer (CCB). The Reserve Bank of India set slightly more stringent minimum capital requirements versus the BCBS’ recommendations. For instance, its minimum CET1 ratio taking into account the 2.5% CCB is 8% as opposed to the BCBS’ minimum of 7%, while the minimum T1 ratio and TCR are 9.5% and 11.5% respectively. It is also stricter in requiring the deduction of all deferred tax assets from CET1 capital and the exclusion of revaluation reserves. Singapore moved to a Basel III-compliant regime in 2013. The Monetary Authority of Singapore’s (MAS) minimum capital ratios are set at a higher level than the Basel committee recommends, with the basic minimum at 6.5% (compared to the Basel recommendation of 4.5%). The MAS also requires a capital conservation buffer of 2.5% so the effective minimum CET1 ratio is 9.0%. Banks are required to meet the 6.5% minimum by 1 January 2015, with Table 4.1  Chinese banks’ minimum capital requirement under 2012 Trial Measures Reserve capital Counter-cyclical capital Additional capital CCAR1 CAR1 CAR Source: Li and Lin (2017)

Basic req.

Additional req.

Exceptional case

SIFIs

– – – 5.0% 6.0% 8.0%

2.5% – – 7.5% 8.5% 10.5%

– 0%–2.5% – 7.5%–10% 8.5%–11% 10.5%–13%

– – 1% 8.5%–n% 9.5%–12% 11.5%–14%

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the CCB phased-in over four years and fully implemented by 1 January 2019. Otherwise, the MAS’ regulations are largely comparable to the Basel committee recommendations, such as on regulatory deductions and transitional arrangements (Marshall et al., 2014).

4.2.2.2  Asia-Pacific CoCos It is very disputable to use the term ‘CoCo’ with respect to issues from Asia-­Pacific banks AT1s as they predominantly lack the feature of a hard trigger, typically the CET1 ratio falling below a given level, that would result in conversion or writedown of principal value. Given that AT1 issues from Asia-­Pacific banks can be classified as equity in the banks’ accounts, they do not need to have such a trigger (You et al., 2018a). This holds for the Korean, Singapore and Hong Kong banks’ AT1 issues. One can see the hard trigger of 5.125% in the Chinese bank AT1s while—interestingly—those issued out of Hong Kong are PONV only. Chinese banks’ issues also differ in that the mechanism for loss absorption is conversion (to H-shares2) at a predetermined price (based on that at the time of issuance), rather than write-down. There are also hard triggers of 5.125% in the Australian banks’ AT1s and 6.125% in case of the Indian banks (see Table 4.2). As far as the Korean Woori’s AT1 issue is concerned, the PONV trigger for write-down would be insolvency or when the bank is unable to make payments without support as determined by its regulator (see Table 4.2). There is a hard trigger for distributions however, as from 1 January 2016 the Korean regulators have determined that, in line with Basel norms, banks would be progressively restricted in their ability to make distributions as the CET1 ratio falls below 8.0%, the new rule to be fully applied from 2019. Unlike the EU AT1 CoCos, the Asia-Pacific AT1s possess a dividend-stopper provision: the coupon cancellation constitutes a restriction on the payment of dividends for ordinary shares (for more on dividend stopper please refer to Sect. 5.1.3 of Chap. 5). The EU regulators are more restrictive than Basel III that banned dividend pushers only (see Sect. 1.3.4.2 of Chap. 1). The lack of hard triggers means that contractual bail-ins will be applied only when banks fall into serious financial difficulties and have reached their PONV. Without hard triggers on the AT1 issues, it is less clear what would trigger loss absorption as the response of regulators may vary. Besides, many investors believe that governments would intervene to support a bank with, inter alia, capital injections, before capital falls to levels that would trigger losses on AT1s and without prompting a non-viability declaration that would trigger losses on Tier 2s. There are basically two arguments behind this belief:  H-shares mean ordinary shares of the domestically registered Chinese company which are denominated in Hong Kong dollar and listed in Hong Kong. 2

WESTPAC BANKING CORP NZ POSTAL SAVINGS BK CHINA CHINA MERCHANTS BANK BANK OF CHONGQING CO LTD HUISHANG BANK BANK OF JINZHOU CHINA CINDA ASSET MGMT BANK OF EAST ASIA LTD CHINA CITIC BANK INTL CHIYU BANKING CORP LTD

Australia

Hong Kong Hong Kong Hong Kong

China

China

China

China

China

China

Bank

Country

500 5.63%

500 4.25%

250 5.25%

USD

USD

3200 4.45%

1496 5.50%

888 5.50%

750 5.40%

1000 4.40%

7250 4.50%

1250 5.00%

USD

USD

USD

USD

USD

USD

USD

USD

11/29/2017

10/11/2016

5/18/2017

9/30/2016

10/27/2017

11/10/2016

12/20/2017

10/25/2017

9/27/2017

9/21/2017

Size Crncy (mn) Coupon Issue date

Table 4.2  Selected Asia-Pacific AT1s outstanding

5.0

5.0

5.0

5.0

5.0

5.0

5.0

5.0

5.0

10.0

Conversion/ write-down

H15T5Y + 315.0 bps

H15T5Y + 310.7 bps

USSW5 + 368.2 bps

USSW5* + 329.0 bps

H15T5Y + 348.6 bps

H15T5Y + 423.1 bps

H15T5Y + 321.0 bps

H15T5Y + 244.3 bps

H15T5Y** + 263.4 bps

Partial/full

Partial/full

Partial/full

Partial/full

Partial/full

Partial/full

Write-down

Write-down

Write-down

Partial/full

Partial/full

Partial/full

Permanent No

Permanent No

Permanent No

Permanent No

Permanent 5.125%

Permanent 5.125%

Permanent 5.125%

Permanent 5.125%

Permanent 5.125%

Permanent 5.125%

Write-­ Hard Loss down trigger absorption Perm/temp CET1

Write-down Full /conversion

Conversion

Conversion

Conversion

Conversion

Conversion

USISDA05* + 516.8 bps Conversion

Noncall yrs At First reset & spread issue Rate

(continued)

Yes***

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Contractual PONV

Bank

650 3.88%

500 5.88%

500 5.25% 300 5.50%

USD

USD

USD USD

5/16/2017 9/22/2016

8/13/2018

10/19/2017

Size Crncy (mn) Coupon Issue date

5.0 5.0

5.0

6.0

H15T5Y + 334.7 bps H15T5Y + 427.4 bps

H15T5Y + 305.1 bps

USSW5 + 179.4 bps

Noncall yrs At First reset & spread issue Rate

Source: CreditSights * US dollar 5-year mid-swap rate ** 5-year Constant Maturity US Treasury Yields ***Double trigger as PONV can be invoked by either HKMA or CBRC on parent

Singapore UNITED OVERSEAS BANK LTD Korea SHINHAN FINANCIAL GROUP Korea WOORI BANK India STATE BK OF INDIA/DUBAI

Country

Table 4.2 (continued)

Write-down Write-down

Write-down

Write-down

Conversion/ write-down

Full Partial/full

Partial/full

Partial/full

Yes

Yes

Contractual PONV

Permanent No Yes Permanent 5.5%, Yes 6.125% from March 2019 onwards

Permanent No

Permanent No

Write-­ Hard Loss down trigger absorption Perm/temp CET1

4  Non-EEA Banks’ and Insurers’ CoCos 

157

(1) it holds mostly for majority state-owned banks like the large Chinese institutions and (2) basing on past precedents it is possible that the Korean, Japanese or Thailand government would proactively support the banks. The argument for expected cash injections is strongest in Japan where the government is authorized to provide proactive support for systemically important banks, provided they are still deemed to be solvent (You et al., 2018a). The dawn of Chinese CoCos is marked by the adoption of the 2012 Trial Measures that required write-down or conversion features to be contained into the secondary capital instruments issued by Chinese commercial banks since 2013. China’s write-down bonds refer to bonds which can be reduced or converted into the ordinary stock automatically when issuing banks are in difficulties so that some indicators have reached the predetermined trigger thresholds. Write-down bonds are included in the bank’s Tier 2 capital and the issuing banks need to pay the agreed interest to investors when indicators do not meet the trigger conditions. According to Li and Lin (2017) in the period 1 January 2013 to end-2016, Chinese commercial banks issued 198 write-down bonds with maturity of generally ten years (only three issues were of maturity of 6, 7 and 15 years respectively). With regard to the Chinese AT1s, many went offshore where they were listed to meet the equity conversion clause (see Table 4.2). The uncertainty around whether Chinese AT1s could be issued with write-down clauses was resolved with Notice No. 3 which made clear that AT1s can be issued in perpetual format with write-down clauses. Notice No. 3 has also encouraged banks to issue innovative loss-absorbing instruments to help them boost CET1. In response to that, China Everbright’s issued in 2017 RMB 30 bn convertible bonds to support CET 1 ratios (You et al., 2018b). The Japanese banks’ AT1 issues have all been domestic and in yen as the domestic market has been very cheap for them. For example in 2016 Mizuho made two Y230 bn issues: one callable in 2021 with a coupon of 1.38% and one callable in ten years with a coupon of 1.55%. Similarly, the Australian banks’ AT1s have been issued in A$ and sold mainly to domestic retail investors. A notable development for capital instruments in 2017 was the emergence of ‘dual trigger’ clauses. Both, Hong Kong Chiyu Bank AT1s (see Table 4.2) and the Macau’s Luso International Banking T2 10NC5.5s3 are issued out of subsidiaries owned by Xiamen International Bank (Chinese city commercial bank). What is new is that loss absorption upon PONV can be triggered by both the issuers’ home authority (HKMA in Chiyu’s case and Monetary Authority of Macau in Luso’s case) and the parent’s (primarily CBRC). If the issues were conducted directly out of Xiamen International Bank, then they would have had notable Chinese AT1 features: a conversion into H-shares  10NC5.5 = 10 non-call 5.5; 10 years maturity note with a call option to be exercised no earlier than five and half years from the issue date. 3

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M. Liberadzki and K. Liberadzki

upon hitting a hard 5.125% CET1 ratio trigger. Instead, they possess merely two PONV triggers and may be written down on loss absorption, which is of course less investor-friendly. The rationale for the inclusion of the additional PONV clause is to allow the capital that is raised to count towards the parent’s capital base (You et al., 2018b).

4.3 Contingent Convertibles Issued by Insurers 4.3.1 Solvency II Regime The requirements of Solvency II are defined by the Solvency II Directive (2009/138/EC)4 and the Commission Delegated Regulation (EU) 2015/35.5 Solvency II became effective on 1 January 2016, after more than 15 years of discussion between insurers and European regulators. It replaced a simplistic Solvency I approach set up in the 1970s with a harmonized EU wide insurance regulatory regime which included more robust capital requirements, improved valuation techniques, stronger risk management and governance standards for the European insurance sector. Similar to the CRD IV/CRR, Solvency II defines three layers of capital. Tier 1 (T1), which is the ‘core capital’, is considered as the cornerstone layer of capital. Under Article 82 of Regulation (EU) 2015/35, Tier 1 capital must represent at least 50% of the company’s Solvency Capital Requirement (SCR). Thereof, up to 20% of an insurer’s total eligible own funds can consist of ‘high quality’ hybrid instruments (so-called Restricted Tier 1, RT1). Surplus funding from high quality hybrid issues above the 20% level may be classified as Ancillary Tier 2. The remainder of own funds may consist of Tier 2 (T2) ­capital, including subordinated debt, which is defined as dated or undated bonds. Interestingly, Tier 2 capital can include letters of credit or guarantees from banks. In addition to the SCR, centred on the Value-at-Risk (VaR) concept, European insurers are also required to hold capital to meet the minimum capital requirement (MCR). MCR which is calculated with a confidence level of 85% with a one-year time horizon as opposed to the SCR that is calculated on a 99.5% confidence level. Common shares and reserves must cover at least 80% of MCR. The remainder is to be covered by T1 and T2 instruments. The MCR is a threshold at which the local regulator is required to intervene.  Directive 2009/138/EC of the European Parliament and of the Council of 25 November 2009, on the taking-up and pursuit of the business of Insurance and Reinsurance. 5  Commission Delegated Regulation (EU) 2015/35 of 10 October 2014, supplementing Directive 2009/138/EC of the European Parliament and of the Council on the taking-up and pursuit of the business of Insurance and Reinsurance. 4

4  Non-EEA Banks’ and Insurers’ CoCos 

Tier 1 Equity capital Reserves Value In Force

159

Minimum 50% of SCR Minimum 80% of MCR

Tier 1 Hybrids