On September 12 the U.K.'s Independent Commission on Banking released its much-anticipated final report, also known as the "Vickers report" after chairman Sir John Vickers.
Much of the press has focused on the report's recommendation to "ring-fence" retail banking operations from riskier businesses under the same roof, but there is another, equally important development: The Vickers report effectively turns all bank debt issued with a maturity greater than twelve months into a form of loss-absorbing contingent capital.
The recommendations at first appear to be quite harsh requiring banks to hold 17-20% of loss-absorbing capacity. But once banks consider the flexibility the commission afforded them with respect to the type of capital acceptable to meet the new requirements, everything becomes quite manageable.
The report's 17-20% capital figure bears a strong resemblance to Swiss regulations released in October 2010 requiring Switzerland's biggest banks to hold 19% Tier 1 capital. This 19% minimum is to be filled by 10% Core Tier 1 and an additional 9% of contingent capital securities.
On the heels of these requirements in early 2011, Credit Suisse announced its future intentions to place 6 billion Swiss francs of Tier 1 contingent capital notes along with an actual placement of $2 billion of contingent capital securities, which count as Tier 2 capital.
There was widespread speculation about the possibility for the creation of a large market for contingent capital securities. But the rationale for such securities since then has waned.
First, there was hope that the additional capital systemically important financial institutions would have to hold could be met by contingent capital. But when details about the "SIFI Buffer" were finally release, the Basel Committee said that it must be filled with Common Equity Tier 1 only. Suddenly a strong driver for the issuance of contingent capital ceased to exist.
Second, getting back to the U.K., the report did not endorse the use of contingent capital to meet its additional capital requirements. But even more to the point about the 17-20% loss-absorbing capital requirement: the Vickers report demands banks have 10% of equity capital against risk weighted assets, with an additional 7-10% which includes long-term unsecured debt that regulators could require to bear losses in resolution.
These "bail-in bonds," as they would be known, are similar to contingent capital by recapitalizing a bank through the conversion of debt into equity or a write-down of principal. However, unlike contingent capital, this occurs only when a bank is put into resolution and not before.
What the commission envisages happening is that when a bank falls below its Basel-mandated hard minimum of 4.5% common equity capital, a bank would be considered non-viable and regulators would intervene to assign losses on bail-in bonds. Importantly, this happens once equity and subordinated debt are completely wiped out so that the capital structure and the typical order of subordination are respected.
The Vickers report treats all debt securities with a maturity over one year as bail-in bonds, including senior unsecured debt — effectively making all debt of this type a form of contingent capital.
Because of the wide spectrum of securities the ICB will accept as loss-absorbing capital, U.K. banks can easily achieve the capital requirements of 17-20% set out in the report. In fact, the report makes the point that "the six biggest U.K. banking groups all already have sufficient senior unsecured term debt in issue to make up the 7% of RWAs" above the 10% equity capital minimum it is demanding.
It is quite clear that no large market for contingent capital securities will be created as a result of the Vickers report or U.K. regulations.
To be fair, most banks were unhappy with the Basel Committee for requiring the SIFI buffer to be filled completely with common equity and specifically lobbied for contingent capital issuance. That's exactly what Barclays argued for in its response to the SIFI buffer requirements and said that using contingent capital instead of common equity for the buffer would translate into £275 billion of additional small- and medium-enterprise lending capacity alone over a ten year period without hurting the loss absorbency capabilities of a bank in a stressed scenario.
But Barclays' comparison of issuing contingent convertibles in that analysis was relative to its cost of equity, not the cost of currently outstanding debt. In fact, according to the report, Barclays has more than enough senior unsecured term debt to meet any requirements demanded by the U.K. above common equity of 10%.
Investors were certainly excited at the prospect of investing in high-yielding contingent capital securities. But in reality, what bank would actually issue debt securities that exceeded its cost of equity unless it was forced to do so by regulators?
Lastly, there appears to be no catalyst coming from the United States for the issuance of contingent capital. Regulatory treatment of preferred stock is still unclear and may still count as Tier 1 capital going forward, rendering contingent capital useless. Importantly, a point that has been made by many market participants is that interest payments on contingent capital are unlikely to be tax deductible for issuing banks under U.S. tax laws because investors have a potential equity claim in liquidation.
A separate market for newly issued contingent capital securities appears to be on hold at the moment.
Michael Shemi is a director at Christofferson, Robb & Co., a money management firm with offices in New York and London.