Contingent Capital

April 22, 2011 By wpengine

Contingent Convertible Bonds and Banker Compensation: Potential Conflicts of Interest?

Gaurav Toshniwal*

Two issues related to financial regulation have received significant academic and regulatory attention since the financial crisis: Contingent Convertible Bonds (“CoCos”) and banker compensation. The discussion, however, has largely been silent on the interaction between the two. This brief note explores the potential conflicts that may exist in the design and implementation of CoCos because of the incentive structure created by managerial compensation. Regulators, academics and market participants will need to address these concerns in designing the regulatory framework for CoCo instruments and managerial compensation.

Contingent Capital Instruments

The financial crisis exposed the inadequacy of equity capital at the major financial institutions. In response, academics, regulators and banking executives have focused on bolstering banking capital requirements, partly through innovative capital instruments.[1] One such instrument is the Contingent Convertible Bond.[2] This bond converts into equity capital based on a pre-set trigger, thereby augmenting a bank’s capital during a financial crisis.[3]

The trigger could be based on three different types of metrics: 1) capital-based triggers that rely on accounting measures of capital adequacy, 2) regulatory discretion-based triggers that allow regulators to mandate conversion of CoCos into common equity during a banking crisis, and 3) market-based triggers that are triggered by declines in stock prices or increases in the premiums of credit default swaps. [4] The potential problems with these different mechanisms have been discussed at length: accounting-based measures may respond too slowly in a financial crisis, market-based measures may be susceptible to banking runs and market manipulation and regulatory discretion-based triggers may lead to ad hoc decisions.[5] In response, some commentators have suggested a dual trigger mechanism—for instance, one that relies on accounting measures coupled with regulatory discretion.[6]

Regulators and banking executives are divided on the benefits of CoCos and their optimal design. The Basel III committee has recommended further study on whether contingent capital instruments should be counted towards equity capital for banking institutions.[7] Regulators in America and Britain have also been ambivalent about approving CoCo transactions.[8] Nevertheless, some regulators have embraced CoCos wholeheartedly. The Swiss National Bank has been particularly aggressive on capital rations; it has mandated capital adequacy ratios of nineteen percent for the major Swiss banks, of which nine percent can be fulfilled with CoCo instruments.[9]

Banking executives are similarly divided on CoCos. Some are concerned about the efficacy of Cocos or about the level of investor demand for such instruments.[10] Others, however, have embraced the instruments. For instance, Credit Suisse has announced that it will issue billions of dollars worth of CoCos; its initial plan to raise CoCo capital was highly successful and the bank successfully raised two billion dollars.[11]

Although there is continuing disagreement over the design of CoCos and their role in fulfilling capital adequacy requirements, these instruments are likely to play a significant role in providing capital support for banking institutions in future financial crises.

Bankers Pay

Banker compensation levels and pay structures have come in for significant criticism since the crisis.[12] Previous compensation policies are said to have exacerbated risk taking and richly compensated bankers despite poor long term performance.[13] Some have viewed the problem of banker pay as a corporate governance problem.[14]

Bebchuk and Spamann have suggested that corporate governance reforms alone may not be sufficient to address these problems because shareholders are incentivized to take risks beyond the socially optimal level.[15] Furthermore, bondholders and other creditors are also not incentivized to monitor financial risks because of the implicit government guarantee of bank debt during a financial crisis.[16] Accordingly, the authors propose that banking executive should be compensated through a broader basket of securities including common shares, preferred shares and debt instruments issued by the bank.[17]

Exploring the Link between CoCos and Banker Pay

The academic literature has largely been silent on the interaction between CoCos and banker compensation. The socially optimal design and implementation of CoCos will be impacted by managerial incentives created by compensation structures. This problem is particularly acute when managerial compensation is partially or exclusively in the form of CoCo instruments. Several banks have announced that they are considering paying senior executives and bankers with such instruments.[18] Barclays, most prominently, has sought approval from the UK regulators for paying its bankers with CoCo instruments.[19] Before approving such plans, regulators need to understand what the proper incentive structure for bankers should be. In particular, they will need to address the following two problems.

First, are bankers incentivized to select the socially optimal design for CoCo instruments? Managers may have considerable influence in the design of CoCo instruments, including selecting the type of trigger (e.g. capital-based) and the trigger level at which the CoCo mandatorily converts into common equity (e.g. if capital adequacy ratio falls below seven percent). Managerial compensation structures will influence their preferences on these design choices. If bankers are primarily compensated with equity stock, they are likely to design CoCo instruments with weak triggers because they would not want their equity holdings diluted by the conversion of these instruments into common equity. If bankers, by contrast, are primarily compensated with CoCos instruments, they may design inefficiently strong triggers because they could potentially acquire cheap stock during a crisis. Thus, the pay structure of bankers will determine their ex-ante preference for different design features of CoCo instruments.

Second, are banking executives incentivized to optimally trigger conversion during a financial crisis? Although the trigger may be “mandatory” in design, managers are likely to have significant discretion regarding the trigger point because of their ability to disclose (or withhold) material information, their use of other market signaling devices, and their discretion over when to approach financial regulators. During a financial crisis, will managers have the appropriate incentives to aid an optimal conversion of these instruments? How will this be impacted by whether managers are partially or solely compensated with equity or CoCo instruments? For instance, if managers are compensated primarily with equity instruments and a mandatory CoCo conversion dilutes equity holders, then managers may be incentivized to delay disclosure of material information to prevent such a conversion from taking place. By contrast, if they are compensated primarily through CoCo instruments, managers might view a financial crisis as a mechanism for acquiring cheap equity in their bank and therefore take overly conservative positions in the bank’s financial disclosures. Thus, different managerial compensation packages may determine the ex-post behavior of bankers when it comes to triggering the conversion of CoCo instruments into equity capital.

In designing and implementing a regulatory framework for CoCos, regulators need to be aware of the potential conflicts of interest that could be created by banker compensation structures. Potential solutions could include regulating both the level of discretion afforded to managers in designing and implementing CoCo instruments and the magnitude of executive compensation that is linked to or denominated in CoCo instruments.

* J.D. Candidate, 2012, Harvard Law School.

[1] See Hal S. Scott, Reducing Systemic Risk Through the Reform of Capital Regulation, 13 J. Int. Econ. L. 763, 763 (2010).

[2] See id. at 770.

[3] See id.

[4] See Louise Pitt et. al, Contingent Capital: Possibilities, Problems and Opportunities 6, Goldman Sachs Global Markets Institute (March 2011).

[5] See id.

[6] See Robert L. McDonald, Contingent Capital with a Dual Price Trigger (2010), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1553430.

[7] See Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems 3, Basel Committee on Banking Supervision (2010), available at http://www.bis.org/publ/bcbs189.pdf.

[8] See Anousha Sakoui & Patrick Jenkins, Stability Concerns over Coco Bonds, Financial Times, Nov. 6, 2009, http://www.ft.com/cms/s/0/7982578c-ca75-11de-a3a3-00144feabdc0.html#axzz1IxBwhf2L; Nicole Bullock & Francesco Guerrera, Wall Street and Fed in Discussions Over CoCos, Financial Times, Nov. 12, 2009, http://www.ft.com/cms/s/0/f312d108-cf2a-11de-8a4b-00144feabdc0.html#axzz1IxBwhf2L.

[9] See Switzerland Gets Extra Tough With Its Banks. Others Will Follow, The Economist, Oct. 7, 2010, http://www.economist.com/node/17202233?story_id=17202233.

[10] See Sara S. Muñoz, A Hard Road for New ‘Coco’ Securities, Wall St. J., Oct. 15, 2010, http://online.wsj.com/article/SB10001424052748703631704575552231208013398.html.

[11] See Jennifer Hughes, Credit Suisse Cocos Issue Deluged, Financial Times, Feb. 17, 2011, http://www.ft.com/cms/s/0/31da02a0-3ac6-11e0-9c1a-00144feabdc0.html#axzz1IxBwhf2L.

[12] See, e.g., Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States 61-66, Financial Crisis Inquiry Commission (2011), available at http://fcic-static.law.stanford.edu/cdn_media/fcic-reports/fcic_final_report_full.pdf.

[13] See id.

[14] See id. at 279.

[15] See Lucian A. Bebchuk and Holger Spamann, Regulating Bankers’ Pay, 98 Geo. L.J. 247, 274–75 (2010).

[16] See id. at 266–67.

[17] See id. at 253.

[18] See Francesco Guerrera et al, Banks Keep Close Eye on Barclay’s Cocos Plan, Financial Times, Jan. 30, 2011, http://www.ft.com/cms/s/0/e939a8a6-2ca2-11e0-83bd-00144feab49a,s01=1.html#axzz1IxBwhf2L.

[19] See Jennifer Hughes & Patrick Jenkins, Barclays Forced to Adapt Cocos Bonus Plan, Financial Times, Feb. 14, 2011, http://www.ft.com/cms/s/0/7e1cac78-387b-11e0-959c-00144feabdc0.html#axzz1IxBwhf2L (noting that Barclay’s initial plan had to be modified because the UK regulators were undecided on the efficacy of such compensation arrangements).

Preferred citation: Gaurav Toshniwal, Contingent Convertible Bonds and Banker Compensation: Potential Conflicts of Interest?, 1 Harv. Bus. L. Rev. Online 77 (2011), https://www.hblr.org//?p=1162.

January 18, 2011 By wpengine

The Coconundrum

Download PDF

Frederick Ryan Castillo*

Digging deeper into their analytical toolbox, policymakers, academics, and regulators are increasingly exploring whether, and to what extent, a system of contingent capital can strengthen the resilience of the banking sector. The global financial crisis unearthed fragile and troubled banks, riddled with excessive leverage, poor quality capital buffers, and liquidity problems. Because these institutions were deemed “too big to fail,” governments were forced to intervene and prop them up by way of costly, taxpayer-funded bailouts. With the benefit of hindsight, regulators are now looking at contingent capital as a potentially speedy and less costly alternative for recapitalizing banks in periods of financial distress.[1]

But is contingent capital a desirable, feasible and sustainable proposition, or is it an overly-simplified theoretical concept fraught with practical difficulties and unrealistic expectations?

Contingent capital—also known as “contingent convertibles” or “CoCos,”[2] “regulatory hybrid securities,”[3] “contingent capital certificates,”[4] or “embedded contingent capital”[5]—refers to debt instruments which mandatorily convert into equity upon the happening of one or more pre-defined events or triggers.[6] Regulators have tinkered with the idea of requiring systemically important banks to issue these instruments as integral components of their capital structures. When a bank encounters a liquidity or capital crisis, the CoCos will be converted into equity, thus increasing the bank’s capital buffers and avoiding the need to seek governmental intervention.

Proponents of contingent capital, who include Mark Flannery[7], Robert McDonald[8], the Squam Lake Working Group[9], and John Coffee, Jr.[10], view it as a desirable and workable mechanism. Contingent capital, it is argued, will ease financial distress, reduce bank leverage, minimize incidents of bank insolvency, avoid costly public bailouts, set up a speedy bank resolution regime, internalize bank failure costs, and insulate the rest of the financial system from possible systemic spillover effects.[11] The Basel Committee on Banking Supervision (BCBS) also observes that the use of contingent capital would lessen moral hazard by increasing private sector involvement in the resolution of future banking crises.[12]

In contrast, critics such as Anat Admati, Peter DeMarzo, Martin Hellwig and Paul Pfleiderer point out that contingent capital and related “bail-in” mechanisms are too complicated to design, pose difficult implementation concerns, and are less effective than the straightforward approach of requiring banks to have more equity capital.[13]The Association of British Insurers has also voiced its concerns as to how the instruments would work in practice, noting that investors in CoCos would be made to absorb “haircuts” or losses when conversion takes place.[14]

However, it may be said that on the balance, the reservations critics have with respect to contingent capital focus largely on the practical difficulties likely to be encountered once these instruments are put into use, and not on the desirability of contingent capital as a potential tool for stabilizing banks. As Coffee points out, contingent capital is not an “abstract academic idea,” but “its optimal design remains open to legitimate and necessary debate.”[15]

Taking the debate a point further, it appears that the feasibility and sustainability of CoCos ultimately turns on a careful consideration and resolution of four key areas.

First, consensus with respect to the appropriate trigger (i.e. the point at which conversion of debt into equity takes place) needs to be reached. At present, there is a wide spectrum of proposals on this issue, with some advocating that the trigger be determined by a country’s regulatory authority, while others are arguing that a more objective measure, such as a reference to a market index or a specified capital ratio, be used.[16] For instance, in August, the BCBS issued a proposal that would allow capital instruments to be written off or converted to common shares at the discretion of the relevant authority if: (a) the bank was judged to be non-viable by the relevant authority or (b) the bank had received a public sector capital injection without which it would have become non-viable.[17] The Squam Lake Working Group suggests a double trigger: regulators must declare the existence of a systemic crisis, and the bank must fall below a given capital ratio.[18] In contrast, Flannery argues that the trigger should not depend on the state of the financial system, but rather on the contemporaneous market value of the firm’s outstanding common equity.[19]

Second, regulators must facilitate the market’s acceptance of CoCos by clarifying their essential investment features and, where appropriate, engaging in meaningful discourse with leading industry groups. For instance, a particular concern among investors is whether credit rating agencies are willing and able to adequately assess the risk features of CoCos.[20] In this regard, Fitch Ratings’ early November statement that it expects to be able to rate these new-generation bank hybrid securities may stimulate renewed interest in CoCos.[21] News last October that Swiss authorities are open to the use of CoCos to fund the capital requirements of UBS and Credit Suisse is also a welcome development.[22]

Third, the appropriate tax treatment of CoCos needs to be settled. The primary issue here is whether tax authorities would be willing to recognize contingent capital as debt (thereby allowing tax-deductible interest expenses) despite the instrument’s convertibility into equity.[23] If so, banks will enjoy the benefits of debt financing and will gravitate toward the use of CoCos in their capital structures.

Lastly, differences in the legal treatment of CoCos across relevant jurisdictions need to be sufficiently understood. Interestingly, the BCBS has already commenced this process by requesting feedback from market participants, including investors in bank capital instruments, on all aspects of its August proposal (on contingent capital and triggers), including “any legal or operational obstacles to their implementation.”[24] The BCBS has even encouraged industry practitioners to work with regulators in drafting terms and conditions for contingent capital instruments while “respecting relevant national constraints.”[25] Whether sufficient harmonization and acceptance of contingent capital across varying legal jurisdictions will be achieved, however, remains to be seen.

The discussion on contingent capital will likely continue and escalate in the coming weeks, but the ultimate verdict on its feasibility and sustainability will not be immediate. The conundrum of contingent capital presents broad challenges to the financial sector and to the economy as a whole, as stakeholders seek new and innovative ways of stabilizing the banking sector and preventing another financial crisis.

* LL.M. Candidate, 2011, Harvard Law School.

[1] See Damian Paletta, ‘Contingent Capital’ Idea Gaining More Steam Within Fed, Wall St. J. (Oct. 13, 2009), http://blogs.wsj.com/economics/2009/10/13/contingent-capital-idea-gaining-more-steam-within-fed; Steve Slater & Clara Ferreira-Marques, Contingent Capital: Cure or Cost for Banks?, Reuters (Oct. 27, 2009), http://uk.reuters.com/article/idUKLNE59Q01K20091027; Giuseppe De Martino, Masimo Libertucci, Mario Marangoni, & Mario Quagliariello, A Proposal for Countercyclical Contingent Capital Instruments, VOX (Oct. 30, 2010), http://www.voxeu.org/index.php?q=node/5728; BoE’s Tucker-CoCos Could Transform Bank Landscape, Reuters (Nov. 16, 2009), http://blogs.reuters.com/financial-regulatory-forum/2009/11/16/boes-tucker-cocos-could-transform-bank-landscape. See also Press Release, Bank for International Settlements, Consultative Proposals to Strengthen the Resilience of the Banking Sector Announced by the Basel Committee (Dec. 17, 2009), http://www.bis.org/press/p091217.htm.

[2] See CoCo Nuts, The Economist (Nov. 5, 2009), http://www.economist.com/node/ 14816673?story_id=14816673.

[3] Squam Lake Working Group on Financial Regulation, An Expedited Resolution Mechanism for Distressed Financial Firms: Regulatory Hybrid Securities (Council on Foreign Relations, Center for Geoeconomic Studies, Working Paper 2009) at 2.

[4] Mark J. Flannery, Stabilizing Large Financial Institutions with Contingent Capital Certificates (2009), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1485689.

[5] Julie Dickson, Superintendant, Financial Institutions Canada, Remarks at Financial Services Invitational Forum (May 6, 2010) at 4, http://www.osfi-bsif.gc.ca/app/DocRepository/1/eng/speeches/jdlh20100506_e.pdf.

[6] Id.

[7] See Flannery, supra note 4.

[8] See Robert J. Mcdonald, Contingent Capital with a Dual Price Trigger (2010), available at http://papers. ssrn.com/sol3/papers.cfm?abstract_id=1553430.

[9] See Squam Lake Working Group, supra note 3.

[10] See John Coffee, Jr., Bail-Ins Versus Bail-Outs: Using Contingent Capital to Mitigate Systemic Risk (2010), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1675015.

[11] See Flannery, supra note 4, at 3; Coffee, supra note 10, at 10, 33; McDonald, supra note 8, at 2, 21.

[12] See Basel Committee on Banking Supervision, Proposal to Ensure the Loss Absorbency of Regulatory Capital at the Point of Non-Viability (2010), available at http://www.bis.org/publ/bcbs174.pdf.

[13] See R. Admati, Peter M. DeMarzo, Martin F. Helllwig, & Paul C. Pfleiderer, Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is not Expensive (2010), http://papers.ssrn.com/ sol3/papers.cfm?abstract_id=1669704.

[14] Huw Jones, UK Insurers Say CoCo Capital Poorly Thought Out, Reuters (Nov. 9, 2010), http://www. reuters.com/article/idUSLDE6A812Z20101109.

[15] Coffee, supra note 10, at 9.

[16] See Coffee, supra note 10, at 34–35.

[17] Basel Committee on Banking Supervision, supra note 12; see also Martin Dozier, Basel Committee Commences Consultation Regarding Contingent Capital Requirement, Financial Markets Blog (Aug. 19, 2010), http://www.alston.com/financialmarketscrisisblog/blog.aspx?entry=3922; Press Release, Bank for International Settlements, Basel Committee Proposal to Ensure the Loss Absorbency of Regulatory Capital at the Point of Non-Viability (Aug. 19, 2010).

[18] Squam Lake Working Group, supra note 3, at 4.

[19] Flannery, supra note 4, at 11.

[20] See Tracy Alloway, CoComplications, Financial Times Alphaville (Nov. 18, 2010), http://ftalphaville.ft. com/blog/2009/11/18/83946/cocomplications; see also Tracy Alloway, Will Rate CoCo Bonds for Food, Financial Times Alphaville (Nov 9, 2010), http://ftalphaville.ft.com/blog/2010/11/09/398811/will-rate-coco-bonds-for-food; Tracy Alloway, Cuckoo for CoCos, Financial Times (Nov 11, 2010), http://ftalphaville.ft.com/blog/2009/11/11/ 82756/cuckoo-for-cocos.

[21] “Mark Brown, Fitch Statement on Bank Hybrid Securities Seen as Constructive, Fox Business (Nov. 8, 2010), http://www.foxbusiness.com/markets/2010/11/08/fitch-statement-bank-hybrid-securities-seen-constructive/#ixzz16QleaUzf.

[22] Jane Merriman, Swiss Give Fresh Momentum to Contingent Bonds, Reuters (Oct. 4, 2010), http://blogs.reuters.com/financial-regulatory-forum/2010/10/04/snap-analysis-swiss-give-fresh-momentum-to-contingent-bonds.

[23] See Coffee, supra note 10, at 44; McDonald, supra note 8, at 16; Humphreys & Pinedo, supra note 2.

[24] Basel Committee on Banking Supervision, supra note 12, at 3.

[25] Id.

Preferred citation: Frederick Ryan Castillo, The Coconundrum, 1 Harv. Bus. L. Rev. Online 29 (2010), https://www.hblr.org//?p=832.

Contingent Capital

Footer