Hybrid Capital
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Speech by Thomas Huertas, Director, Banking Sector, FSA
City & Financial Bank Capital Seminar
26 June 2008
Capital is the cornerstone of banking. Capital is the foundation on which banks take risks and achieve rewards, and capital is ultimately what protects deposits.
Bank deposits are money, and bank deposits are the means by which consumers and businesses predominantly settle their transactions, whether they are paying utility bills or settling multi-million pound purchases of securities. Without banks, or more particularly, without the deposits that banks provide, a modern economy could grind to a halt. Banks are considered essential to financial and economic stability.
For this reason, governments around the world provide special protection to deposits and special liquidity facilities to banks. Banks' deposits are guaranteed up to certain limits, and banks have access to the central bank as a provider of liquidity and, in extreme cases, as a lender of last resort. Other firms do not routinely have these privileges. Other firms do not have this safety net. As the current crisis has demonstrated, the authorities have a contingent credit risk on the banking system.
For this reason, societies regulate and supervise banks. These regulations are akin to the covenants that a commercial lender would impose on a borrower. That is perhaps most evident in the form of capital and liquidity requirements that banks face.
My purpose this morning is to talk about the quality of capital that banks should be required to keep in order to satisfy their covenant that they will remain safe and sound, that they will not default and wreak havoc on either their depositors or the financial system at large. Specifically, I will cover two topics: the extent to which hybrid capital should qualify as Tier I capital under the Basel framework or the Capital Requirements Directive, and, second, how hybrid capital would be treated under the banking reform proposals that the Tripartite Authorities are about to table here in the UK.
From the standpoint of the depositor, and the regulator charged with protecting those deposits, capital provides protection if it is available to absorb losses on a going concern basis. Such capital instruments reduce the probability of default. Instruments which lower the loss given default may diminish the reduction in wealth that a depositor might suffer as a result of the failure of a bank, but such instruments cannot and do not prevent the disruption to depositors and potentially to the financial system and the economy at large that the failure of a bank could cause.
For this reason, regulation differentiates among different types of capital -- in Basel jargon, between Tier I and Tier II capital. Broadly speaking, Tier I capital should be capital that is available to absorb losses on a "going-concern" basis, or capital that can be depleted without placing the bank into insolvency, administration or liquidation. Tier II capital should be capital that can absorb losses on a "gone-concern" basis, or capital that absorbs losses in insolvency prior to depositors' losing any money.
The purest form of Tier I capital is shareholders' equity, but this is the most expensive. Shareholders' equity certainly absorbs losses; indeed it bears first loss. It is permanent in the sense that it does not have to be repaid at any time. It is also flexible, in the sense that there is no obligation to pay dividends or to effect distributions to shareholders. The failure to pay a dividend is not an event of default and cannot give rise to insolvency or bankruptcy proceedings – a stark contrast to debt finance where the failure to make an interest payment could be an event of default and ultimately be grounds for a bankruptcy proceeding or winding up order.
But equity is costly. It is risky, and investors require a return commensurate with that risk. Dividends are not tax-deductible, so it takes a higher amount of operating earnings to generate a pound of dividends than a pound of interest payments on debt capital, such as long-term subordinated debt.
The conundrum facing banks is how to secure capital that protects deposits and cossets shareholders; how to strengthen the creditworthiness of deposits whilst saving costs for shareholders and boosting the return on equity.
The answer is hybrid capital – capital that acts like debt as far as the taxman is concerned, and capital that acts like equity as far as the depositor is concerned. This hybrid capital is junior to deposits, but senior to equity.
The question is whether hybrid capital represents admirable alchemy or invidious innovation. Market participants have been quite imaginative in devising structures that meet diverse requirements in different jurisdictions to qualify as debt for tax purposes and equity for accounting purposes.
But how should regulators regard hybrid capital? For the regulator, it makes a great deal of difference as to when the hybrid capital provides protection to depositors. Does the hybrid capital absorb losses on a going concern basis, like shareholders' equity? Or does the hybrid capital only absorb losses on a gone concern basis, after the bank has entered into insolvency or administration? In the opinion of CEBS and certainly in the view of the UK FSA, hybrid capital has to absorb losses on a going concern basis, if it is to qualify as Tier I capital.
In the analysis underlying its advice to the European Commission, CEBS used common equity as a benchmark for hybrids. This was widely criticised by industry as not understanding the distinctive nature of hybrids. Industry's key point is that making hybrids behave like common equity will upset the fixed income investor base for hybrids. To keep hybrids attractive, they may not be able to absorb losses in quite the same way as common equity.
Well, if hybrids can't do that, they shouldn't count toward Tier I capital in quite the same way as shareholders' equity. It is really as simple as that. Hybrid capital is good capital but it is not the best form of capital, and regulators – and I believe markets -- will distinguish between core Tier I capital and other forms of capital.
If hybrids are to count toward Tier I capital at all, they must, in the view of CEBS, meet certain characteristics.
First of all, the capital must be issued and fully paid-up. The proceeds must be immediately available without limitation to the issuing institution.1. The main features of the instrument must be easily capable of understanding by investors, and the bank must periodically and publicly disclose the terms and conditions of the instrument as well as the proportion of Tier I capital that the instrument accounts for.
Second, the economics of the instrument have to work. It has to absorb losses. It has to be permanent, and it has to be flexible.
Let me say a few words about each of these characteristics in turn. With respect to loss absorption any Tier I capital instrument has to be able to absorb losses, not only in the case of liquidation or insolvency, but also on a going concern basis. The instrument must help the institution to continue operations as a going-concern. This means that the instrument should help prevent insolvency, and it should make the replenishment of the institution's shareholders' equity more likely, if that equity is depleted. Features such as convertibility into common equity are steps in this direction. Simple subordination of the instrument to deposits, however deep, is not sufficient, as this implies that the instrument can only absorb losses in a winding-up or insolvency situation, precisely the situation that Tier I capital is supposed to help the bank avoid.
Permanence is also important. If the capital has to be repaid, it should not count as Tier I. CEBS recommended that Tier 1 hybrids be undated and that early redemptions be subject to strict conditions and to prior supervisory approval. In detail, hybrids may be callable after a minimum of 5 years if they contain a pure call option; if a call option is associated with an incentive to redeem; it is only permitted after a minimum of 10 years. Step ups and principal stock settlements in conjunction with a call option are considered as incentives to redeem; step ups permitted only if they are considered moderate.
Finally, flexibility of payment is also important. If the instrument is to count toward Tier I capital, the bank has to have the flexibility to stop payments to investors at any time. CEBS proposed that Tier 1 hybrids should be non-cumulative and that the issuer must be able to stop paying its coupon and for an unlimited period of time whenever necessary. Indeed, if a bank is in breach of its minimum capital requirement, it must, in the view of CEBS, waive payments. Dividend pushers are acceptable but must be capable of being waived. Alternative Coupon Satisfaction mechanisms or ACSMs are permitted where issuer has full discretion over payment and only if the ACSM achieves the same result as a cancellation of as coupon.
Finally, CEBS suggested that there be limits on the amount of hybrids in Tier I capital, and CEBS suggested grandfathering for existing hybrid instruments that currently qualify as Tier I capital but do not meet the requirements for loss absorbency, permanence and flexibility that I have outlined here. In sum, the advice balanced market considerations and prudential concerns.
By and large, the Commission has followed CEBS advice in its proposals to amend the Capital Requirements Directive – proposals that are now out for consultation. However, the Commission proposals differ from the CEBS advice in three important aspects:
On loss absorbency the Commission was less definitive than CEBS with respect to the requirement that hybrids be able to absorb losses on a going concern basis. As this is the most important function of Tier I capital, CEBS has objected strongly to the Commission and recommended in writing that the Commission revert to the CEBS advice on this point.
On permanence, the Commission proposal would allow for dated instruments with a lock-in clause. That seems contrary to the concept that Tier I capital should be permanent, and CEBS has written to the Commission that it would be prudent to require hybrid capital to be permanent.
On limits, the Commission has proposed a set of limits that differentiate among the types of hybrids according to whether or not the hybrid is likely to promote recapitalisation or to be redeemed. In other words, the Commission is proposing a set of limits that would imply that hybrids come in three varieties, good, better and best with banks having greater scope to use the higher quality form of hybrids.
However, the Commission proposal does not alter the ratio of hybrids to core Tier I capital or shareholders' equity. Hybrids can still account for up to 50% of total Tier I capital. That implies that core Tier I capital can account for as little as 2% of the bank's risk-weighted assets – a ratio that many Member States, including the UK, feel is too low, particularly as many debt investors also appear to feel that such a low core Tier I ratio is too low.
In conclusion, let me say a few words from a UK perspective. As you know, the Government is planning to introduce legislation that will introduce a special resolution regime for banks. This will enable the authorities to handle failing banks more effectively, more quickly and more efficiently.
The trigger that will place a bank into this regime is the failure of the bank to meet its threshold conditions, specifically, the failure of the bank to maintain adequate financial resources, including capital and liquidity. With respect to capital, this means the failure of the bank to meet its capital requirement. The decision as to whether or not the bank meets threshold conditions is a supervisory decision, and the FSA, as the bank's supervisor, will – in consultation with the Treasury and the Bank of England -- make that decision.
I should emphasise that threshold conditions differ from the standards for corporate insolvency. In particular, the threshold condition for capital is the bank's capital requirement. So the resolution regime for banks could be initiated when the bank still has significant positive net worth.
This is in marked contrast to normal corporate insolvency procedures. But the justification for this is that the banking license represents a privilege to take deposits from consumers and other market participants. The bank can keep this license as long as it maintains adequate capital and meets the other threshold conditions. If it does not meet threshold conditions, the authorities are justified in executing early intervention, in stepping in to resolve the bank so as to protect depositors, preserve financial stability and safeguard the public finances.
The choice of resolution tools will be up to the Bank of England, subject to consultation with the Treasury and the FSA, and subject to the approval of the Chancellor of the Exchequer if the tool involves the use of public funds. The range of tools includes
- a transfer of part or all of the failing bank to a private sector third party;
- a transfer of part or all of the failing bank to a publicly-controlled bridge bank;
- the power to take a bank into temporary public sector ownership; and
- a new bank insolvency procedure. This would involve the payout of covered deposits to eligible depositors within a very short time frame, and for this purpose the legislation will also propose a number of measures to strengthen the ability of the FSCS to do so.
The intent of the legislation is to enable failing banks to be resolved in a manner that minimises the collateral damage that a bank failure could cause to depositors and to the financial system and economy at large. It is intended to provide greater assurance that exit from banking can occur, and occur in an orderly fashion.
But the regime is not intended to protect providers of capital to banks. Capital, including hybrid capital and Tier II capital, such as subordinated debt, will be subject to loss in the special resolution regime. It will not be protected. It will incur risk, and investors should look to extract the requisite possibility of reward from banks in exchange for taking that risk.
1.An exception might be made for hybrid capital issued through a SPV, if the proceeds are made available to the bank at a pre-determined trigger point, well before serious deterioration in the bank's financial position.