Basel III – Implications for banks' capital structure: What happens with hybrid capital instruments?

Content

List of figures and tables

1. Introduction

2. Basel III
2.1 History
2.2 Implementation and objectives of Basel III
2.2.1 Common equity capital (Core Tier 1)
2.2.2 Additional core capital (Additional Tier 1)
2.2.3 Supplementary capital (Tier 2)
2.2.4 Additional capital buffer
2.2.5 Risk coverage
2.2.6 Leverage ratio
2.2.7 Liquidity requirements
2.3 Comparison of the capital definition of Basel II and Basel III
2.4 Critical consideration of Basel III

3. Hybrid capital
3.1 The market for hybrid capital
3.2 Silent partnership
3.3 Participatory notes
3.4 Subordinated liabilities
3.5 Trust preferred securities
3.6 Convertible- and warrant bonds

4. Contingent capital
4.1 Contingent convertible bonds
4.3 Critical assessment of the suitability as a component of core capital
4.4 The market for contingent convertible bonds
4.5 The features of contingent convertible bonds
4.5.1 The Trigger
4.5.2 Conversion Ratio
4.5.3 The Term
4.5.4 Factors impacting on pricing
4.5.5 Optimal design of contingent convertible bonds
4.5.5.1 From the perspective of regulators
4.5.5.2 From the perspective of shareholders
4.5.5.3 From the perspective of investors

5. Impact of Basel III
5.1 Impact on banks funding structure
5.2 Impact on banks hybrid capital
5.2.1 Impact on convertible bonds
5.2.2 Impact on contingent convertible bonds
5.3. Impact on Commerzbank AG

6. Conclusion

List of abbreviations

illustration not visible in this excerpt

List of figures and tables

Figure 1: Minimum capital ratios under Basel II and Basel III

Figure 2: Impact of Basel III on German banks in 2010

Table 1: Different types of contingent capital

Table 2: Differences between Bail-ins and CoCos

Table 3: Balance sheet items Commerzbank AG 2010

Table 4: Balance sheet items Commerzbank AG 2012

1. Introduction

Many banks contributed through their high-risk business models to the financial crisis in 2007. As the global banking system got into a ''life-threatening crisis'', many countries decided to support banks with large bailouts. Banks play an important role in today`s economy, because they can influence the amount of money and investment activities in the economy.^[1] The bailouts were seen necessary for the survival of the global banking system. As a result, there are some countries - partly through the bailouts themselves, but also in part due to already existing structural financial deficits - now or in front of the inability to pay, so they have become the subject of bailouts itself.

The financial crisis has shown that for a bank's solvency it is not only the amount of equity that is important, but also significantly the quality of equity.^[2] In particular hybrid capital was not used to a sufficient extent to absorb losses, although it is partially core capital under Basel II.^[3] Because of this the Basel Committee on Banking Supervision decided in December 2010 on new capital- and liquidity rules for banks (''Basel III framework''). The Basel III framework implemented the regulatory requirements of the action plan to strengthen the financial system.^[4] In particular the qualitative requirements were raised for core capital. Under these new regulations core capital is crucial, including factors such as stocks and retained earnings, because it can fully and immediately be claimed for losses. The old forms of hybrid capital will be recognized in regulatory capital to a lesser extent in the future, because the regulators want a higher loss absorbency from forms of hybrid capital. This has implications especially for subordinated bonds. The aim is to involve subordinated creditors and equity investors in the recovery phase in the cost of crisis management. The new capital requirements mean major structural changes for the banks, because the comparatively cheap hybrid capital must be replaced by capital of higher quality.^[5] During the financial crisis bondholders were largely spared because banks, which were technically bankrupt, got help from the countries in question due their importance for the financial system. Even the claims of subordinated bond investors were thereby maintained. Subordinated bank bond investors are only liable in the event of bankrupt (''gone concern''). The risk of the resulting problem of negative incentive effects (''moral hazard'') is now reduced by the early inclusion of subordinated creditors. The aim is to reflect the risks of subordinated bonds in the conditions, therefore a benefit of the assumption of risk by the countries should no longer be possible. Now the investors of subordinated bonds take losses, if the banks are unable to refinance privately.

Based on these intentions two basic approaches for improved bondholder liability have emerged: First, a new form of hybrid capital, so-called contingent convertible bonds (CoCos), a fixed-income security which is a capital buffer for a bank in financial distress and so could be attributed to regulatory equity capital.^[6] This hybrid capital is in the form of a mandatory convertible bond, which can contribute to making up for losses such as equity in the event of a crisis.^[7] Second, the ''Bail-in'' of bondholders. The difference is: CoCos are market-based instruments, Bail-ins result from discretionary intervention. In order to meet the new regulatory requirements, many banks are considering the advantages of CoCos. The first issues have already been made, for example by the Lloyds Banking Group in November 2009.^[8] The Basel Committee on Banking Supervision is still thinking too about this new form of hybrid capital, so it is worth having a critical look at the impact of integrating these new instruments into the regulatory framework of Basel III.

Therefore this book attempts to answer the question of how CoCos differ from convertible bonds, and how these instruments are suitable for contributing as core capital under Basel III. The place ability of CoCos and the challenges resulting from their use are discussed in this book. Based on the different design options for a coco bond, the most sensible will be determined and put into practice. So far it is a mainly theoretical issue with little empirical evidence, so the book will explain and evaluate the various theoretical aspects. Overall a comprehensive picture of the impacts resulting from the new capital definitions will be created. Hybrid capital takes a special role in this analysis, since it is no longer counted to the same extent as before. To meet the minimum capital ratios of Basel III the handling with hybrid capital will often be the decisive factor.^[9]

The background to the introduction of Basel III is first described at the beginning of the book. This is in addition to a short presentation of the Basel III document and the new capital definitions. In particular, the decisive criteria for assigning capital instruments to core capital, additional core capital or supplementary capital are examined. To create a kind of basic understanding of the functioning of convertible bonds and CoCos, hybrid capital will then be explained. In the following part of the book the design options of CoCos and different interests of investor groups are shown. Then the Commerzbank AG is analysed by means of an analysis of how the capital components changed in Basel II through to Basel III over the last two years. The effect of Basel III on hybrid capital can and will be illustrated with a practical example. At the end of the book follows a short conclusion regarding the potential impact of Basel III on hybrid capital and the new capital instrument CoCos.

Information up until 30.04.2013 has been considered in this book.

2. Basel III

The result of the financial crisis was a new regulatory framework, Basel III, developed by the Basel Committee on Banking Supervision.

2.1 History

As the financial crisis began in 2007, it had a devastating impact on the world economy and in particular on the global banking system. A few countries could only be saved with the help of other countries.^[10] It was shown in the financial crisis, that the capital of banks had deficits in terms of quality and problems with loss absorption.^[11] To cope in future crises without government rescue packages, the Basel Committee on Banking Supervision adopted new capital and liquidity rules. The Basel Committee on Banking Supervision is a coalition of major industrialized- and emerging countries, whose task is the development of recommendations for international banking regulation.^[12]

The committee had previously developed the Basel I and Basel II frameworks. Basel II was intended to ensure the stability of the financial system by means of a three-pillar approach.^[13] The first pillar contains minimum capital requirements, the second pillar the supervisory review process and the third pillar market discipline.^[14] But the recommendations were either not fully carried out or they could not prevent the financial crisis. For example, the Basel II requirements are still not fully implemented in the U.S. financial system.^[15] They only apply to large financial institutions. In addition, these financial institutions can stretch the implementation of the regulation requirements over several years. In response to the weaknesses of Basel II and the financial crisis, the Basel III document was finalized within one year.

2.2 Implementation and objectives of Basel III

In December 2010 the Basel committee on Banking Supervision published the final framework, consisting of one part relating to capital requirements and another part to liquidity requirements.^[16] In 2011 Basel III was adopted at the level of the European Union with the Capital Requirements IV Directive and for example in 2012 into national law in Germany. From 2013, the new capital standards will be introduced gradually up until 2019.^[17] So the banks have enough time to implement the regulations and can continue to provide credit to the economy.^[18]

The aim is to increase the resilience of the banking sector by increasing the quantity and quality of regulatory capital. The three pillars of Basel II will be more focused and strengthened. Furthermore, an attempt is made to address the issue of loss absorption of regulatory capital, because banks have found in the financial crisis ways to continue their business with public bailouts without taking losses on regulatory capital as originally planned. In future all capital instruments of regulatory capital must bear losses if a bank is no longer in a position to survive.^[19] Therefore, Basel III include: A new definition of regulatory capital, the introduction of capital buffers, a leverage ratio, a global liquidity standard and a Credit Valuation Adjustment (CVA) risk charge. Furthermore, the regulation of the Over the Counter (OTC) derivatives markets, the regulatory recognition of rating agencies, changes in the trading book and new rules for credit risk and risk mitigation techniques are addressed.^[20]

Basel III defines four types of regulatory capital: common equity capital, additional core capital, supplementary capital and additional capital buffer.^[21]

2.2.1 Common equity capital (Core Tier 1)

The regulatory capital should bear losses and prevent banks from suffering negative consequences. Because of this consideration, the Basel Committee on Banking Supervision defines which type of regulatory capital is liable in different cases. Common equity capital (''Core Tier 1'') and additional core capital (''Additional Tier 1'') bears losses from current operations and is called "going concern” capital.^[22] Supplementary capital (''Tier 2'') is called "gone-concern" capital and bears losses, if a bank can not survive.^[23]

Figure 1: Minimum capital ratios under Basel II and Basel III (own illustration)

illustration not visible in this excerpt

The core capital represents the subordinated capital and represents the possibility of retaining remuneration from the liquidation proceedings, so it is the highest quality capital.^[24] Through the Basel III capital framework it will be given more weight, in securing the existence of financial institutions, since the low core capital ratios were one of the main causes of the financial crisis.^[25] The lack of quality in core capital attracted attention, as many banks during the financial crisis continued to show high capital ratios, despite displaying depreciation of their capital.^[26] The Tier 3 capital will no longer recognized as regulatory capital, and the two previously existing classes of supplementary capital (''Upper Tier 2'' and ''Lower Tier 2'') are to be merged into a single class of supplementary capital (''Tier 2''). Core capital is divided into common equity capital and additional core capital. The total capital requirements through Basel III have increased to 8% of risk-weighted assets. The core capital requirements increased from 4% to 6% and the core common equity capital increased from 2% to 4,5%. So the capital with the highest quality and liability for loss absorbency has the highest weight in the total capital requirements. In addition to the total capital requirements, an additional capital buffer of 2,5% is to be formed. This buffer is to be built in by 2019 by means of common equity capital instruments. In result a total of 7% common equity capital and additional core capital on risk-weighted assets must be held by the banks in 2019.^[27] At the beginning of the implementation in January 2013 were the following minimum capital ratios: common equity capital of 3,5%, core capital of 4,5% and total regulatory capital 8% of risk-weighted assets.

In addition to the new capital definitions, the possibility of attribution to core capital or supplementary capital is to follow a list of principles in the future. For example, in stock corporations common equity capital can only be share capital or reserves. In banks with other legal forms the reserves can be the typical equity instruments. This is the consequence of the 14 defined principles.^[28] The decisive principles are the following: In the event of liquidation, common equity must have the most subordinate claim. Furthermore, the capital must be permanently provided and no incentive for early repayment exist. A refund can only happen in the event of insolvency. The form of capital must be recognized as equity capital in accordance with the national accounting.

2.2.2 Additional core capital (Additional Tier 1)

Additional core capital demands the same high standards as common equity capital. Fully paid-in financial instruments which are not common equity, can be assigned to the additional core capital, if they satisfy the same 14 principles.

The additional core capital also falls under the going-concern approach.^[29] Required properties of these additional core capital instruments are for example, that they are issued and fully paid-in. Furthermore, they must qualify through a subordination to deb creditors and an unlimited capital transfer. But under special requirements the possibility of cancellation after five years is given. Capital instruments which are defined as a liability in accordance with the national accounting law must prove their loss absorption either through conversion to ordinary shares or depreciation.^[30]

Hybrid capital which does not meet the 14 principles for additional core capital or 9 principles for supplementary capital, has gradually decreasing recognized up until 2013. Under Basel II it was possible, that the innovative hybrid capital could be 15% of the core capital. In future it will no longer be recognized. It could be the case that CoCos will close the gap and play an important role as a convertible hybrid capital instrument.

2.2.3 Supplementary capital (Tier 2)

In the definition of supplementary capital an international harmonization was performed for the affected capital instruments. A catalog of 9 principals was also established in order to arrive a clear definition of attributable instruments.^[31] The central requirement is the subordination of capital instruments to the deposits and creditors of the bank. The instruments must be issued and fully paid in. In contrast to core capital no unlimited duration is specified, only a minimum term of five years.^[32] Capital instruments of supplementary capital could be convertible bonds, participation notes or subordinated long-term debt.^[33]

2.2.4 Additional capital buffer

Basel III addresses the problem of pro-cyclicality by means of the introduction of an additional capital buffer. These measure have a complementary effect for risk prevention: While higher capital positions absorb expected losses, the additional capital buffer absorbs unexpected losses. The additional capital buffer will be phased in between 2016 and year end 2018. If a bank can not meet the buffer requirements, it does not lose its banking license, but as long as the buffers are not complied with, banks are required to withhold (part of) their gain to strengthen the capital base. Dividend payment, bonuses and stock repurchase programs could be affected by these restrictions. The additional capital buffer will be 2,5% of risk-weighted assets. The capital requirements of the additional capital buffer must be met with common equity capital instruments.

In addition a counter-cyclical buffer can be determined by the national supervisor and should be between 0% and 2,5%. This is intended to act as another regulatory tool to prevent economic overheating and excessive lending. In the past, it has been shown that excessive lending in advance of an economic downturn led to disproportionate excessive losses in the banking sector. In times of excessive credit growth the counter-cyclical buffer should be used. Changes in the amount will be announced 12 months in advance.

Global Systematically Important Financial Institutions must have a higher loss absorbency capacity to reflect the higher risks that they pose to the financial system. 30 financial institutions are being classified by the Basel Committee on Banking Supervision as systematically important. They will be required to meet the additional loss absorbency requirement using progressive Common equity Tier 1 capital only and in amounts ranging from 1 – 2,5 %.

2.2.5 Risk coverage

Several measures should improve the risk coverage by banks:^[34]

- Increase in capital requirements for credit and market risks, as well for complex securitizations (''Pillar I'')
- Increased standards for the banking supervisory review process (''Pillar II'')
- Increased standards for disclosure (''Pillar III'')
- Risk positions in the trading book
- Reduction of complex securitizations and re-securitizations
- Reduction of counterparty risk from derivatives, repos, securities transactions
- Increased capital requirements for counter party exposures from derivatives- and securities transactions
- Reducing the reliance on external ratings

2.2.6 Leverage ratio

The leverage ratio is an alternative ratio to the risk-weighted ratio. This represents the unweighted total assets in relation to the regulatory capital and should save the banking sector from excessive debt and reduce the risk of quickly destabilizing debt reduction. The leverage ratio complements the capital standards under Pillar 1. In addition, it is an additional protection against model risk and measurement error as it supplement the risk-based measures with a simpler measure based on gross positions.

In 2018 the ratio will be taken as binding minimum size. Transitionally a limitation of Tier 1 ratio of 3% of total assets is provided.^[35] From 2015 the leverage ratio of the bank is to be published as part of the disclosure in Pillar 3.

2.2.7 Liquidity requirements

The financial crisis showed that adequate liquidity is crucial for the functioning of global financial markets. The situation in the financial crisis was that market liquidity suddenly disappeared, which brought the banking sector the need to refinance. Central banks around the world needed to intervene with liquidity measures.

In response to these weaknesses in the financial system, the Basel Committee on Banking Supervision created basic principles for liquidity management and supervision review and introduced two liquidity ratios:^{[36] [37]}

- The Liquidity Coverage Ratio (LCR) should ensure that banks have, in case of a pre-defined stress scenarios, enough short-term liquidity to offset cash outflows for a month. This short-term liquidity needs to consist of liquid and freely available assets of high quality, which can also be sold in times of crisis.
- The Net Stable Funding Ratio (NSFR) requires that banks they have enough long-term funding sources to function for their maturity profile. The ratio will prevent banks from obtaining funding from too many short-term sources. This will be proved with a one year stress scenario.^[38]

2.3 Comparison of the capital definition of Basel II and Basel III

While Basel II deals with the eligible capital instruments and their properties, Basel III determines the principals in a catalog which have to be met. So Basel III doesn’t directly determine any existing capital instruments which may then be added to the capital. Through the principals catalog banks have to take action to adapt to the rules. This could prevent banks from always bringing new capital instruments on the market, which would meet the requirements of the Basel Committee on Banking Supervision technically, but with lower quality and loss absorbency.

Basel II has divided equity into three classes. The core capital (''Tier 1'') is defined as common equity capital and consists of shares. It is complemented by open reserves. Furthermore, innovative hybrid capital instruments can be added (max. 15%).^[39] The supplementary capital (''Tier 2'') consists of hidden reserves, general bad-debt allowance, hybrid instruments and subordinate instruments. Additional capital (''Tier 3'') is the short-term subordinated debt to cover market risks.^[40]

Basel III divided equity into different components. Core capital is differentiated in common equity capital (''Core Tier 1'') and additional core capital (''Additional Tier 1''). In addition supplementary capital (''Tier 2'') and an additional capital buffer are implemented. This is for capital instruments which have been agreed upon. For capital instruments that no longer are taken into account by the banking regulator, transitional provisions are introduced.^[41]

2.4 Critical consideration of Basel III

Basel III has been criticized by banks with the argument that it would hurt them and that economic growth will be slower. The Organisation for Economic Co-operation and Development (OECD) estimated that the implementation of Basel III would reduce annual gross domestic product (GDP) growth by 0,05% - 0,15%.^[42] The American Bankers Association, Independent Community Bankers of America and some liberal Democrats in the U.S. Congress criticized Basel III in their comments to the Federal Deposit Insurance Corporation (FDIC). They said if the Basel III requirements were to be implemented, small banks in particular would be hurt by a dramatic increase in their capital requirements and this would have bad implications for mortgages and small business loans.^[43] In Germany it was feared that the ten largest German banks needed to raise 105 billion euros of additional core capital and remove loans worth up to 1.000 billion euros. However for some economists Basel III does not go far enough to regulate banks.^[44]

3. Hybrid capital

Hybrid capital is used as a term for various financial instruments that can not be directly attributed to equity or debt.^[45] These financial instruments occupy an intermediate position, with which companies can close funding gaps. Hybrid capital instruments can be flexibly designed and equipped with different characteristics. In their liability they are subordinated to other creditors, but primarily to equity investors. As risk compensation a higher dividend is granted compared to conventional debt. Moreover, hybrid capital usually involves an expiration date.^[46]

In accordance with the requirements of Basel II hybrid capital was attributed to the regulatory capital and improved the capital ratio.^[47] Some benefits are tax incentives and lower payments in comparison to equities. This means lower costs for the issuers.^[48] So the capital base under Basel II was strengthened through hybrid capital and the banks had increasing scope for new lending to the economy.^[49]

Of biggest importance to the German banking market are hybrid financial instruments such as silent participations, trust preferred securities, participation notes, convertible- or warrant bonds and subordinated liabilities.^[50]

3.1 The market for hybrid capital

In December 2009, the 15 largest banks in Germany had a volume of 50 billion euros hybrid capital attributed to core capital and another 62 billion euros attributed to supplementary capital.^[51] 80-90% of the total supplementary capital was hybrid capital.^[52] Hybrid capital had- and continues to have great importance in the German bank balance sheets and for the entire German banking system.

3.2 Silent partnership

The typical silent partnership is basically characterized by the fact that the investor has no power to be represented or to involve themselves. He or she has only a financial function and will share in the profits of the company. A loss-sharing can be agreed. The atypical silent partner is also involved in the assets and the hidden reserves. The silent partnership is a popular hybrid capital instrument because it is very flexible for the issuer and can be tailored to the investor.^[53] For the silent investor it is often an advantage that others will not get any knowledge about his or her participation in the company. The participation is undertaken only internally and the investor can partake of the profits of the company.^[54]

3.3 Participatory notes

With the purchase of a participatory note the investor acquires a legal entitlement to the profits or the proceeds of liquidation. It is also possible to agree a fixed remuneration component, or the participation in the loss can be agreed in the terms of the notes. The owner of the participatory note has almost no opportunity to influence the decisions of the issuing company. This allows the issuer to obtain near-equity volume without involvement through the investor. There is no statutory regulation for participatory notes in Germany, so their free design is possible.^[55]

3.4 Subordinated liabilities

Subordinated liabilities are issued as a loan or in certificated form as a bond. They are subordinated in relation to other liabilities of the issuing company. The subordination is related to interest payment and redemption. The loss-sharing is limited to the failure of payments. The compensation for the investor is usually higher than in normal debt. A fixed basic compensation is common - mostly through interest payments – as is possibly a share of the profits. In relation to risk classification the subordinated liabilities are between the participatory notes and the standard bonds. For the issuing company subordinated liabilities have the advantage, that in times of crisis the interest and principal payments may be suspended. In addition, the credit scope is not reduced by the inclusion of subordinated liabilities.^[56]

3.5 Trust preferred securities

Trust preferred securities are generally issued by bank holding companies. A bank creates trust-preferred securities by issue a trust issuing debt to a new entity, while the trust issues the trust preferred securities. They are a hybrid capital instrument with characteristics of subordinated debt and preferred shares. They usually have a very long term and regular fixed or variable payments (for example dividends or interest). The deferral of payments for up to 5 years is allowed, if the company makes no profit. 30% of the volume of hybrid capital in Europe in 2006 were trust preferred securities and so this was the biggest hybrid capital instrument.^[57]

3.6 Convertible- and warrant bonds

Convertible- and warrant bonds are the hybrid instruments that combine debt- and equity characteristics.^[58] It originated and was used by investors the mid- 19th century for the first time. Investors in convertible- and warrant bonds have the right to purchase a specified number of shares of the issuer.^[59] This conversion happens in a specified period with predetermined exchange ratios. The number of shares which can be purchased is the "conversion rate". Through the option to convert the bond to stock, a convertible bond has typically a lower interest payment than a similar non-convertible debt. A convertible bond is a contractual debt obligation to distribute payments in cash, or in another financial assets. Because the right to convert the bond into shares of the issuer is included, a corresponding decision for the creation of conditional capital is required first by the general shareholder meeting of the company. The issuing company has a wide latitude in designing this type of hybrid capital. This mainly concerns the nature and amount of compensation. For the investor it is interesting to invest, because he or she acquires in addition to the bond the right to be a shareholder of the company.^[60] If the investor does not use this right, he or she receives interest payments as well as the nominal value of the bond at the end of the term. If he or she converts their bond into shares, they do no longer have a claim on interest- and principal payments. A rational investor would only make use of their right to convert if the conversion value would exceed the straight value.^[61] The key benefit of a convertible bond for the issuer, is a reduced cash interest payment.

The value of this type of bond is determined by the level of interest rates, the volatility of interest rates, the amount and the changes in the credit risk of the issuer, the coupon amount, the maturity, the dividend yield, the conversion rate and a possible mandatory conversion right. Overall it is a complex function with several factors and a lot of design possibilities which can be adapted to the needs of the issuer.^[62]

There are a lot of different financial instruments that belong to the convertible capital class:^[63]

- Conventional convertible bond: A fixed income security that gives the holder the right, in the conversion period, to exchange it into shares in a predetermined ratio.
- Exchangeable bonds: A bond that gives the investor the right to convert the bond at any time into a fixed and given number of shares. In contrast to the convertible bond, the issuer of a exchangeable bond is not the company that issues the underlying shares, but typically one of the major shareholders.
- Mandatory convertible bond: A variation of the conventional convertible bond, in which the rights of investors are restricted. While the investor in a conventional convertible bond has the maturity choice if he converts into shares or not, the mandatory convertible investor has to convert his bond at maturity at the latest. The risk of loss in the case of falling share prices, is therefore higher than in conventional convertible bonds. With issue of a mandatory convertible bond an indirect capital increase happens with equity dilution for the original shareholders.
- Warrant bonds: Warrant bonds are bonds with option rights. Investors have the right to buy shares of the bond issuer at a predetermined price. They differ from convertible bonds in that the bond still exist after the option right has been traded. Repayment at the end of the duration and interest payment is still the same as with conventional bonds, but the option is separated from the bond. That warrant can be traded separately on the markets.
- Contingent convertible bond: A convertible bond which automatically converts into a previous amount of shares when a pre-set trigger is reached within the duration of the bond.

4. Contingent capital

Contingent capital originally describes a very general kind of put option that allows the issuer to issue new capital to pre-determined conditions. Currently many constructs and concepts are summarized under the term contingent capital - CoCos are also in some ways a variation of this. Currently “CoCos-like constructs” are frequently referred to as CoCos, although they do not have the characteristics of CoCos, but are a form of contingent capital. Contingent capital can be divided into three categories, which differ in terms of trigger consequences to the effect that the principal amount is either turned into equity or written off.^[64]

illustration not visible in this excerpt

Table 1: Different types of contingent capital

Any financial instrument belongs to the class of contingent capital, if it turns into equity or will be reduced in par after a trigger event happened. However, a coco bond will always convert into equity after the trigger event happened and is therefore one particular form of contingent capital. Due their particular characteristics CoCos are currently the subject of discussions about their eligibility for regulatory capital.

4.1 Contingent convertible bonds

In order to meet the capital requirements of Basel III, the capital instrument CoCos are an interesting instrument.^[65] In the late 1990s scientific papers were written which dealt with the instrument in a broader sense, but CoCos are only now attracting increased interest.^[66] They belong to hybrid bonds, which rank between debt and equity, since they combine characteristics from both.^[67] In essence, they are hybrid capital in the form of a mandatory convertible bond. The conversion is limited by predefined trigger, for example, the ratio of common equity to the risk-weighted assets or the arrangement of banking supervision.^[68] The investor in a coco bond has no private right of conversion in contrast to conventional convertible bond investors.^[69] For example, if the ratio of common equity falls below a defined value (trigger event) in the terms and conditions, an allocation of losses on debt will happen automatically. Through this intermediate position between debt- and equity capital the instrument represents a new form of hybrid capital.^[70] For the investor it is transparent that the bond will be converted, if the trigger event occurs. The conversion is done only once and for ever.^[71] The conversion takes place in the capital market and thus in the private sector. With the conversion the issuing company receives new equity immediately. At the same time it reduces its interest obligations. CoCos generate no new money at the time of conversion into the bank, but transfer a debt in new equity capital, which allows a better absorption of losses. In the event of a liquidity crisis they are of no help.^[72] The conversion of CoCos corresponds to an immediate improvement in the quality of capital. The conversion should take place at a time when a bank is, due to the market situation, still not in a position to strengthen its capital base by issuing new shares. This instrument supports the capital structure in times of financial downturn without the constraint of tax-inefficient capital in times of financial upturns.^[73] If the triggering event does not happen, CoCos are similar to convertible bonds in interest payments or repayment.^[74]

[...]

^[1] See Squam Lake Working Group on Financial Regulation (2009), p. 2

^[2] See Basel Committee on Banking Supervision (2010), p. 1

^[3] See Dübel, Hans-Joachim (2010), p. 2

^[4] See Lüders, Uwe / Manns, Thorsten / Schnall, Markus (2011), p. 1

^[5] See Deutsche Bundesbank (2011), p. 7

^[6] See Basel Committee on Banking Supervision (2009), p. 5

^[7] See Deutsche Bundesbank (2011), p. 11

^[8] See See Lloyds Banking Group (2009)

^[9] See See Bamberger, Tanja / von Pföstl, Georg (2010), p. 6

^[10] See Deutsche Bundesbank (2010), p. 9

^[11] See Zwahlen, Stephan A. (2010), p. 165

^[12] See Basel Committee on Banking Supervision (2010b), p. 1

^[13] See Staub, Christian (2010), p. 494 - 497

^[14] See Basel Auschuss für Bankenaufsicht (2006), p. 2-4

^[15] See Bundesverband Deutscher Banken (2010), p. 23

^[16] See Basel Committee on Banking Supervision (2010a)

^[17] See Basel Committee on Banking Supervision (2010b), p. 69

^[18] See Basel Committee on Banking Supervision (2010b), p. 30-31

^[19] See Basel Committee on Banking Supervision (2010c), p. 1-4

^[20] See Lüders, Uwe / Manns, Thorsten / Schnall, Markus (2011), p. 2-3

^[21] See Basel Committee on Banking Supervision (2010b), p. 13

^[22] See Basel Committee on Banking Supervision (2010b), p. 10-12

^[23] See Basel Committee on Banking Supervision (2010), p. 1-11

^[24] See Basel Committee on Banking Supervision (2010b), p. 14

^[25] See Basel Committee on Banking Supervision (2010b), p. 1

^[26] See Manns, Thorsten / Aberer, Bartle (2010), p. 2

^[27] See Basel Committee on Banking Supervision (2010b), p. 55

^[28] See Basel Committee on Banking Supervision (2010b), p. 14-17

^[29] See Basel Committee on Banking Supervision (2010a), p. 13

^[30] See Basel Committee on Banking Supervision (2010b), p. 17-18

^[31] See Basel Committee on Banking Supervision (2010b), p. 19-20

^[32] See Basel Committee on Banking Supervision (2010b), p. 19-20

^[33] See Bundesfinanzminesterium (2010)

^[34] See Basel Committee on Banking Supervision (2010b), p. 40-46

^[35] See Investopia (2013)

^[36] See Basel Committee on Banking Supervision (2010d), p. 3

^[37] See Basel Committee on Banking Supervision (2010b), p. 78

^[38] See Committee on Financial Service (2011), p. 12

^[39] See Basel Committee on Banking Supervision (2006), p. 277

^[40] See Basel Committee on Banking Supervision (2006), p. 16-21

^[41] See Basel Committee on Banking Supervision (2010b), p. 13-33

^[42] See OECD (2011), p. 36

^[43] See Independent Community Bankers of America (2012), p. 3-5

^[44] See Reich, Robert (2011)

^[45] See Bosse, Michael / Hultsch, Christoph (2011), p. 48

^[46] See Werner, Horst S. (2007), p. 21-22

^[47] See Lanzrath, Werner (2011), p. 2

^[48] See Deutsche Bundesbank (2011), p. 7

^[49] See Werner, Horst (2007), p. 30

^[50] See Föcking, Michael (2006), p. 23-24

^[51] See Deutsche Bundesbank (2010), p. 20

^[52] See Dübel, Hans-Joachim (2010), p. 2

^[53] See Link, Gerson (2002), p. 20

^[54] See Grunow, Hans-Werner G. / Figgener, Stefanus (2006), p. 204

^[55] See Werner, Horst S. (2007), p. 56-57

^[56] See Werner, Horst S. (2007), p. 58-60

^[57] See Basel Committee on Banking Supervisors (2007)

^[58] See Basel Committee on Banking Supervision (2010b), p. 10

^[59] See Canellos, Peter / Paul, Deborah (2002)

^[60] See Werner, Horst S. (2007), p. 60-61

^[61] See Fabozzi, Frank J. (2002), p. 189

^[62] See Wöster, Christoph (2003), p. 71

^[63] See DB Research (2011), p. 4

^[64] See De Spiegeleer, Jan / Schoutens, Wim (2011), p. 12

^[65] See Flannery, Mark J. / Perotti, Enrico (2010)

^[66] See Doherty, Harrington (1997), p. 23

^[67] See Financial Times (2009)

^[68] See Bayer, Tobias (2010), p.1

^[69] See Collender, Robert N. / Pafenberg, Forrest W. / Seiler, Robert S. (2010), p. 7-9

^[70] See Bayer, Tobias (2010), p.1

^[71] See Deutsche Bundesbank (2010), p. 116

^[72] See Flannery, Mark J. (2009), p. 3

^[73] See Pennacchi, George / Vermaelen, Theo / Wolff, Christian (2011), p. 2

^[74] See Acharya, Viral V. (2010), p. 162