Airbags for banks?

by Prof. Dr. Martin Hellmich *

THE NEWS

Credit Suisse Group has issued Sfr6bn ($6.2bn) of contingent convertible bonds (CoCo-Bonds).

WHAT ARE CoCo-BONDS?

Contingent convertible bonds are like normal bonds with an exception: they are converted into equity by a trigger event such as the event of a decline in the banks Tier 1 capital ratio to less than 7 per cent.

Such bonds are intended to bolster a lenders equity in a crunch through the commitments of private sector investors. This mechanism shall avoid scenarios rather where too-big-to-fail financial institutions must be saved with taxpayer money as in the recent crisis. By converting the bonds the lender would at once have solved two problems by having less debt and more equity.

An airbag for the finance industry?

As CoCos automatically become equity if a banks capital falls below a set level they will play in future a crucial role under the new Basel III requirements and especially by meeting Swiss regulators demands to hold almost double the amount of capital required under new Basel III rules.

BASEL III RULES

Basel III aims to improve and raise the quality of capital held by banks. Banks will be required to hold a greater amount of tangible common equity (minimum requirement for maintaining normal operations raised to 4.5% against the current 2% of risk weighted assets) which has the greatest loss-absorbing capacity.

What really counts in the end…

Common equity forms a part of Tier 1 Capital. There are also stricter criteria for other instruments that will be considered as part of Tier 1 Capital. These instruments must be able to absorb losses for the bank on a “going-concern” basis, i.e. it assumes that this capital will allow the bank to remain solvent.

THE IMPORTANCE FOR SWISS BANKS

Big Swiss banks UBS and Credit Suisse must hold almost twice as much capital as set out in the new international Basel III standards.

They must build their safety net to 19%, 10% of which are in the form of the safest and most liquid equity and 9% in CoCo bonds.

In this context CoCo-Bonds are playing a crucial rule in limiting the risk that a bank failure would drag down the economy and shifting the burden of protecting struggling banks from the taxpayer to the private sector.

Switzerland’s locomotives are Switzerland’s bulk risk

This instrument is of a specific high importance for a country like Switzerland where the worth of the banking sector in relation to the total economy is quite high and the capacity of the state and the tax payer would be massively overstrained in a situation where one of the two big players would be in an existential struggle.

*Martin Hellmich ist Managing Director der Brokerage Firma Cantor Fitzgerald Europe in London.

Er ist Fakultätsmitglied des Lorange Institute of Business sowie der Frankfurt School of Manangment and Finance.

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