Contingent Convertible Securities Meet the FDR Framework

In seeking to bridge the gap between the level of capital a financial institution is required to hold under Basel III and the far higher capital levels recommended by David Miles and Anat Admati, the Bank of England's Andrew Haldane has suggested using Contingent Convertible Securities (Co-Cos).

Co-Cos are suppose to automatically convert into equity as a financial institution runs into trouble.

As reported in a Guardian article,

In contrast to his Bank of England colleague David Miles, who has said banks should more than double their capital ratios to 20%, Haldane argued that piling in more capital to banks might not be answer. Instead, he questioned whether the new regime for bank capital – known as Basel III after the Swiss city where the regulators are based – "will be sufficient to cope with next time's crisis". 

Basel III is replacing Basel I – the first international standard for bank capital agreed in 1988 – and Basel II, which was implemented before the 2007 financial crisis unfolded. 

"There may be straightforward ways to rebalance the Basel scales, re-injecting market discipline," Haldane said. "Having banks issue a graduated set of contingent convertible securities [to the bankers as part of their bonus], which are responsive to early signs of market stress, is one possible way of doing so."

A primary reason for having bankers purchase Co-Cos is that with current financial reporting they are the only substantial buyers of Co-Cos.  Of all the potential investors, only bankers have access to the current assets and liability-level detail of their financial institution and can therefore assess the risk.  No other investor can assess the risk and therefore value these securities.

The FDR Framework suggests a way to make Co-Cos attractive to investors and address the following problems Mr. Haldane identifies with Basel III capital requirements.

A critic might argue that regulatory capital ratios have become too complex to verify, too error-prone to be reliably robust and too leaden-footed to enable prompt corrective action,

Under the FDR Framework, the steps needed to make Co-Cos attractive to investors and an important part of a financial institution's capital structure are:

• Require financial institutions to disclose their current assets and liability-level data.  Access to this data will allow investors to assess the risk of the financial institution and value the Co-Cos.

• Require financial institutions to issue two types of Co-Cos:  one funded by banker bonuses and the second, of equal or greater size, purchased by investors not affiliated with the financial institution.

It is the price on the investor Co-Cos that addresses Mr. Haldane's issues.  The price on the investor Co-Cos will be very sensitive and will reflect what the market thinks is the risk and solvency of the financial institution.  If the price declines substantially, it is a clear signal that prompt corrective action is needed.

Investor Co-Cos are the best friend of the regulators responsible for financial institution supervision.  Their price is the market's way of telling the regulator that there are issues with a specific institution.