New source of bank capital comes with new type of risk

In his Wall Street Journal column, Simon Nixon looks at how turning depositors into creditors directly effects the ability of a bank to use its capital to absorb losses.

Spanish banks have added a unique twist of effectively turning some depositors into equity holders. That puts customers on the front line. 

Some banks started by persuading depositors to switch from low, interest-bearing accounts into preference shares, which paid a fixed, higher interest rate. The benefit for the banks was that these securities counted as core capital under banking rules. 

UBS says Spanish banks issued €32 billion ($42.7 billion) of such instruments from 2007 to 2010. 

But as the crisis deepened, these instruments became illiquid, trading at deep discounts. 

At the same time, they ceased to count as core capital under new rules known as Basel III. So banks have encouraged investors to convert preference shares into either common stock or mandatory convertible notes, which pay a high initial yield before later converting into stock.... 

While deposit-for-equity swaps have boosted capital ratios, they also mean new risks. If customers face big losses, it could hit confidence. 

Note, customers have already incurred big losses as the securities they are holding are trading at deep discounts!

Given an estimated one million retail investors bought preference shares and mandatory convertibles, maintaining confidence is now a systemic concern. 

So Spanish bank equity may not be truly loss-absorbing....

A big uncertainty is whether customers will stick around. Banks are taking no chances ... And the government has ruled out direct equity injections, saying if new capital is needed it will take the form of contingent convertibles. That would postpone dilution.

Score one for the Spanish banks.

In theory, by converting depositors to equity holders, they procured hostages that will prevent the government from adopting the Swedish model and requiring banks to absorb all the losses hidden on and off their balance sheets today.

In theory, the government will continue implementing policies under the Japanese model to protect the level of bank book capital.  An example of this would be ruling out direct equity injections and promising to only use contingent convertibles to supply needed capital.

In reality, the depositors who converted to equity securities have already experience significant losses.  The depositors know that these losses are directly related to the existence of losses hidden on and off the bank balance sheets.

The depositors who converted to equity securities also know that under the Swedish model the value of their securities might not be wiped out.

The banks can be given the opportunity to rebuild their book capital after recognizing the losses.  So long as the securities are in a bank with a franchise that is able to generate future earnings, there is no need for capital from the government.