What should count as bank capital?

My last post looked at a RBNZ consultation paper which addressed the question “How much capital is enough?”. The overall quantum of capital the RBNZ arrived at (16% of RWA plus) seemed reasonable but it was less obvious that relying almost entirely on CET1 was the right solution. That prompted me to revisit an earlier consultation paper in which the RBNZ set out its case for why it did not want contingent capital instruments to play a significant role in the capital structure of the banks it supervises. This post explores the arguments the RBNZ marshals to support its position as part of a broader exploration of the debate over what counts as capital.

The traditional approach to this question assumes that common equity is unquestionably the best form of capital from the perspective of loss absorption. Consequently, the extent to which alternative forms of funding count as capital is judged by common equity benchmarks; e.g. the extent to which the funding is a permanent commitment (i.e. no maturity date) and the returns paid to investors depend on the profitability or capacity of the company to pay (failure to pay is not an event of default).

There is no dispute that tangible common equity unquestionably absorbs loss and is the foundation of any company’s capital structure but I believe contingent convertible capital instruments do potentially add something useful to the bank capital management toolkit. I will attempt to make the case that a foundation of common equity, supplemented with some debt that converts to common equity if required, is better than a capital structure comprised solely or largely of common equity.

The essence of my argument is that there is a point in the capital structure where adding contingent convertible instruments enhances market discipline relative to just adding more common equity. The RBNZ discusses the potential value of these structures in their consultation paper:

49. The theoretical literature on contingent debt explores how these instruments might reduce risk (i.e. lower the probability of insolvency) for an individual bank.  

50. Two effects have been identified. Firstly, adding contingent debt to a bank’s balance sheet directly increases the loss absorbing potential of the bank, relative to issuing pure debt (but not relative to acquiring more common equity). This follows directly from the fact that removing the debt is an essential part of every contingent debt instrument. Secondly, depending on the terms, contingent capital may cause bank management to target a lower level of risk (incentive effects). In other words, in theory, a contingent debt instrument both reduces the probability a bank will incur losses and absorbs losses that do eventuate. Because of both these factors, contingent debt is expected, in theory, to reduce the risk of bank failure.  

51. Focusing on the second of these effects, management incentives, it matters whether, when the debt is written off, holders are compensated in the form of newly issued shares (“conversion”). If conversion is on such a scale as to threaten existing shareholders with a loss of control of the bank, it will be optimal for bank management to target a lower level of risk exposure for a given set of circumstances than would have been the case otherwise. For example, bank management may be less tolerant of asset volatility, and more likely to issue new equity to existing shareholders, when capital is low rather than risk triggering conversion.”

RBNZ Capital Review Paper 2: What should qualify as bank capital? Issues and Options (para 49 – 51) – Emphasis added

So the RBNZ does recognise the potential value of contingent debt instruments which convert into common equity but chose to downplay the benefits while placing much greater weight on a series of concerns it identified.

What’s in a name – The RBNZ Taxonomy of Capital

Before digging into the detail of the RBNZ concerns, it will be helpful to first clarify terminology. I am using the term Contingent Convertible Instruments for my preferred form of supplementary capital whereas much of the RBNZ paper focuses on what it refers to as “Contingent debt instruments“, which it defines in part as “debt that absorbs loss via write-off, which may or may not be followed by conversion”.

I had not picked this up on my first read of the RBNZ paper but came to realise we are talking slightly at cross purposes. The key words to note are “contingent” and “convertible”.

  • The “contingent” part of these instruments is non-negotiable if they are to be accepted as bank regulatory capital. The contingency is either a “non-viability event” (e.g. the supervisor determines that the bank must increase common equity to remain viable) or a CET1 ratio of 5.125% or less (what APRA terms a “loss absorption trigger” and the RBNZ refers to as a “going-concern trigger”)
  • “Conversion” however is optional. Loss absorption is non-negotiable for bank regulatory capital but it can be achieved in two ways. I have argued that loss absorption is best achieved by converting these capital instruments into common equity but prudential regulation is satisfied so long as the instruments are written-off.

I had taken it as given that these instruments would be convertible but the RBNZ places more emphasis on the possibility that conversion “may or may not” follow write-off. Small point but worth noting when evaluating the arguments.

Why does conversion matter?

The RBNZ understandably focuses on the write-off part of the loss absorption process whereas I focus on conversion because it is essential to preserving a loss hierarchy that allocates losses to common equity in the first instance. If we ignore for a moment the impact of bail-in (either by conversion or write-off), the order in which losses are applied to the various sources of funding employed by a bank follows this loss hierarchy:

  • Going Concern:
    • Common Equity Tier 1 (CET1)
    • Additional Tier 1 (AT1)
  • Insolvency – Liquidation or restructuring:
    • Tier 2 (T2)
    • Senior unsecured
    • Super senior
      • Covered bonds
      • Deposits
      • Insured deposits

Under bail-in, writing off a contingent capital instrument generates an increase in common equity that accrues to the existing ordinary shareholders thereby negating the traditional loss hierarchy that requires common equity to be exhausted before more senior instruments can be required to absorb loss.

Conversion is a far better way to effect loss absorption because ordinary shareholders still bear the brunt of any loss, albeit indirectly via the dilution of their shareholding (and associated share price losses). In theory, conversion shields the AT1 investors from loss absorption because they receive common equity equivalent in value to the book value of their claim on the issuer. In practice, it is less clear that the AT1 investors will be able to sell the shares received at the conversion price or better but they are still better off than if they had simply seen the value of their investment written-off. If you are interested in digging deeper, this post looks at how loss absorption works under bail-in.

The RBNZ does recognise this dynamic but still chose to reject these advantages so it is time to look at their concerns.

RBNZ concerns with contingent capital

The RBNZ identified six concerns to justify its in principle decision to exclude the use of contingent capital instruments in the NZ capital adequacy framework.

  1. Possible under-estimation of the tax effects of contingent debt
  2. Reliance on parent entities as purchasers of AT1 contingent debt
  3. Not suitable for retail investors
  4. Banks structured as mutual societies cannot offer contingent debt that includes conversion into common equity
  5. Potential for regulatory arbitrage arising from the tension between tax and capital regulation
  6. Difficulties with exercising regulatory oversight of contingent debt

I don’t imagine the RBNZ is much concerned with my opinion but I don’t find the first three concerns to be compelling. I set out my reasons later in the post but will focus for the moment on three issues that I think do bear deeper consideration. You do not necessarily have to agree with the RBNZ assessment, or the weight they assign to them, but I believe these concerns must be addressed if we are to make the case for contingent debt.

Stronger arguments against contingent debt

1) Contingent debt gives the larger, listed banks a competitive advantage over mutual societies that are unable to issue ordinary shares

The RBNZ notes that all New Zealand banks are able to issue a version of contingent debt that qualifies as capital, but that some types of banks may have access to a broader – and cheaper – range of capital opportunities than others. The current definition of capital is thus in part responsible for a somewhat uneven playing field.

The primary concern seems to be banks structured as mutual societies which are unable to issue ordinary shares. They cannot offer contingent debt that includes conversion and must rely on the relatively more expensive option of writing-off of the debt to effect loss absorption.

I think this is a reasonable concern but I also believe there may be ways to deal with it. One option is for these banks to issue Mutual Equity Interests as has been proposed in Australia. Another option (also based on an Australian proposal) is that the increased requirements for loss absorbing capital be confined to the banks which cannot credibly be allowed to fail or be resolved in any other way. I recognise that this option benefits from the existence of deposit insurance which NZ has thus far rejected.

I need to do bit more research on this topic so I plan to revisit the way we deal with small banks, and mutuals in particular, in a future post.

2) Economic welfare losses due to regulatory arbitrage opportunities in the context of contingent debt

The tax treatment of payments to security holders is one of the basic tests for determining if the security is debt or equity but contingent debt instruments don’t fall neatly into either box. The conversion terms tied to PONV triggers make the instruments equity like when the issuer is under financial stress while the contractual nature of the payments to security holders makes them appear more debt like under normal operating conditions.

I can see a valid prudential concern but only to the extent the debt like features the tax authority relied on in making its determination regarding tax-deductibility somehow undermined the ability of the instrument to absorb loss when required.

There have been instances where securities have been mis-sold to unsophisticated investors (the Monte dei Paschi di Sienna example cited by the RBNZ is a case in point) but it is less obvious that retail investment by itself is sufficient cause to rule out this form of capital.

The only real difference I see over conventional forms of debt is the line where their equity like features come into play. Conventional debt is only ever at risk of loss absorption in the event of bankruptcy where its seniority in the loss hierarchy will determine the extent to which the debt is repaid in full. These new forms of bank capital bring forward the point at which a bank balance sheet can be restructured to address the risk that the restructuring undermines confidence in the bank. The economics of the restructuring are analogous so long as losses are allocated by conversion rather than by write-off alone.

3) Difficulties experienced with the regulatory oversight of contingent debt

Possibly their core concern is that overseeing instrument compliance is a complex and resource-intensive process that the RBNZ believes does not fit well with its regulatory model that emphasises self-discipline and market discipline. The RBNZ highlights two concerns in particular.

  • Firstly the RBNZ has chosen to respond to the challenge of vetting these instruments by instituting a “non-objection process” that places the onus on issuers to confirm that their instruments comply with the capital adequacy requirements.
  • Secondly, notwithstanding the non objection process, the added complexity of the instruments relative to common equity, still requires significant call on prudential resources.

This I think, is the strongest objection the RBNZ raises against contingent debt. Contingent debt securities are clearly more complex than common equity so the RBNZ quite reasonably argues that they need to bring something extra to the table to justify the time, effort and risk associated with them. There is virtually no justification for them if they do, as the RBNZ asserts, work against the principles of self and market discipline that underpin its regulatory philosophy.

Three not so compelling reasons for restricting the use of contingent capital instruments (“in my humble opinion’)

1) Possible under-estimation of the tax effects of contingent debt

The first concern relates to the RBNZ requirement that banks must acknowledge any potential tax implications arising from contingent debt and reflect these potential “tax offsets” in the reported value of capital. Banks are required to obtain a binding ruling from the NZ tax authority (or voluntarily take a tax ”haircut”). The RBNZ acknowledges that a binding ruling can provide comfort that tax is fully accounted for under prudential requirements, but quite reasonably argues that this will only be the case if the ruling that is sought is appropriately specified so as to capture all relevant circumstances.

The RBNZ’s specific concern seems to be what happens when no shares are issued in the event of the contingent loss absorption feature being triggered and hence no consideration is paid to investors in exchange for writing off their debt claim. The bank has made a gain that in principle would create a tax lability but it also seems reasonable to assume that the write off could only occur if the bank was incurring material losses. It follows then that the contingent tax liability created by the write off is highly likely to be set off against the tax losses such that there is no tax to pay.

I am not a tax expert so I may well be missing something but I can’t see a practical risk here. Even in the seemingly unlikely event that there is a tax payment, the money represents a windfall gain for the public purse. That said, I recognise that the reader must still accept my argument regarding the value of having the conversion option to consider it worth dealing with the added complexity.

2) A reliance on parent entities as purchasers of AT1 contingent debt

I and the RBNZ both agree that one of the key planks in the case for accepting contingent debt as bank capital is the beneficial impact on bank risk taking generated by the risk of dilution but the RBNZ argues this beneficial impact is less than it could be when the instrument is issued by a NZ subsidiary to its publicly listed parent.

I may be missing something here but the parent is exposed to dilution if the Non-Viability or Going Concern triggers are hit so I can’t see how that reduces the incentive to control risk unless the suggestion is that NZ management will somehow have the freedom to pursue risky business strategies with no input from their ultimate owners.

3) Retail investors have acquired contingent debt

The RBNZ cites some statistical evidence that suggests that, in contrast to the experience overseas, there appears to be limited uptake by wholesale investors of contingent debt issued by the big four banks. This prompts them to question whether the terms being offered on instruments issued outside the parent group are not sufficiently attractive for sophisticated investors. This concern seems to be predicated on the view that retail will always be the least sophisticated investors so banks will seek to take advantage of their relative lack of knowledge.

It is arguably true that retail investors will tend be less sophisticated than wholesale investors but that should not in itself lead to the conclusion that any issue targeted at retail is a cynical attempt at exploitation or that retail might legitimately value something differently to the way other investors do. The extent that the structures issued by the Australian parents have thus far concentrated on retail, for example, might equally be explained by the payment of franking credit that was more highly valued by the retail segment. Offshore institutions might also have been negative on the Australian market therefore pushing Australian banks to focus their efforts in the domestic market.

I retain an open mind on this question and need to dig a bit deeper but I don’t see how the fact that retail investment dominates the demand for these structures at a point in time can be construed to be proof that they are being mis-sold.

The RBNZ’s answer ultimately lies in their regulatory philosophy

The reason that the RBNZ rejects the use of these forms of supplementary capital ultimately appears to lie in its regulatory philosophy which is based on the following principles

  • Self discipline on the part of the financial institutions they supervise
  • Market discipline
  • Deliberately conservative
  • Simplicity

The RBNZ also acknowledges the value of adopting BCBS consistent standards but this is not a guiding principle. It reserves the right to adapt them to local needs and, in particular, to be more conservative. It should also be noted that the RBNZ has quite deliberately rejected adopting deposit insurance on the grounds (as I understand it) that this encourages moral hazard. They take this a step further by foregoing any depositor preference in the loss hierarchy and by a unique policy of Open Bank Resolution (OBR) under which deposits are explicitly included in the liabilities which can be written down in need to assist in the recapitalisation of an insolvent bank.

In theory, the RBNZ might have embraced contingent convertible instruments on the basis of their consistency with the principles of self and market discipline. The threat of dilution via conversion of the instrument into common equity creates powerful incentives not just for management to limit excessive risk taking but also for the investors to exert market discipline where they perceive that management is not exercising self-discipline.

In practice, the RBNZ seems to have discounted this benefit on the grounds that that there is too much risk, either by design or by some operational failure, that these instruments might not convert to common equity. They also seem quite concerned with structures that eschew conversion (i.e. loss absorption effected by write-off alone) but they could have just excluded these instruments rather than a blanket ban. Having largely discounted or disregarded the potential benefit, the principles of deliberate conservatism and simplicity dictate their proposed policy position, common equity rules.

Summing up

This post only scratches the surface of this topic. My key point is that contingent convertible capital instruments potentially add something useful to the bank capital management toolkit compared to relying entirely on common equity. The RBNZ acknowledge the potential upside but ultimately argue that the concerns they identify outweigh the potential benefits. I have reviewed their six concerns in this post but need to do a bit more work to gain comfort that I am not missing something and that my belief in the value of bail-in based capital instruments is justified.

Tony

Author: From the Outside

After working in the Australian banking system for close to four decades, I am taking some time out to write and reflect on what I have learned. My primary area of expertise is bank capital management but this blog aims to offer a bank insider's outside perspective on banking, capital, economics, finance and risk.

4 thoughts on “What should count as bank capital?”

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