Bundesbank Goes Virtue-Signaling as Europe's Banks Burn
(Bloomberg Gadfly) -- The Bundesbank has in its sights a complicated and confusing asset class known as contingent convertibles, and is worried that they no longer do their intended job. The central bank's suggested remedy misses the point and risks making a bad situation worse.
The security, known as a CoCo or Additional Tier 1 bond, is designed to prop up faltering banks by providing capital from junior creditors. If a bank's core equity Tier 1 capital ratio falls below the minimum set out the bond's prospectus, the securities either convert to equity or are written off. Designed in the wake of the financial crisis, they are supposed to offer an early warning system that a bank is in distress.
Investors have been gorging on these bonds in recent years. Most recently, Spain's Ibercaja Banco sold 350 million euros ($431 million) of them on Tuesday, after receiving orders for as much as 1 billion euros. Offering a 7 percent coupon in a world of low interest rates certainly helped.
But an event the following day shows how focusing on capital ratios misses the bigger picture. Cooperative Bank of Cyprus is being forced to find a buyer as it grapples with a pile of non-performing loans. The lender's last reported core equity tier 1 ratio was 15.23 percent -- well above regulatory requirements.
In its monthly report, the Bundesbank rightly highlights how AT1 trigger points in Europe are too low -- EU law sets the absolute minimum at just 5.125 percent though issuers can offer higher levels -- to be of practical use as a warning sign. The German central bank suggests the minimum should be higher, though it doesn't say what the right level is.
That's irrelevant, because looking at capital ratios misses the wider picture -- as banks have built up their buffers, other issues are more pressing. Look at the capital ratios of banks that recently collapsed, and they were actually well above the ECB's minimum. Spain's Banco Popular Espanol SA reported a ratio of 12.13 percent, and was paying a dividend a little more than a month before it was rescued by Banco Santander SA.
The problem these banks faced was a sudden loss of liquidity -- not that the CoCos provided any warning of that.
The turmoil around the threat that Deutsche Bank AG may not be able to pay a coupon on an AT1 in 2016 shows that the securities are only half up to the job. While they helped the bank raise needed capital, if they had been bailed in, the funds would have made next to no difference to a bank of its magnitude and Armageddon across the financial system could have ensued. Given Deutsche Bank's stumbles this year, the timing of the report is unhelpful.
This is because it is one of probably a number of German banks that would be unlikely to welcome efforts to raise the securities' trigger points. That would make them riskier, and so investors would demand higher coupons to participate.
Other European governments would also be likely to object. Italy's banking system is only just staggering along under the weight of its non-performing loans and the government is unlikely to welcome a measure that could tip any more of the country's banks over the brink.
That opposition has meant the EU never raised the trigger point for CoCos as banks bolstered capital levels from their post-crisis low. That has made them far less useful as an early warning mechanism and a seemingly low-risk way for investors to pick up some yield.
What investors and regulators need now are real-time data on bank stresses, such a deposit flight or loan losses -- Deutsche Bank's capital levels are fine but it faces questions about the sustainability of its business model, and more information here would be a lot better. Everyone should turn their focus on clarifying a bank's "point of non-viability" -- a judgment that the European Central Bank makes.
The Bundesbank's suggestion amounts to little more than an exercise in virtue-signaling. It will be well aware the proposals will fall on deaf ears around Europe. Investors are much more concerned about what really puts a bank into trouble -- a sudden lack of liquidity. Better for regulators to address this rather than tinker with one of their old creations.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Marcus Ashworth is a Bloomberg Gadfly columnist covering European markets. He spent three decades in the banking industry, most recently as chief markets strategist at Haitong Securities in London.
©2018 Bloomberg L.P.