As APRA moves to tighten rules on bank capital levels, a new class of convertible bonds comes to the rescue, promising to avoid taxpayer-funded bailouts without the heavy-handed — and costly — regulations on the private sector.
The Australian financial watchdog should embrace the newcomer, allowing banks to use these novel convertible bonds to meet the higher capital levels recommended by the recent Financial System Inquiry.
The name of the game is Equity Recourse Notes (ERNs), a new breed of hybrid contingent capital proposed in a forthcoming paper by Jeremy Bulow (Stanford University) and Paul Klemperer (Oxford University).
ERNs are issued as a debt liability, yet its currently-due payments can be easily converted into shares in times of financial distress, therefore saving taxpayer funding to the ailing bank. In this sense, these are almost like contingent convertible bonds (aka ‘cocos’) but with a vital difference on the timing of conversion.
Currently, cocos are converted into shares whenever the regulator authority deems appropriate. Not only does this process generate excessive uncertainty to bondholders, but also has the potential to magnify the distressing crisis environment.
ERNs, on the other hand, have their conversion trigger clearly pre-defined as a percentage of the bank’s share price at the moment of the bond issuance. Hence, ERN conversion into equity is immune to outside political forces (and economic negative effects) that might restrain the regulator from acting.
The research team outlines an example in which a bank’s share price is $80 and the pre-defined percentage converting trigger in the ERN is 25%, then whenever in a crisis-like event the bank’s share price falls to $20 (=$80×25%), the bank is allowed to service the debt by issuing new shares. That is, without further regulatory interference, old debt is converted into equity, giving an extra relief for illiquid banks to fight back.
Another important feature is that such a mechanism is countercyclical. In times of crisis, ERNs are designed to generate incentives for both issuer (the bank) and new creditors towards more lending — not less, as occurs under current traditional financing.
As bank’s share prices fall, possibly triggering ERN debt conversions, fresh ERN issuance benefits both bank and new creditors. Banks not only save on cash payments to service their old debt, but also receive new funds to invest in new opportunities, helping stop the downward spiral effects into the wider financial markets.
On the other side, new creditors are attracted into lending fresh money to the distressed financial institution. Falling share prices opens opportunity for bargains, and automatically classifies new ERNs as senior to existing ones.
Although ERNs have not yet been tested, their implementation should be straightforward. The clear and simple structure of ERNs — closely related to the European style call option instruments — make them easy to price and trade.
Such a strong everybody-wins prospect might seem too good to be real, but the new proposal to make banks safer without the need for stifling regulation is already being hailed as a “miraculous conversion”.
Notwithstanding this welcoming acceptance, would ERNs have worked in the last Global Financial Crisis? The researchers answer resoundingly yes, with lower funding necessity and — most importantly — no taxpayer money involved.
For regulators worldwide to embrace this new debt instrument, important decisions are to be made.
First, there is the regulatory choice of percentage that should trigger conversion. The lower the fraction, the riskier the system becomes, even encouraging short-selling by bondholders to acquire voting control; whereas the higher the fraction, the more equity-like ERN becomes, which reduces its attractiveness as a debt instrument. Although this matter is left for further discussion, a 25% minimum advocated in the seminal paper might be a reasonable compromise.
Second, the ERN should be considered as equity for capital level requirements, preferably as ‘Additional Tier 1 Capital’. In practice, this means allowing banks to meet the new extra prime capital level requirement using ERNs.
Despite all this promise, ERNs are not crisis-proof, nor a panacea for mankind’s financial troubles. There are still some pending issues that only time and experience will help to clarify.
As noted, ERNs have not yet been put to the test in the real world. Hence, not much is known regarding investors’ real appetite for this breed of financial instrument. The risk of capital dilution between different cohorts of ERN holders will also need to be taken into account. And, as with intrinsically every convertible bond, there is always a liquidity risk — there is no guarantee of the ability to trade them in distressed times.
Nonetheless, for APRA to consider them seems not only reasonable, but desirable — at least to give them a feasibility trial. ERNs are cheaper than traditional equity requirements, safer than common debt liabilities and relatively immune to stifling — possibly misguided— overregulation.
APRA should heed the refreshing winds of change: not more regulation, not less regulation, but a better regulation environment for a safe and thriving Australia.
Home > Commentary > Opinion > A market-oriented solution for the too-big-to-fail problem
A market-oriented solution for the too-big-to-fail problem
As APRA moves to tighten rules on bank capital levels, a new class of convertible bonds comes to the rescue, promising to avoid taxpayer-funded bailouts without the heavy-handed — and costly — regulations on the private sector.
The Australian financial watchdog should embrace the newcomer, allowing banks to use these novel convertible bonds to meet the higher capital levels recommended by the recent Financial System Inquiry.
The name of the game is Equity Recourse Notes (ERNs), a new breed of hybrid contingent capital proposed in a forthcoming paper by Jeremy Bulow (Stanford University) and Paul Klemperer (Oxford University).
ERNs are issued as a debt liability, yet its currently-due payments can be easily converted into shares in times of financial distress, therefore saving taxpayer funding to the ailing bank. In this sense, these are almost like contingent convertible bonds (aka ‘cocos’) but with a vital difference on the timing of conversion.
Currently, cocos are converted into shares whenever the regulator authority deems appropriate. Not only does this process generate excessive uncertainty to bondholders, but also has the potential to magnify the distressing crisis environment.
ERNs, on the other hand, have their conversion trigger clearly pre-defined as a percentage of the bank’s share price at the moment of the bond issuance. Hence, ERN conversion into equity is immune to outside political forces (and economic negative effects) that might restrain the regulator from acting.
The research team outlines an example in which a bank’s share price is $80 and the pre-defined percentage converting trigger in the ERN is 25%, then whenever in a crisis-like event the bank’s share price falls to $20 (=$80×25%), the bank is allowed to service the debt by issuing new shares. That is, without further regulatory interference, old debt is converted into equity, giving an extra relief for illiquid banks to fight back.
Another important feature is that such a mechanism is countercyclical. In times of crisis, ERNs are designed to generate incentives for both issuer (the bank) and new creditors towards more lending — not less, as occurs under current traditional financing.
As bank’s share prices fall, possibly triggering ERN debt conversions, fresh ERN issuance benefits both bank and new creditors. Banks not only save on cash payments to service their old debt, but also receive new funds to invest in new opportunities, helping stop the downward spiral effects into the wider financial markets.
On the other side, new creditors are attracted into lending fresh money to the distressed financial institution. Falling share prices opens opportunity for bargains, and automatically classifies new ERNs as senior to existing ones.
Although ERNs have not yet been tested, their implementation should be straightforward. The clear and simple structure of ERNs — closely related to the European style call option instruments — make them easy to price and trade.
Such a strong everybody-wins prospect might seem too good to be real, but the new proposal to make banks safer without the need for stifling regulation is already being hailed as a “miraculous conversion”.
Notwithstanding this welcoming acceptance, would ERNs have worked in the last Global Financial Crisis? The researchers answer resoundingly yes, with lower funding necessity and — most importantly — no taxpayer money involved.
For regulators worldwide to embrace this new debt instrument, important decisions are to be made.
First, there is the regulatory choice of percentage that should trigger conversion. The lower the fraction, the riskier the system becomes, even encouraging short-selling by bondholders to acquire voting control; whereas the higher the fraction, the more equity-like ERN becomes, which reduces its attractiveness as a debt instrument. Although this matter is left for further discussion, a 25% minimum advocated in the seminal paper might be a reasonable compromise.
Second, the ERN should be considered as equity for capital level requirements, preferably as ‘Additional Tier 1 Capital’. In practice, this means allowing banks to meet the new extra prime capital level requirement using ERNs.
Despite all this promise, ERNs are not crisis-proof, nor a panacea for mankind’s financial troubles. There are still some pending issues that only time and experience will help to clarify.
As noted, ERNs have not yet been put to the test in the real world. Hence, not much is known regarding investors’ real appetite for this breed of financial instrument. The risk of capital dilution between different cohorts of ERN holders will also need to be taken into account. And, as with intrinsically every convertible bond, there is always a liquidity risk — there is no guarantee of the ability to trade them in distressed times.
Nonetheless, for APRA to consider them seems not only reasonable, but desirable — at least to give them a feasibility trial. ERNs are cheaper than traditional equity requirements, safer than common debt liabilities and relatively immune to stifling — possibly misguided— overregulation.
APRA should heed the refreshing winds of change: not more regulation, not less regulation, but a better regulation environment for a safe and thriving Australia.
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