Fixed income
15 May 2020 | By Lloyd Harris

In praise of big (bank) buffers

The latest, clear signals from the European Central Bank should provide significant reassurance for coco investors – here’s why.

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Banks have found themselves back in the spotlight as the coronavirus pandemic has unfolded. While the ghosts of the aftermath of the global financial crisis (GFC) continue to lurk in investors’ and the public’s memories, the reality, as we have argued before (see here), is that banks will be a key element of the economic solution to the present predicament. Perhaps most important of all, is that regulators have been quick to recognise this fact.

One of the most emphatic statements to this effect from a senior central banker so far came on 13 May, in a lengthy published interview with Andrea Enria, Chair of the Supervisory Board of the European Central Bank.

Investors in all forms of bank capital would be wise to take note of the detailed implications of Enria’s comments. From the perspective of those of us who invest in contingent capital bonds or “cocos,” as they are often called, the most reassuring remark in the interview was as follows (emphasis mine):

“There were some concerns that we might also consider other restrictions, including on additional Tier 1 instruments. Let me be clear: we are not planning to put any constraints on payments of such instruments. Restrictions on payments of these instruments will be automatically triggered only if banks hit certain capital levels set out in the legislation – but as of today, banks still have significant buffers to use before reaching that point.”

The importance of this statement is that it draws a deep line in the sand between the approach taken by regulators after the GFC – a crisis which was absolutely triggered by the actions and behaviour of banks – and the measures regulators are taking now to ensure that banks are well positioned to support the economic recovery.

After the 2008 crisis, regulators acted on the principle that state injections of fresh equity into banks would be forthcoming only after a bank’s bondholders had suffered meaningful capital losses.

The situation in which we find ourselves in 2020 could hardly stand in starker contrast; as Enria’s statement shows, regulators are now bending over themselves to keep bank bondholders happy and reassured, even as it has been made clear that bank equity investors and highly-paid bank employees will be expected to absorb swingeing cuts to dividends and variable compensation respectively. In short, regulators have done away with the so-called “bail-in” rules that were put in place after the GFC. 

This prompts an obvious question: why are regulators apparently so keen to protect the interests of bondholders, seemingly at the expense of equity investors? The answer is fundamentally rooted in regulators’ understanding that a combination of robust capital buffers and liquidity is the key to banks’ ability to support an economic recovery – credit investors, including in cocos, are seen as an important part of the solution.

Yet, given the uncertainty about the future path of the pandemic, bank credit investors could be forgiven for asking how sustainable such overt support for bondholders really is. In other words, can banks realistically continue to make their coco coupon payments?

To address this point, coco investors must look at the gap between a given institution’s current Tier-1 capital ratio, and the point at which it must “switch off” its coupons. Again here, regulators have been highly supportive, and have materially increased this gap. As a result, many European banks now benefit from a larger capital “buffer” (that which ensures coco coupons can continue to be paid) than they did entering the present crisis. Indeed, it is my expectation that the average Tier-1 capital ratio of European banks could well end 2020 at a level very close to where it was at the end of 2019.

These are, of course, profoundly challenging times. Nobody is suggesting that the near future offers the certainty on which both financial markets and the broader economy have historically thrived. For now though, I firmly believe that the willingness of regulators to provide such explicit statements of support for bank bondholders should enable us to take significant comfort.

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