Just add sweetener

The European Banking Authority (EBA) has served up a curate’s egg. The regulatory body’s December 8 announcement that lenders can use contingent capital to plug a euro 115-billion shortfall in their balance sheets could genuinely help cash-strapped lenders. But, some details may need tweaking.

Debt investors are generally wary of contingent convertible capital — known as Cocos — because they automatically convert into equity at times of stress. Cocos tend to be an easier sell if they have fixed maturities and coupons which cannot be arbitrarily deferred, like Credit Suisse’s $2-billion issue earlier this year. The Swiss bank’s planned 19 per cent capital ratio of core Tier-I and other Cocos also helped: It makes the breaching of the seven per cent core Tier-I conversion trigger less likely.

The EBA’s requirements look less enticing. According to its term sheet, the securities must be perpetual, and coupons can be deferred by the bank or the regulator. Moreover, the trigger point for conversion remains a capital ratio of seven per cent – only two percentage points below the nine per cent target set by the EBA. Debt investors are unlikely to be interested in such a risky product without a huge coupon.

The EBA rules are not a complete turn off. The body will also allow banks to issue Cocos that not only convert if things go wrong, but also if they go right. This might appeal to some investors, such as those that bought into Bank of Cyprus’ euro 1.3 billion Coco, which triggers if the Cypriot lender’s shares rise.

Meanwhile, Cocos could be a great way for governments to step in. For some lenders, such as Germany’s Commerzbank, the capital shortfall under the EBA’s calculations is so big that a direct government equity injection would massively dilute private shareholders. Taking Cocos could allow the state to help without taking control.

But, a better plan would be for the EBA to allow national regulators more leeway. The Basel III rules to be implemented in Europe by January 2013 should allow Cocos to be triggered at the lower capital ratio of 5.1 per cent — which will make them more appealing to investors. To give hard-up banks a chance of raising some extra money, the EBA could take a similar approach.