CoCo protections plan eases investor concerns

Author: Lizzie Meager | Published: 25 Aug 2016
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Prices may have recovered from earlier volatility, but investor concerns haven't
A draft proposal suggesting greater protections for contingent convertible instruments (CoCos) has been heralded as a welcome clarification for investors.

The undated non-paper, circulated by the European Commission and seen by IFLR, sets out a framework whereby CoCos would be given priority if a bank’s maximum distributable amount (MDA), including dividends and bonuses, is under pressure.

CoCos or additional tier 1 securities (AT1), hybrid debt instruments that convert to equity in times of crisis, were introduced to absorb losses after the financial crisis revealed holes in banks’ capital structures. Right now issuers have some flexibility as to the AT1/equity pecking order – but that could soon change.

“There’s been nothing to guarantee that the creditor hierarchy will be respected in anything other than a winding-up or resolution, and that’s been a frequently raised concern,” said Tom Grant, partner at Allen & Overy.

Issuers often do include language in their AT1 prospectuses claiming the hierarchy would be respected in any event.

For example in its August AT1 prospectus supplement, Royal Bank of Scotland explains that it’s the ‘current intention of our board of directors…to take into account the relative ranking of these instruments’. But it goes on to say that it may depart from that intention at any time, a decision that’s ‘in its sole discretion’.

That’s all it is though – a statement of intent at the time of issue. Ultimately coupon payments, which are not cumulative, can be skipped at the board’s discretion without activating a default, even while dividends and staff bonuses are still paid.

“Hardwiring those principles into the regulatory framework would give investors more security,” added Grant.


  • A draft proposal for enshrining the creditor hierarchy in rules has been circulated by the European Commission and welcomed by investors in CoCo securities;
  • Concerns earlier this year that issuers would not make their payments rattled investors and prompted regulators to review the framework;
  • While issuers include a statement of intent to respect the hierarchy in their issuing documents, this can be abandoned at the discretion of management;
  • Issuers will lose some of the flexibility the current regime affords them. But happy, more secure investors means higher demand;
  • Issuance dropped sharply in the first half of 2016 to €13.9 billion, down from €34.8 billion the previous year.

Changing the framework could see the reintroduction of dividend stoppers, which were prohibited under the Capital Requirements Directive (CRD) IV. Permitted everywhere except in the EU, they block dividend and bonus payments unless coupons are also paid on AT1 securities.

The idea was that a dividend stopper makes it harder for banks to stop paying CoCo coupons when they actually need to preserve capital.

“If the creditor hierarchy is to be enshrined in rules, the manner of implementation will need to take into account local corporate regimes across member states,” said Grant. “Each one will potentially have differing rules around how dividends may be declared.”

CoCo chaos

The uncertainty has caused little concern among investors until earlier this year, when the European Central Bank (ECB) published the results of its bank risk test, the supervisory review and evaluation process (SREP) in February.

While no coupons were actually missed, the volatility raised concerns that banks wouldn’t make the payments, which then exacerbated the problem, and prices slumped.

Meanwhile credit default swaps to be used as CoCo insurance policies were snapped up, at the time a worrying reminder of crisis precursors.

"Financial institutions have a bit more flexibility as to how they prioritise payments, and that will fall away with these changes"

This was worsened by an ongoing debate between regulators as to how to calculate the MDA. Confusion ensued when it looked like this calculation could block interest payments for some issuers.

Much of the drama surrounded Deutsche Bank, which in turn launched a buyback of its own senior debt to prove there was no problem. But that largely stemmed from a quirk in German law requiring companies to calculate their so-called available distributable items, a formula based on company earnings.

One source said the issues arose primarily because it was the first time ECB has completed such an exercise in a harmonised way across all banking union countries.

“It revealed the discrepancies between states, so the intention is to remove those legal obstacles, and provide clarity through the CRD V,” she explained.

That volatility seems to have acted as a wake-up call for regulators, who have turned their attention to coordinating the capital levels that determine whether or not banks can make payments.

“Right now, financial institutions have a bit more flexibility as to how they can prioritise payments, and that discretion will fall away with these changes,” said Connie Milonakis, partner at Davis Polk & Wardwell in London. “Equally if investors are happy, there’d be more demand and that’s positive for issuers too.”

The Association for Financial Markets in Europe’s (Afme) Q2 prudential report reflects a sharp decline in issuance. In the first half of 2016 total CoCo issuance by European banks reached €13.9 billion, down significantly from the €34.8 billion for the same period the year before.

Prices have recovered from the earlier volatility. They suffered at the hands of uncertainty over the EU referendum, but perhaps surprisingly were unaffected by the European Banking Authority’s (EBA) stress tests. From this Afme concludes that changes in bank valuations are likely to be for reasons other than capital level concerns.

The European Commission has allegedly given itself a deadline of end of 2016 for legislative changes to the CRR, so a more concrete proposal could be known in the near future.

See also

Necessity is the mother of CoCo invention
CoCos hit by new prospectus regime
CoCos’ stars have finally aligned