Bank hybrid debt can work, but the fix it requires will be painful. The European Central Bank is having second thoughts about banks issuing securities that can be turned into equity or stripped of their coupons in a crisis, according to reports. Yet better than banning them would be for investors to price them properly. They may need to see real losses first.
It's no surprise that the ECB has doubts over additional Tier 1 securities, known as contingent capital or CoCos for short. Banks have issued nearly 100 billion euros of these bonds. Yet concerns over Deutsche Bank's ability to pay coupons in February turned into misplaced panic over the bank's health.
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The case for these quirky securities remains: European banks need capital, and CoCos are cheaper for their issuers than equity. Still, the question facing regulators is whether CoCos are a reliable form of capital.
Deutsche has already given its answer. Its co-Chief Executive John Cryan thinks CoCos are a "bad product" because they cost a lot to issue, but absorb small amounts of losses. And investors don't understand them: they think such hybrids are safer than they are, creating panic when banks get close to the level at which coupons are cancelled - known as the maximum distributable amount (MDA).
But CoCos could be rehabilitated, especially if regulators made rules simpler and standardised, so that risks could be better understood. A big part of the panic this year was caused by uncertainty over accounting and capital rules. Giving banks greater discretion to keep paying coupons in case of a small loss would also help.
Investors are in any case doing a better job of pricing hybrids than they were. The spread, for example between the yields of UniCredit and Societe Generale's CoCos is now three per cent, versus 0.5 per cent points in July last year. CreditSights reckons the Italian bank's "cushion" before coupons are cancelled is just 2.3 billion euros, less than half French bank's 5.9 billion euros.
What investors really need to see is a coupon suspension. That would show that coupons can be cut off without triggering panic, and provide clarity over how severe losses are in such a situation. While it may lead to a smaller market, it should be a more rational one too.
