Coco’s are not the ‘canary in the coalmine’

Additional Tier 1 bonds are not the ‘canary in the coal mine’ instruments envisaged by regulators, but complex financial products that expose the financial markets to significant risk.

Additional Tier 1 bonds, a type of contingent convertible (CoCo) bond, hit the headlines in February after a tranche issued by Deutsche Bank plummeted in the wake of poorly received 2015 figures. The episode exposed fundamental weaknesses with this form of capital and the way it has been evaluated by rule-makers.

Regulators in Europe may be recognising they have an Additional Tier 1 problem. This form of capital is too small to save a bank, but large enough to cause all bank bonds to come under suspicion. Regulators voiced the wish to have an early warning market indicator after the Global Financial Crisis and described AT1 as the ‘canary in the coal mine’. The analogy is flawed. The doomed canary dies, but it doesn’t blow up the mine. The Deutsche experience reminded the market that the AT1 is just another complex financial product, with all the negatives that term inspires.

In the wake of the market reaction to Deutsche’s results, the bank would have been unable to issue AT1 bonds or any other form of subordinated debt. Deutsche Bank has about €5.6bn of Additional Tier 1 bonds, and a balance sheet of about €1.6tr. If it got in real trouble, the so-called capital represented by the AT1 bonds would be eaten up in a restructuring nanosecond.

Holders of AT1 instruments are asked to assume greater risk than equity holders in certain circumstances. In particular, holders may have to forfeit their notes for no compensation, or watch equity investors take cash from a bank (in the form of dividends) which has stopped paying interest to the note holder. Equity holders are asked to bear the risk of total loss because they own the firm and appoint – and can hold to task – management teams. But AT1 holders are only along for the ride and cannot influence management.

In the history of banking, both capital and liquidity concerns have been the cause of collapses, but those in the latter category – when a loss of confidence triggers a loss of funding access – are particularly rapid and difficult to solve. As a result,regulators should not endorse instruments that can breed the type of concern we witnessed in February regarding one of the largest banks in one of the most economically developed countries in the world.

Gregory Turnbull-Schwartz, investment manager at Kames Capital

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