Investors have very short memories when central banks offer comfort.
Junior bank debt has rallied sharply since Mario Draghi, European Central Bank president, lent his support last week. UBS this week sold the first so-called additional tier 1 capital bonds since mid-January, attracting bids for more than five-times the size of the deal.
The risk is that too much support for the asset class will undermine the purpose of this form of bank capital, which is to absorb losses in times of stress. That strengthens the argument that the only capital worth the name is plain equity.
These junior bonds, sometimes known as contingent convertibles or CoCos, sold off dramatically in January and February because of fears that some banks would be forced to suspend coupon payments due to weak capital positions. Deutsche Bank was among the worst hit, but bonds issued by well-capitalized banks like UBS were dragged down too.
Banks must reduce or skip coupons when their capital falls beneath minimum requirements. They should also cut or scrap dividends to shareholders and bonuses in this situation.
But for bondholders, a missed coupon is gone forever while shareholders and bankers or executives can be paid more in future years, which seems unfair. Some in the ECB see this as a factor in the recent panic selling. So, Mr. Draghi last Thursday flagged a European Commission paper, which sets out two ways to help.
The first is uncontroversial in theory and would bring the eurozone in line with what U.K. regulators do. However, it could effectively cut eurozone banks’ capital requirements, which goes against the work of recent years.
All supervisors demand that banks hold more capital than their risk models suggest is needed in order to account for uncaptured risks—including the risk that models can be wrong.
But in the U.K. this supervisory add-on comes in two parts: a hard requirement based on specific rules, which effects whether dividends, bonuses and coupons can be paid, and a softer, undisclosed requirement for risks that are difficult to quantify. The latter is important in stress tests, but can be breached without immediate consequences.
In the eurozone, these are lumped together in a single, hard target. Yet this treatment, which is seen as harsher by eurozone banks, has not resulted in higher capital requirements compared with their U.K. rivals.
The second Commission suggestion looks more controversial. It proposes treating junior bond coupons differently from dividends so that bondholders don’t lose payouts as quickly as shareholders.
is a slippery slope. First, some bankers will push to treat bonuses differently, too. The argument goes that these are to incentivize the people who make the money, without whom no bondholder or shareholder would get a cent.
Second, such a change would muddy the idea that these kinds of junior bonds really are capital at all. In the last crisis, similar capital was a poor substitute for real equity: It failed to absorb losses and resulted in larger public bailouts.
The truth is that volatility and higher costs for these bonds today are the price that ensures they will do their job in future crises. If they don’t behave like equity capital or suffer like capital, you can bet they aren’t really capital at all.
Source: The Wall Street Journal
