EU mulls protection for bank’s debt securities

Bloomberg

The European Union is considering adding to protections for banks’ riskiest debt securities by requiring that lenders pay coupons on such bonds before stock dividends and staff bonuses.
Coupons on additional Tier 1 securities, such as contingent convertibles, or CoCos, “should be given priority” if capital levels are breached that trigger limits on payouts, according to an undated European Commission document prepared for a meeting of national experts. Banks would only be able to pay stock dividends if such coupons are paid in full, according to the proposed rules from the EU’s executive body.
Regulators introduced CoCo bonds — undated securities with optional interest payments that are gone forever if missed — to replace forms of debt which didn’t absorb losses in the 2008 financial crisis. Under current EU law, a lender could theoretically skip a coupon rather than a share dividend, a feature that helped roil markets earlier this year and prompted some investors to dub the securities “junior equity.”
The CoCo proposal is part of a rule overhaul in which the commission is reining in supervisors’ powers to impose capital requirements exceeding the legal minimum and giving the banks more leeway to set those capital levels themselves. That move to curb so-called Pillar 2 requirements, a crucial factor for payout limits, started with a March paper that also raised the option of protecting CoCo coupons.

Capital Definition
The commission’s latest discussion paper, obtained by Bloomberg, refines the definition of common equity Tier 1 capital, allowing equity to qualify only “if distributions for this instrument are paid after all legal and contractual obligations have been met, including payments on non-CET1 own funds instruments,” according to the document.
Concern that some banks might have insufficient capital to be allowed to pay coupons on their CoCos rocked the market in the first quarter of this year, pushing the mean price of bonds on Bank of America Merrill Lynch’s CoCo Index to as low as 88.8 cents on the euro from a 2015 high of 104.6 cents. The price has now rallied to 99.13 cents, just below par value.
Banks’ capital requirements fall into two basic categories plus a series of buffers under the framework set by the Basel Committee on Banking Supervision.
Pillar 1 requirements are one-size-fits-all and set out the minimum levels all lenders must meet to be considered solvent. Pillar 2 requirements, set by the European Central Bank in the euro area, are defined for each bank individually.
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In response to the turmoil in the first quarter, the ECB has decided to adopt the commission’s plan to divide Pillar 2 into a part that’s binding and another part that’s “guidance.” In calculating whether they have the funds to make a payout, lenders don’t need to consider the ECB’s capital guidance, in effect giving them more room to make discretionary payments.
While the ECB is currently applying that split of the Pillar 2 capital voluntarily, the commission’s proposal would enshrine it in EU banking law. The authority to give capital “guidance” would even be purged from the legal text, according to the proposal, to avoid even the impression that it is binding.
The commission also proposes clarifying current rules to underscore that “setting a target level of capital is in the first place up to the bank.” Under existing law, financial firms are already required to assess their capital needs.
Under the proposal, supervisors would “regularly review” the capital levels set by banks based on stress tests and regular evaluations of the risks to which lenders are exposed and which they pose to the financial
system.