* Instrument could be used to address US trading risks
* Bankers favour equity convertible structure
* BaFin blessing expected to follow final release of capital rules
By Aimee Donnellan
LONDON, Jan 31 (IFR) - Deutsche Bank, which announced a hefty quarterly loss of USD3.5bn on Thursday, is considering issuing contingent capital (CoCo) bonds in order meet new U.S. capital rules set to be imposed on the largest foreign banks.
The U.S. Federal Reserve, which is way ahead of its European regulatory counterparts in implementing Basel III capital requirements, moved to introduce new capital requirements on large foreign bank holding companies in December.
The intention is to mitigate risks to the financial system, and would force foreign banks to group all their subsidiaries under a holding company that would be subject to the same capital standards as U.S. holding companies.
The biggest banks will also need to hold liquidity buffers.
Germany's biggest lender, rated A2/A+/A+, is one of the European banks on the Fed's list.
After taking charges to draw a line under a series of scandals and to clean up its balance sheet without asking shareholders for cash, Deutsche must now address risks on the US trading side of its business.
"This (CoCo) is certainly one of the options that is in discussion, and it's one of the options that could be a solution to some of the topics," Deutsche Bank's CFO Stefan Krause said on an analyst call.
Some European banks have already dipped their toes into the nascent CoCo market with roaring success, but the transactions that have come to the market so far have been more about testing investor appetite for different types of structures.
The issuers that have printed deals so far, most notably Belgium's KBC and the UK's Barclays, have also had the backing of domestic regulators who have said they will count such instruments as capital.
Germany's bank regulator BaFin is yet to make a decision on how it views CoCos, but bankers say that once there is more clarity on how they fit into a bank's capital structure its position could change.
"CoCos make a lot of sense in the UK and Switzerland where the regulators have embraced the idea and I think BaFin would be more receptive to CoCos if they could find a place for them in their Pillar 2 requirements," said a banker.
Deutsche's core tier one capital ratio under Basel III rules rose to 8% at the end of 2012, from less than 6% at the end of 2011.
Investors' hunt for yield has allowed European banks to utilise permanent write-down structures rather than the equity convertible option seen on some earlier CoCos.
Deutsche has yet to disclose any details about the structure of the potential capital note, but a recent widening in financial spreads could make it more difficult to execute a permanent write-down security in the short term, bankers say.
Over the past 10 days, senior spreads have widened by around 1bp-2bp per day and bankers are expecting further softening as headline risk begins to weigh on the market.
"In a bullish market it makes sense to go for a permanent write-down structure but if the market turns it will be more difficult to convince investors to buy a product where they could lose everything," said a hybrid capital banker.
"Issuers should stick with one structure to avoid upsetting investors."
KBC's blowout USD1bn 10-year Reg S bond earlier this month, when markets were rallying, had a permanent write-down structure.
The deal, which attracted USD8.5bn of orders from mainly European institutional accounts, was touted as the first real test of investor demand for such instruments in 2013, and the strength of demand provided reassurance to European banks faced with issuing billions of dollars worth of CoCos.
Prior to KBC, Barclays' CoCo from last November, a BBB- rated Tier 2 10-year bullet, attracted USD17bn of demand and only paid a coupon of 7.625% despite its aggressive structure.