Contingent capital: cure or cost for banks?

By Steve Slater and Clara Ferreira-Marques - Analysis

LONDON, Oct 27 - Britain's Lloyds (LLOY.L) is poised to raise billions of pounds in so-called contingent capital, in what could be a litmus test for a new kind of debt that converts into equity if a bank hits rocky times.

Contingent, or "top up," capital has been used before, but never on the scale now being considered. Issuance by U.S. banks alone could top $300 billion, analysts reckon.

At its most basic, it is a debt instrument that converts into common equity during a period of financial strain, effectively shoring up a bank's capital position without diluting shareholders until it is needed.

"It opens another avenue for banks, and one that should be perceived positively by investors, subject to terms and conditions," said Joseph Dickerson, analyst at Execution.

"It was frowned on by regulators in the past, but if Lloyds' (move) is approved, it shows regulators would be willing to endorse it for others," he said.

The devil is in the detail, however, and contingent capital is likely to be expensive for issuers, who need to lure debt investors into buying an instrument that could turn to shares.

For most banks, contingent capital is expected to be hybrid debt that converts into core capital at a trigger point, such as when the Core Tier 1 ratio falls below a certain level.

Regulators on both sides of the Atlantic have backed the idea of this "top up" capital, seduced by the fact it would kick in before a bank actually collapses, thus shielding customers.

It could also make banks more disciplined. Dilutive share issuance looms large and quickly for any lender that approaches trouble -- hence the nickname "death spiral convertibles" -- and riskier banks would have to pay more to investors.

"(Contingent capital) could become a meaningful and cost effective way to allow banks to develop a counter-cyclical form of capital capable of averting a future financial crisis," said Frederick Cannon at Keefe, Bruyette & Woods.

Lloyds Banking Group would not be the first to use a tool of this type -- Danske Bank (DANSKE.CO), received capital with a conversion option, for example -- but it would be blazing a trail and will be closely watched by European peers including Royal Bank of Scotland (RBS.L), Intesa Sanpaolo (ISP.MI) and Credit Agricole (CAGR.PA), analysts said.

Bank of America (BAC.N) and other major U.S. lenders could also be encouraged to follow suit.

KBW's Cannon said top U.S. banks could issue between $152 billion and $303 billion if required to raise contingent capital equivalent to 2 to 4 percent of their risk-weighted assets.

Part-nationalized Lloyds may convert more than 5 billion to 7 billion pounds of hybrid debt into contingent capital, people familiar with the matter have told Reuters, as part of its more-than-20-billion-pound plan to avoid a government insurance scheme for bad debts.

Lloyds has a total of 15.5 billion pounds in preference shares, preferred, innovative Tier 1 securities and upper Tier 2 -- all of which might be used in a contingent capital deal.