Contingent capital: cure or cost for banks?

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.


The success of Lloyds and any other issuer will depend on pricing and investor demand. So far, appetite is uncertain.

One of the largest deals, Lloyds’ hybrid Tier 1 bonds due 2015, currently trades at 62 cents to the dollar, indicating a level of stress.

That bond yields 9.7 percent and Lloyds may need to offer an annual coupon of around 12 percent for its contingent capital to reflect the risk of conversion into equity, analysts said.

“I would think they will be expensive, because they have a potentially high risk for investors. If you are an investor that holds a product that converts into a fixed number of shares of equity at a time when the share price is dropping, it is subject to significant risk,” said Barbara Havlicek, senior vice-president Hybrid Capital Group at Moody’s in New York.

But for some banks with limited options or big fundraising needs -- like Lloyds -- it could still be the right fix.

Other key factors are the size, trigger and conversion price, analysts said -- raising the prospect of a complex tool at a time when regulators are trying to simplify the landscape.

The conversion trigger needs to be set low enough that it is unlikely to be reached, but high enough that it provides help before a bank hits crisis point. That could see it triggered when the Core Tier 1 equity falls below 5 or 6 percent, depending on new industry standards under discussion.

A well-structured deal could limit the threat of adding to a downward spiral in a share price, and shareholder dilution could at least be offset by the end of costly coupon payments, which for Lloyds could add up to almost 1 billion pounds a year.

Some pension funds and insurers holding the bonds may also face restrictions on holding equity.

But early success and backing from U.S. Federal Reserve Chairman Ben Bernanke and Bank of England Governor Mervyn King -- who both signaled they liked the idea -- should help.

“Contingent capital makes sense now, the question is what will it look like,” Havlicek at Moody’s said. “When an issuer needs capital and markets may not be open, to have a product where there’s a built-in ability to get capital at a time of distress makes sense for the issuer.”