Ensuing the most recent global financial crisis, several regulatory reforms have been enacted, with the aim of attaining a sound and transparent financial system, to ensure systematic stability, and enhance investor and consumer protection.
In response to the credit crisis and the several flaws in banking regulation, Basel III - focused on both micro and macro prudential regulation and supervision, was introduced.
The latter legislation seeks to; improve the banking industry’s capacity to absorb shocks emerging from both economic and financial stress, enhance risk management practices, and strengthen the banks' disclosures to the public at large – founding principles on which Basel III rests.
To realise these founding principles, and thus ensure economic stability and efficiency, the Basel Committee on Banking Supervision (BCBS) set four capital ratios, which depository institutions must oversee and abide to.
The employed capital ratios measure a banking institutions’ capital in relation to its risk-weighted assets, that can be found both on- and off- the balance sheet, and whose values are approximately adjusted for credit risk, that is, the risk of a loss arising from a borrower’s failure to meet its contractual obligations.
Looking at the most popular capital ratios, the Basel Committee on Banking Supervision separates capital into three domains, namely; ‘Common Equity Tier 1 (CET1) Capital’, ‘Tier 1 Capital’, and ‘Total Capital’.
CET1 capital; a component of Tier 1 capital mainly consists of common stock held by a banking institution, whilst the additional Tier 1, accounts for instruments that are not common equity. Should an economic crisis crop up, equity is typically taken first from Tier 1. It is worth highlighting that the latter type of capital absorbs losses without requiring the bank to cease its operations.
With regards to ‘Total Capital’, the ratio takes into consideration Tier II capital - capital intended to absorb any losses incurred in the event of a liquidation. Items that are considered as Tier II capital include, but are not limited to: Undisclosed and asset revaluation reserves, and subordinated debt.
Due to leverage and high risk-based capital ratios being the main culprits of the recent global financial crisis, the Bank of International Settlements (BIS), in 2014 implemented a non-risk based regulation, namely the Tier 1 leverage ratio.
To ensure sufficiently liquidity and thus prevent and mitigate long-term non-cyclical systemic risks, additional supplementary supervisory buffers may be employed by the relevant regulatory and supervisory authorities. It is worth noting that supplementary buffers tend to vary according to the systemic importance of the said financial institution to the economy at large.
Albeit stronger regulatory requirements are said to have spurred banking institutions to steadily increase capital ratios, the current interest rate scenario – central to bank profitability and mainly reliant on Net Interest Income, has undoubtedly increased pressure on banking institutions, to remain compliant with the imposed capital adequacy ratios. To clarify thoughts, a low interest environment tends to negatively impact a bank’s top-line, which in turn effects profitability and thus, the said capital ratios.
Should the current economic scenario persist, and the European Central Bank continue to further cut interest rates, leaving interest rates at significantly low levels, pressure on banking institutions, especially those considered to be significant to the economy at large, will undoubtedly increase.
In a bid to ensure that banking institutions are in-line with the imposed requirements, and are thus able to meet supervisory expectations, European banks are increasingly seeking access to markets directly, through their issuance of cocos - Contingent Convertible securities. More often than not, coco bonds are primarily issued by banking institutions to shore-up their Tier 1 Capital.
Whilst, from an investment perspective, contingent convertibles may indeed offer some value, coco bonds may not be the best bet for portfolios seeking to mitigate downside risk, this being due to their nature where one may potentially accept significant equity downside for a bit of yield spread.
That said, given the very low yielding environment and the fact that coco bonds tend to offer a spread to the more conventional fixed income assets (namely due to their complex and subordination element), cocos have become increasingly popular amongst investors who are craving for yield.
However, when looking at cocos, one should indeed be very mindful in the bond picking process, to ensure their sanity, mainly when it comes to the aforementioned regulatory requirements.
Our top pick for 2019 was Banco Santander, the Spanish bank, which continued to benefit from a more benign economic environment in Brazil, from where it generates a substantial revenue stream.
Disclaimer: This article was issued by Christopher Cutajar, credit analyst at Calamatta Cuschieri. For more information visit https://cc.com.mt/. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.