Equity recourse notes: no magical free markets pill
I have been pretty busy recently so now trying to catch up with a number of things.
I read in The Economist a couple of weeks ago that a new hybrid capital instrument proposal for banks could bypass regulatory decisions and rely on market triggers instead. I decided to investigate.
The principle isn’t very complex at first glance but raises a number of questions. According to Bulow and Klemperer (see their paper here), those equity recourse notes (ERNs) would classify as a type of convertible hybrid capital that avoid the flaws of Basel 3’s contingent convertible (CoCos). The problem with CoCos was already known by Bagehot in the 19th century: define an artificial threshold and get ready for a panic once you officially announce that this threshold has been breached.
ERNs hope to avoid this problem by getting rid of the regulatory trigger altogether. According to the authors, ERNs are
a form of “contingent capital” that start life as debt, but any currently-due payment is automatically converted into equity if the share price is below a trigger on the day the payment is due. The crucial features are that
(1) conversions are based on whether the share price is below a trigger that is a fixed fraction of the issue-date share price,
(2) conversions into shares value those shares at the trigger price, and
(3) conversions occur one payment at a time–only currently-due payments convert.
Essentially, banks would have the ability to pay interests on ERNs with newly-issued shares rather than cash (thereby safeguarding some precious liquidity in times of stress).
Some extra features of ERNs include:
– ERNs cannot contain covenants limiting the issuance of future ERNs. (See Section 3; there can be covenants limiting the future issuance of conventional debt.)
– Cash dividends and buy-backs are subject to regulatory approval. (This prevents a bank from undermining the role of ERNs by announcing that it will buy back the stock from any conversion or buy back ERNs prior to any repayment that would be converted; of course, major banks already require regulatory approval for dividends and buybacks.)
– Banks have the right to make payments on ERNs in shares (valued at the trigger price) even if the shares are trading above the trigger price. We would not expect to see this option used much, but it ensures that a bank will never fail because it cannot pay off an ERN.
– In bankruptcy, ERNs convert entirely into shares (that is, each ERNholder receives the number of shares equal to the ERN’s face value divided by the trigger price).
– The full benefits of ERNs require restrictions on their term structure.
And to implement ERNs within banks’ capital structure, the authors came up with the following reform programme:
1. Have ERNs replace traditional cocos;
2. Require all SIFIs’ long-term debt be substituted by ERNs;
3. Require secured debt (and defaulted contracts such as loan commitments) to have recourse (beyond specified collateral) only to shares or ERNs;
4. Isolate deposits in well-capitalised subsidiaries, with capital requirements similar to those the private market, or at least central banks, apply when lending against similar assets;
5. Slowly (to allay concerns about, and to respond to, any unintended consequences) narrow the eligible collateral in these subsidiaries.
So ERNs, as devised by Bullow and Klemperer, clearly aren’t some sort of magical free market solution: they still require significant regulatory intervention in order not to undermine the whole mechanism.
The authors also claim that ERNs are counter-cyclical, by facilitating capital issuance in bad times and hence supporting new lending opportunities, and prevent regulatory capital manipulation.
A few points quickly emerge:
It seems like banks could be vulnerable to ‘attacks’ from investors: if a bank’s stock is trading slightly above the trigger, some market participants could well short the stocks, pushing them below the trigger, and then earn a free lunch by benefiting from the effects on the share price of the dilution created by the automatic issuance of further shares. The authors point out that dilution would only be slow. This is true, but if the share price was already trading slightly above the trigger, even a minor dilution could push it permanently below the threshold. The situation would then be self-reinforcing as more investors would sell the stock as they expect further dilution to occur.
In particular in times of stress, when creditors would rather secure cash than extra equity stakes as payment, the automatic selling could push the share price in a downward spiral*. Equally, the mandate of a number of fixed-income investors does not allow them to hold equity investments. Consequently, they would have to get rid of the shares, creating further downward pressure on the share price. The risk here is permanent and self-reinforcing dilution.
The paper claims that ERNs would prevent such downward spiral scenario, as the value of the share issued would be below the value of the cash saved (and that, if ever necessary, banks could anyway buyback shares using the saved cash, which seems to contradict the features they described above, i.e. regulatory approval). While there is indeed some truth in this theory as it would benefit the book value of the bank, the market value is something entirely different and relies on the discounted free cash flows (or dividends as is often the case with banks) that originate from future earnings. Current cash levels do not impact a permanently reduced ability to generate income. Their points also do not address most of the cases I have described above.
A potential solution could be to redeem the ERMs whose trigger price is ‘permanently’ above the share price, although this may not always be possible when contractual or regulatory constraints are present.
The claim that banks will have counter-cyclical incentives to lend is also dubious. In times of stress, leverage can indeed accelerate a bank’s demise. What ERNs do is that banks’ most liquid assets (i.e. reserves/cash) become partly safeguarded, limiting banks’ incentives to call loans or sell securities on the market. But in times of stress, banks are likely to see their cash inflows reduced due to the difficulty of issuing new ERMs on the capital markets, or because the economic situation makes borrowers less creditworthy. It is then highly unlikely that ERNs would allow banks to lend during such periods. At best, they would relief some pressure on banks’ funding structure and liquidity (and leverage to an extent).
All in all, and there may be some critical points that I have missed or misinterpreted (their paper is pretty dense), ERNs aren’t some sort of magical free markets pills unlike what The Economist seemed to imply. However, I have nothing against experimenting: in a world free of regulatory constraints, banks are free to issue the type of securities they wish as long as investors are happy to purchase them. Whether the securities end up doing the work they were initially supposed to or not, markets would learn.
PS: it does seem to me that ERNs could be issued by any sort of corporations. I am unsure why the paper only focuses on banks.