Cadwalader Clients & Friends Memo: Contingent Convertible Bonds and the Impact of Basel III

Cadwalader Clients & Friends Memo: Contingent Convertible Bonds and the Impact of Basel III

In January 2011, the Basel Committee on Banking Supervision (the "Basel Committee") set out rules to supplement Basel III regulations on capital adequacy and liquidity. The Basel III reforms aim to improve the quality and level of capital within firms (further details of the Basel III reforms are set out below).

In July 2011, following a consultation period, the Basel Committee announced that global systemically important financial institutions ("G-SIFIs") would not be permitted to use contingent convertible bonds ("CoCos") to meet additional capital requirements introduced in the Basel III reforms. A CoCo is a fixed income security that automatically converts into equity capital when a pre-arranged trigger is met.

However, the Basel Committee supports the use of contingent capital to meet national loss absorbency requirements that supplement Basel requirements. An example of these supplementary national requirements is a proposal by the Swiss Financial Market Supervisory Authority ("FINMA"), referred to as the "Swiss Finish". The Swiss Finish will require Swiss banks to meet total capital ratio requirements of 19 per cent. Of this proposed 19 per cent. total capital ratio, large Swiss banks may use CoCos to meet 9 per cent. of their total capital ratio. The remaining 10 per cent. must be held in the form of common equity, comfortably covering the "Basel" element of the capital requirement.

It is expected that a number of large European and Asian banks may issue CoCos to meet national capital requirements set above the Basel III minimums. However, issuances of CoCos in the United States are not expected due to unfavourable tax treatment. CoCos are viewed as equity rather than debt in the US, meaning that interest payments would not be tax deductible.

Contingent Convertible Debt

The term CoCo is a broad term used to describe debt securities that automatically convert into equity on the occurrence of specified events, hence their description as 'contingent' instruments. If the contingency event does not occur, conversion will not be triggered and debt instruments will be redeemed at maturity, just as conventional debt instruments are redeemed.

In general terms, the structure of these instruments is such that the occurrence of specific events, such as the equity capital ratio falling below 8 per cent, will trigger a mechanism activating conversion of the debt into equity at a predetermined rate. The price and ratio of shares resulting from the debt conversion is determined ex ante.

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