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
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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