Hybrid Securities
Hybrid Securities Structuring, Pricing and Risk Assessment Kamil Liberadzki and Marcin Liberadzki Warsaw School of Economics, Poland
Kamil Liberadzki and Marcin Liberadzki 2016 Softcover reprint of the hardcover 1st edition 2016 978-1-137-58970-5 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6-10 Kirby Street, London EC1N 8TS. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2016 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan in the US is a division of St Martin s Press LLC, 175 Fifth Avenue, New York, NY 10010. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave and Macmillan are registered trademarks in the United States, the United Kingdom, Europe and other countries. ISBN 978-1-349-88780-4 ISBN 978-1-137-58971-2 (ebook) DOI 10.1007/978-1-137-58971-2 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Names: Liberadzki, Kamil, author. Liberadzki, Marcin, author. Title: Hybrid securities : structuring, pricing and risk assessment / Kamil Liberadzki, Marcin Liberadzki. Description: Houndmills, Basingstoke, Hampshire ; New York, NY : Palgrave Macmillan, 2015. Includes bibliographical references. Identifiers: LCCN 2015037078 Subjects: LCSH: Convertible securities. Classification: LCC HG4652.L53 2015 DDC 332.64/57 dc23 LC record available at http://lccn.loc.gov/2015037078
Contents List of Tables and Figures Preface Acknowledgments vi ix xii 1 The Definition of Hybrid Securities 1 2 Evolution of Hybrids 9 3 Legal Framework for Financial Hybrids in the Banking Industry 23 4 CRD IV Package Legal Framework 27 5 CRR Additional Tier 1 Financial Instruments 31 6 CRR Tier 2 Bonds 57 7 The Role of Hybrid Securities in the BRRD 63 8 Hybrid Securities Issued by Insurers 81 9 Corporate Hybrids 87 10 Issuing Hybrids 101 11 Public Offering and Admission to Trading 105 12 Regular and Timely Ongoing Disclosure 115 13 Financial Intermediation 121 14 Non-EEA CoCos 135 15 Bonds Credit Risk Modeling 143 16 Contingent Convertible Bonds Pricing 163 17 Structural Model for Corporate Hybrid Valuation 183 18 Hybrid Securities Impact on Risk 193 Notes 209 References 213 Index 219
List of Tables and Figures Tables 5.1 Characteristics of the first CoCos issued 42 5.2 Comparison of selected AT1 CoCos issues 51 6.1 Comparison of selected T2 CoCos issues 60 8.1 Main characteristics of the EUR 500 million subordinated 30NC10 hybrids issued by Vienna Insurance Group 84 9.1 Comparison of existing corporate hybrid securities 88 9.2 Comparison of existing corporate hybrid securities 89 9.3 SWOT analysis of hybrids 90 9.4 Shareholder structure (%) and treasury shares 92 9.5 Issue of PECS 94 15.1 The fixed-to-float SSE hybrid bond features 146 15.2 The Société Générale AT1 CoCo characteristics 147 15.3 Cash flow schedule of the Société Générale AT1 CoCo from February 17, 2015, until the first call date 148 15.4 Average default probabilities (PD), credit spreads, credit spreads due to default and credit risk premiums by credit rating category, 1994 2010 149 15.5 The rating scale 160 16.1 The Deutsche Bank AT1 EUR denominated CoCo bond characteristics on July 28, 2015 181 Figures 2.1 Theoretical value (prior to maturity) of a convertible bond (CB) and of a contingent convertible (CoCo) versus the price of the underlying share S * 21 vi
List of Tables and Figures vii 4.1 Issuance of subordinated debt by euro area banks (Q1 2009 Q3 2014, EUR billions) 28 8.1 Hybrid structuring under Solvency II 82 9.1 Transfers during no-call period: under PECS issue, under Shares Purchase Agreement and under Swap Agreement 97 14.1 The structure of CoCo issue as for the second quarter of 2013 by nationality of issuing bank (a) and by region as for August 2014 (b) 136 15.1 The SSE bond (see Table 15.1 for the characteristics) T-spread evolution in the period 4Q 2014 1Q 2015 147 15.2 Two Poisson process realizations with a fixed intensity parameter value 151 15.3 Credit Default Swap 154 15.4 Model relationship between asset swap spread, CDS spread and bond loan cost with respect to the (a) non-default case and (b) default case 159 15.5 Rating transition probability 160 16.1 The step function approximating Φ 165 16.2 Uncorrelated Wiener process (left-hand illustration) and a correlated one with the positive correlation coefficient (right-hand illustration) 168 16.3 Binomial process of stock price 170 16.4 The three-step trinomial model geometry 171 16.5 Asset value binomial process (top) and equity ratio binomial process (bottom) 173 16.6 Binomial tree for the CoCo bond value 174 2 18.1 Graph of E T as a function of E T 1 197 2 18.2 Bounds for VaR α ( X )( E = E K ( i i ) C) 199 * T0 2 1 18.3 Two value stripes used for contagion effect measuring 205
Preface Hybrid securities combine features of both debt and equity. Where exactly they are situated in the debt equity continuum is determined by their subordination, loss absorption, coupon deferral and perpetual nature. These equity-like characteristics allow them to be more loss absorbing and thus qualify as regulatory capital. This description reflects the character of hybrid financial instruments in the Basel II Capital Accord, but is not designed to meet the requirements of Additional Tier 1 (AT1) capital under the more recent, post-crisis, Basel III. The new generation of AT1 hybrids commonly referred to as contingent convertibles, or CoCos, embed a unique feature of contingent conversion into common equity or mandatory write-down of principal value. Contingent capital is the core of new capital accord and as such lies at the heart of this book. The problems of the market performance of CoCos and their ability to absorb loss are crucial when assessing the capital requirements of Basel III. These instruments are undergoing rapid evolution, driven by a market necessity to introduce equity-like instruments that will act as loss absorbers instead of common equity. If there were no problems with raising common equity, AT1 instruments would not play such a significant role in Basel III. The market for CoCos is growing, as a growing number of financial institutions are unable to raise the required amount of equity and have to raise their own funds by means of hybrid capital. If these problems continue, the role of hybrids may become more prominent, as they may be considered as a replacement of common equity for the purpose of the next tiers of Basel III: counter-cyclical buffers, SIFI surcharges and so on. Hence, their importance for the financial system is already established, and they have potential for further growth. Simultaneously, these relatively new instruments are just testing the market, and some problems with their pricing model remain unsolved. Deferral risk is expressed in the credit spread of AT1 instruments, but there are still no structural methods to price them precisely. This study proposes a model for doing so. Another important issue is contagion risk linked to AT1 hybrids. A hard lesson from the most recent financial crisis is that innovative financial instruments do not eliminate risk, but rather transfer it elsewhere. The complexity and interconnectedness of the credit derivatives market ix
x Preface has made this transfer a dangerous channel of transmitting price shocks to markets that had been considered to be diversified. It is of critical importance to assess the sensitivity of hybrid instruments to this. To date, no such assessment has yet been performed. The equity-like flexibility that hybrids offer makes them attractive also for non-financial issuers. From the rating perspective, corporate hybrids may be treated to a certain extent as equity, thus not negatively affecting leverage ratios, while, if properly structured, the interest they pay is tax-deductible. These factors, combined with investors appetite for high yields, are the main reasons behind their emergence. In this book we have set out to prove that AT1 CoCos may decrease the probability of default and lower the cost of senior debt. The capital buffer they provide is designed to absorb losses, so they should also decrease the credit risk associated with senior debt. This combination of equity-like features will serve the following purposes: (i) perpetuity of hybrid instruments ensures stable, long-term financing that is highly unlikely to be called by the issuer in times of financial stress, as such an action would require a regulator s consent; (ii) coupon deferral means that payments attached to a hybrid are obviously junior to payments on senior debt; (iii) financial stress will trigger conversion or write-down of hybrid bonds before it does any harm to holders of senior bonds, and finally (iv) on a gone concern basis, senior debt will be satisfied in the first place. Therefore, holders of senior debt will bear a lower risk than before the introduction of a hybrid into the issuers balance sheet. This fact should be mirrored by (i) an increase of the senior debt market price right after the issue of hybrids is announced to the public and (ii) a decrease in the senior debt credit spread. There is still a room for the modernization of AT1 hybrids, and for the proposal of some alternative hybrid instruments. One idea is to replace the regulatory capital trigger event of contingent conversion with a market-oriented trigger. This and other proposals are a consequent element of CoCos evolution that adopts various elements of preceding hybrids: Basel II hybrids, conventional convertibles, but also so-called catastrophic bonds developed by the insurance industry. When it comes to CoCos themselves, the convertibles into equity (issued by Lloyd s of London) were the actual pioneers and the principal write-down structure was developed later by Rabobank. In the meantime, while the Basel regulator was assessing the eligibility of CoCos for tier capital structure purposes, many different structures were proposed. This means that AT1 hybrid financial instruments are not artificial instruments designed entirely by the Basel regulator: the globally applied Basel III framework
Preface xi is used in financial engineering to structure AT1 hybrids for prudential capital requirements. This also means that observations of AT1 hybrids market performance may give rise to modernization proposals and functional merits will be crucial when assessing these instruments. Directly applicable Capital Requirements Regulation (CRR) has introduced CoCos, among other AT1 instruments, to legal systems of all EU member states. It must be remembered that CRR contingent conversion/ write-down provisions and bail-in provisions of the newly introduced Bank Recovery and Resolution Directive (BRRD) do overlap. That brings confusion about conversion mechanisms and points of non-viability. When compared to traditional company law, which is heavily shaped by EU Directives, CoCos bring an abrupt turn away from the principle of shareholders pre-emptive right to subscribe to new shares issued by a company. Until CRR and EU Second Capital Directive, this right was considered to be essential for the corporate structure as a tool to protect shareholders against dilution of their rights. Any provision of a company s statutes that would aim to exclude this right was forbidden. There should be little doubt that contingent conversion results in dilution of control. This fact raise essential questions: (i) on the relation between pre-emptive rights and issuance of CE CoCos, (ii) whether admission of CE CoCos to trading on an EEA regular market has the same consequences as admission of shares and conventional convertible bonds to such trading and, more generally, (iii) to what extent the corporate structure of financial institutions is unique when compared to a typical joint-stock company, as it is shaped by lex specialis. The complex nature of hybrid instruments calls for a high degree of investor protection. Low yields elsewhere encourage new investors to buy hybrids; it was the same with CDOs a decade ago. Then the question arises as to whether all investors are able to properly assess or manage the risks involved. First and foremost, these doubts regard retail clients. Uncertain loss-absorption hierarchy and complex conversion or coupon cancelation mechanisms may pose a risk beyond individuals assessment capabilities.
Acknowledgments During our studies on hybrid securities, we especially benefited from discussions and scientific cooperation with Prof. Piotr Jaworski. Our thanks are also due to Aimee Dibbens at Palgrave Macmillan for her enormous help. xii