Doubts raised over viability of Lloyds CoCo bonds trigger

Bankers and regulators are looking at possible standards for contingent capital, but are struggling with the definition of an appropriate trigger.

When the UK's Lloyds Banking Group announced its capital-raising plans on November 3, 2009, including a £13.5 billion rights issue and £7.5 billion of enhanced capital notes (ECNs) or ‘CoCo bonds', it probably didn't realise quite how closely they would be scrutinised.

Five months later, bank analysts and regulators across the world are evaluating the structure and implications of the ECNs, as well as a similar issue by Rabobank in March, as if they had been issued only yesterday.

The reason is simple: the reforms of the Basel II framework could force banks to ramp up their capital ratios as early as 2012. The ECNs, a form of convertible capital, offer them an appealling model for holding that equity in the form of bonds, which are cheaper to hold but will convert into high-quality capital when needed.

Regulators understand the appeal; they are busy discussing how contingent capital could be slotted into the capital framework and whether it should be classified as minimum requirements or buffer capital. The Basel Committee on Banking Supervision has committed to discuss concrete proposals at its next meeting in July.

But the big stumbling block in designing a standard for contingent capital is the definition of the trigger - the point at which the debt converts into equity. Neither regulators nor bankers can reach consensus on a universal trigger point. They are struggling with questions such as whether it should be based on a regulatory number, such as a capital ratio, or discretionary numbers the bank itself can devise.

"The trigger is a challenging aspect of this product, particularly from a regulatory perspective. It might be this is not an instrument that lends itself to one universal trigger that is suitable for all institutions. It is difficult to define a trigger that ensures a level playing field across jurisdictions and gives banks confidence these instruments will be a source of capital when needed," says Peter Jurdjevic, head of the capital products team at Barclays Capital in London.

In the Lloyds case, the ECNs are currently classified as lower Tier II capital-qualifying bonds, and if the bank's core Tier I ratio drops below 5%, they will convert into core Tier I capital. But in light of Basel II reform proposals that will force all banks to significantly increase their capital bases, some analysts have questioned whether that trigger might be less likely to be breached under the new capital framework.

"Under the proposed new Basel framework, we think the chances of the 5% trigger being reached will be far more remote. Investors factor this into their investment decisions, as well as the fact the bonds can be called at par if they cease to fulfil their regulatory capital role," says a senior capital expert at a European bank.

Other bankers have also pointed out the possible dangers of using a regulatory ratio for the trigger that is only tested when the bank prepares and publishes its results. For Lloyds, which publishes its capital ratios only twice a year, that could mean a delay of several months between a point of stress for the bank and the actual conversion of the bonds.

A Lloyds spokesperson declined to comment on the chances of the trigger being breached, as the Basel II reforms are still open for consultation, but denied the possibility of any significant conversion delay following a stress on the bank. "The 5% core Tier I trigger is a mechanical and objective trigger that creates loss absorption at the time the bank needs it."