As the market frets about how Spain’s banking bail-out will be financed at the supranational level, it's easy to forget that the way the bank recapitalisations happen will be critical.
Earlier suggestions that the government might try to strengthen the banks without having the funds itself — through a promissory note or fiddling around with paper that could be repo'd at the central bank — are off the table.
That leaves direct equity injections, or some form of hybrid capital. Both have their merits.
An equity injection would go some way towards wiping out existing shareholders through dilution — and would give Spain’s Fund for the Orderly Restructuring of the Banking Sector, Frob, a say in how the institutions are run. That might encourage public acceptance of the whole recap business in Spain, where many are upset with the bail-outs, arguing that savings banks suffered from poor management that are undeserving of public rescue.
On the flipside, the market discipline angle of an equity injection would be slightly less appealing to a government that knows many of those haircuts would fall on investments made by mamá and papá voters.
That is one reason why a contingent capital security could be a better way of recapitalising. Another is that a Coco would be likely to have better sell-down prospects. If the securities were structured with yields approaching double digits, as some have suggested, the government might find willing private buyers of such securities in a few years’ time.
But perhaps the most appealing aspect of subscribing to contingent capital instruments in the banks is that they would provide a revenue stream to the state. Paying an annual coupon around the 10% mark makes the injections more painful for the banks, of course, but these things are not meant to be comfortable.
More to the point, as sovereign debt markets work themselves into a fluster over the additional debt burden, a bail-out that pays its way should be welcomed. And if the sovereign can clip the ticket on the way through — charging banks a spread over the cost of its own loan — then so much the better.