Contingent capital has taken an intriguing twist with Rabobank’s announcement of a roadshow for a new loss absorbing instrument.
Rabo’s interest in contingent capital has been no secret, but the firm’s mutual status made the form it might take something of a mystery. In the UK, Yorkshire Building Society availed itself of profit participating deferred shares to construct a contingent capital instrument last December. The structure, however, mimicked that of Lloyds Banking Group’s groundbreaking contingent capital issue in November, with conversion to shares based on a regulatory capital trigger.
Rabobank’s proposed issue takes an entirely different approach, demonstrating the flexibility of the contingent capital concept, but also raising questions as to the motivation for the deal. Instead of converting to equity or equity-like instruments, Rabobank’s contingent notes face an automatic writedown and redemption of three quarters of their principal if its equity capital ratio falls below 7% (it currently stands at 12.5%).
Intriguingly, Rabobank is going ahead with the deal despite a lack of favourable regulatory treatment under existing rules — the notes will be classified as senior debt. The bank claims that the notes are being issued in anticipation of “tougher requirements for solvency”, and it is indeed conceivable that new rules will give them some benefit for the deal, but at the same time the notes clearly do not meet the proposed European rules for core capital. They are closer in form to hybrid capital, yet rank senior in a jump-to-default situation to hybrid capital.
Furthermore, the immediate cash redemption upon trigger breach, while improving the bank’s capital ratio, would presumably also increase liquidity pressure on the bank.
Rabobank insists that contingent issuance is still the right thing to do, as it will provide extra protection for senior bondholders and hedge against tail risk, without diluting the firm’s capital.
The deal may also provide some answers to questions that have dogged the contingent capital concept since its inception, namely who is the product for and where should it be priced. Unlike the previous issues from the UK, the notes are not being offered in an exchange, with the threat of coupon cut-off hanging over existing bondholders. Investors will also be comforted by the fixed redemption price, which will make valuation much simpler, and the relatively simple trigger formula which makes the bonds less subject to interference from the regulator.
If Rabobank finds a willing market for its structure, no doubt other banks will be looking closely at replicating it. Few, however, will be able to afford such expensive senior debt. Regulators can expect bankers to be knocking on their doors soon.