Ever since contingent convertible debt emerged as a concept, people have argued about how to trigger them. Regulators asked for regulatory triggers, bankers asked for asset triggers, and nobody anywhere near the market asked for market value triggers.
Regulatory triggers won the day, giving power to the authorities to determine the point at which a bank is no longer viable. Risk-weighted asset triggers are still in most capital instruments, but the market expects regulators to step in long before the 5.125% trigger level which the bank capital community spent so long lobbying for.
Nonetheless, the proposals keep coming. The Economist outlined a new proposal by the name of “equity recourse note” last week, a debt instrument which starts paying coupons in shares when the institution's share price hits 25% of its starting level.
But before regulatory triggers won out, market value triggers enjoyed powerful backing, including from the Bank of England’s chief economist Andrew Haldane. Investors are better than regulators at determining the health of the institutions in which they invest, proponents said.
Besides the simple point that markets have demonstrated irrationality in numerable notable instances — take the 2010 flash crash — there are other, more salient, reasons why market value triggers are a bad idea.
The first reason: investors don’t have access to all the information they really need to make accurate judgments about the ability of most bank capital issuers’ ability to pay.
Additional tier one investors have already got used to optional coupons, a lack of information on distributable items, or the cash they have available to make dividend and AT1 coupon payments, among other things.
Equity investors do not have this information either, but regulators do. Adding a second layer of uncertainty on top of the existing uncertainty (bank capital holders would have to predict what equity markets might think about the same thin slices of information) does not help.
But, even with more transparent bank balance sheets, one bad day of trading could turn an entire market of capital bondholders into equity holders.
Market value triggers would also be more susceptible to (completely rational) investor manipulation, with the public equity price a giant target for capital structure arbitrage.
As a bank got close to its trigger, short selling would intensify in the shares, as investors bet on dilution once the price hit the trigger. Rather than being self-stabilising, a market value structure would make the ERNs more likely to trigger.
The CDS market (if it were possible to structure a CDS on the proposed notes) would also gyrate, since protection buyers would be trying to force conversion too, hoping that they would be paid out.
On the other side, bank management and existing holders would be trying to dodge the trigger. Stock buybacks, optimistic predictions or flashy hires might keep the shares away from the trigger, but could be a long way from good corporate governance. There are all sorts of more esoteric strategies for supporting share prices at troubled institutions.
In short, such an instrument would provide incentives on both sides to try to manipulate a bank’s share price, free of any fundamental valuation motives. The noble sentiment behind market value triggers (that markets know best) fails just when it starts to matter most.
Market value triggers aren’t a new idea, but they continue to be a bad one.