The 2007/08 Global Financial Crisis (GFC) was a defining event for the world’s banking industry in the 21st Century. Governments in the US and the UK, fearing widespread systemic risks, decided on taxpayers' bail-out of failing financial institutions. Public outcry on the socialization of bank losses and the moral hazard associated with bail-outs led to regulatory changes in the US (Dodd-Frank Act 2010) and the European Union (Bank Recovery & Resolution Directive of 2015). These regulatory changes hope to provide a process for the orderly resolution of future banking crisis.
In January 2011, the Basel Committee on Banking Supervision set out regulation on capital adequacy and liquidity of banks to supplement Basel III. Under Basel III, banks are required to hold Minimum Total Capital of 8% of its risk-weighted assets at all times. In addition, Capital Conservation Buffer of a further 2% of Common Equity Tier 1 capital will be phased-in progressively between the start of 2016 to end of 2018.
The full implementation of Basel III will impose more stringent requirements on banks’ capital, leverage ratio and liquidity. Everything being equal, the measures are likely to put pressure on banks ROE (return on equity). Furthermore, the 30 global Systemically Important Financial Institutions (a bank, insurance company, or other financial institution whose failure might trigger a financial crisis) are required to have progressive Common Equity Tier 1 capital of between 1% and 2.5% for additional loss absorbency.
As equity capital is expensive to raise and are dilutive to existing shareholders, the Basel Committee is supportive of the use of contingent convertible securities ("Coco"). A Coco bond is a hybrid security which converts into equity or could be written-down or written-off on the occurrence of specified events. These bonds may also allow the banks to skip interest payments without defaulting. Cocos are most likely perpetuals with no maturity date although issuing banks may redeem them.
Bank bail-outs during the GFC further exacerbated governments' fiscal deficits and hence the emphasis now is for bail-ins rather than bail-outs of failing financial institutions. A Coco bond can therefore be seen as an automatic bail-in instrument.
In the run-up to full implementation of Basel III, banks are in a race to bolster their capital through traditional instruments as well as new securities such as the Cocos. Will such hybrid security work effectively, as they were designed to, in times of financial stress remains an open question. Other than regulatory changes, banks in Europe, Japan and a few other countries have now to confront a negative interest rate environment. Can banks absorb these costs without passing them on to depositors and for how long are the key questions facing many senior banking executives today. As such, how does that leave us – the 21st Century banking consumers?