As readers may know, at Awbury we are always interested in reading new financial research; so a recent article in The Economist, on the subject of Equity Recourse Notes (ERNs), piqued our curiosity.
Since the financial crisis, it has become received wisdom that banks need to have more capital, and that such capital should be primarily true equity, or instruments that provide loss absorption in the event of financial stress or insolvency. This has led not only to banks raising more equity capital, but also to the rise of the “CoCo”, or Contingent Convertible bond, as well as the concept of “bail-in-able” capital, as regulators attempt to create instruments and approaches that do not “promise” and then “fail to deliver” the intended loss absorption, as was all too common during the depths of the 2008/9 financial crisis.
Of course, CoCos have yet to be tested in combat; although the Republic of Austria is doing its best to show that the “bail-in” concept within the recently-implemented EU Bank Recovery and Resolution Directive (BRRD) does have “teeth” as it goes about liquidating the HETA structure that was created out of the Hypo-Alpe-Adria bank fiasco.
In the midst of continuing complexity and uncertainty, a suggestion has been made by 2 academic economists, Jeremy Bulow and Paul Klemperer, in a paper entitled “Equity Recourse Notes: Creating Counter-cyclical Bank Capital”, that consideration be given to an alternative form of what amounts to “bail-in-able” capital- the ERN.
In essence, ERNs are a form of debt, whose currently-due payments convert into equity if the issuing bank suffers a substantial decline in share price- i.e., below a trigger level set at the time of issuance and applicable on the date when any payment under the ERN is due. They are a form of contingent capital (an area in which Awbury has expertise), but not of the “all-or-nothing” form that CoCos take (whether by conversion to equity, or write-off of principal), except in bankruptcy when they are intended to convert fully into shares (with the number issued being equal to the face value of the ERN divided by the pre-set trigger price.)
It is axiomatic that an ERN converts based upon a market trigger; whereas CoCos approved for bank capital convert based upon regulatory triggers. CoCos address regulatory capital; ERNs address economic capital. CoCos are vulnerable (strange as it may seem) to forbearance by a regulator; whereas ERNs would convert automatically, but gradually. Regulatory behaviour can be a “wilderness of mirrors” because of concerns that forcing recapitalization can potentially exacerbate a potentially delicate situation. ERNs also remove the incentive for a bank to manipulate regulatory measures, as the conversion is independent of its regulatory capital position.
ERNs can also act as counter-cyclical buffers, as they create new capital in an environment when raising traditional capital may be impossible, or viewed as prohibitively expensive by a bank management “hoping for the best”.
Of course, as always, the “devil is in the detail”, but it is our view that having a further mechanism for providing banks with capital in times of stress, which is transparent and gradual in its impact, is something to be welcomed; and rational bank managements, as well as regulators, should give serious consideration to adding ERNs to their inventory of capital and risk management tools.
– The Awbury Team
Awbury Insights 