Many banks contributed through their high-risk business models to the financial crisis in 2007. The financial crisis has shown that for a bank's solvency it is not only the amount of equity that is important, but also significantly the quality of equity. In particular hybrid capital was not used to a sufficient extent to absorb losses, although it is partially core capital under Basel II. Because of this the Basel Committee on Banking Supervision decided in December 2010 on new capital- and liquidity rules for banks (''Basel III framework''). The Basel III framework implemented the regulatory requirements to strengthen the financial system. In particular the qualitative requirements were raised for core capital. Under these new regulations core capital is crucial, because it can fully and immediately be claimed for losses. The old forms of hybrid capital will be recognized in regulatory capital to a lesser extent in the future. This has implications especially for subordinated bonds. The aim is to involve subordinated creditors and equity investors in the recovery phase in the cost of crisis management. The new capital requirements mean major structural changes for the banks, because the comparatively cheap hybrid capital must be replaced by capital of higher quality.
A new form of hybrid capital have emerged, so called contingent convertible bonds(CoCos), a fixed-income security which is a capital buffer for a bank in financial distress and so could be attributed to regulatory equity capital. This hybrid capital is in the form of a mandatory convertible bond, which can contribute to making up for losses such as equity in the event of a crisis. In order to meet the new regulatory requirements, many banks are considering the advantages of CoCos.
Therefore this thesis attempts to answer the question of how CoCos differ from
convertible bonds, and how these instruments are suitable for contributing as core capital under Basel III. The place ability of CoCos and the challenges resulting from their use are discussed in this thesis. Based on the different design options for a coco bond, the most sensible will be determined and put into practice. So far it is a mainly theoretical issue with little empirical evidence, so the thesis will explain and evaluate the various theoretical aspects. Overall a comprehensive picture of the impacts resulting
from the new capital definition will be created.
Table of Contents
1. Introduction
2. Basel III
2.1 History
2.2 Implementation and objectives of Basel III
2.2.1 Common equity capital (Core Tier 1)
2.2.2 Additional core capital (Additional Tier 1)
2.2.3 Supplementary capital (Tier 2)
2.2.4 Additional capital buffer
2.2.5 Risk coverage
2.2.6 Leverage ratio
2.2.7 Liquidity requirements
2.3 Comparison of the capital definition of Basel II and Basel III
2.4 Critical consideration of Basel III
3. Hybrid capital
3.1 The market for hybrid capital
3.2 Silent partnership
3.3 Participatory notes
3.4 Subordinated liabilities
3.5 Trust preferred securities
3.6 Convertible- and warrant bonds
4. Contingent capital
4.1 Contingent convertible bonds
4.3 Critical assessment of the suitability as a component of core capital
4.4 The market for contingent convertible bonds
4.5 The features of contingent convertible bonds
4.5.1 The Trigger
4.5.2 Conversion Ratio
4.5.3 The Term
4.5.4 Factors impacting on pricing
4.5.5 Optimal design of contingent convertible bonds
4.5.5.1 From the perspective of regulators
4.5.5.2 From the perspective of shareholders
4.5.5.3 From the perspective of investors
5. Impact of Basel III
5.1 Impact on banks funding structure
5.2 Impact on banks hybrid capital
5.2.1 Impact on convertible bonds
5.2.2 Impact on contingent convertible bonds
5.3 Impact on Commerzbank AG
6. Conclusion
Objectives and Research Themes
This thesis examines the regulatory transformation introduced by Basel III, specifically focusing on how capital requirements impact hybrid capital instruments, with a primary emphasis on the emergence and suitability of Contingent Convertible Bonds (CoCos) as a core capital component.
- Evolution of regulatory capital definitions from Basel II to Basel III.
- Market dynamics and design variations of hybrid capital instruments.
- Functional analysis of CoCos as a mechanism for loss absorption.
- Empirical evaluation of the impact of Basel III on the capital structure of Commerzbank AG.
Excerpt from the Book
4.1 Contingent convertible bonds
In order to meet the capital requirements of Basel III, the capital instrument CoCos are an interesting instrument. In the late 1990s scientific papers were written which dealt with the instrument in a broader sense, but CoCos are only now attracting increased interest. They belong to hybrid bonds, which rank between debt and equity, since they combine characteristics from both. In essence, they are hybrid capital in the form of a mandatory convertible bond. The conversion is limited by predefined trigger, for example, the ratio of common equity to the risk-weighted assets or the arrangement of banking supervision. The investor in a coco bond has no private right of conversion in contrast to conventional convertible bond investors. For example, if the ratio of common equity falls below a defined value (trigger event) in the terms and conditions, an allocation of losses on debt will happen automatically. Through this intermediate position between debt- and equity capital the instrument represents a new form of hybrid capital. For the investor it is transparent that the bond will be converted, if the trigger event occurs. The conversion is done only once and for ever. The conversion takes place in the capital market and thus in the private sector. With the conversion the issuing company receives new equity immediately. At the same time it reduces its interest obligations. CoCos generate no new money at the time of conversion into the bank, but transfer a debt in new equity capital, which allows a better absorption of losses. In the event of a liquidity crisis they are of no help. The conversion of CoCos corresponds to an immediate improvement in the quality of capital.
Summary of Chapters
1. Introduction: Discusses the motivation behind the Basel III framework following the 2007 financial crisis and introduces the research scope regarding hybrid capital and CoCos.
2. Basel III: Provides a comprehensive overview of the Basel III regulatory framework, including capital definitions, buffers, leverage ratios, and liquidity requirements.
3. Hybrid capital: Analyzes the market for various hybrid financial instruments such as silent partnerships, participatory notes, and traditional convertible bonds.
4. Contingent capital: Details the nature of CoCos, including their design features, triggers, market potential, and their suitability for meeting core capital requirements.
5. Impact of Basel III: Investigates the structural financial impact of the new regulations on banks, with a specific case study analyzing the capital structure of Commerzbank AG.
6. Conclusion: Summarizes the effectiveness of CoCos in improving loss absorbency and discusses the outlook for their integration into global banking regulatory frameworks.
Keywords
Basel III, Hybrid Capital, Contingent Convertible Bonds, CoCos, Regulatory Capital, Core Tier 1, Loss Absorbency, Financial Regulation, Banking Supervision, Commerzbank AG, Risk-Weighted Assets, Capital Buffer, Leverage Ratio, Liquidity Coverage Ratio, Net Stable Funding Ratio
Frequently Asked Questions
What is the primary focus of this thesis?
The work focuses on the regulatory changes brought by Basel III and their impact on the use of hybrid capital in the banking sector, specifically examining Contingent Convertible Bonds (CoCos).
What are the central themes of the research?
Central themes include the transition from Basel II to Basel III, the mechanics of hybrid capital instruments, the design of CoCos, and their role as effective loss-absorption tools.
What is the core research question?
The thesis aims to answer how CoCos differ from traditional convertible bonds and how these instruments contribute to fulfilling core capital requirements under the Basel III framework.
Which scientific methodology is employed?
The research primarily utilizes a theoretical analysis of regulatory frameworks and financial literature, complemented by a practical case study of Commerzbank AG.
What does the main part of the work cover?
The main part covers the historical context of Basel III, the market for hybrid capital, the detailed features and design options for CoCos, and an empirical analysis of Commerzbank's capital structure.
What defines the core capital category in Basel III?
Core capital, or Common Tier 1, is defined by its high quality and ability to bear losses from ongoing operations ("going concern" capital), including items such as common shares and retained earnings.
What differentiates a market-based trigger from a discretionary trigger?
A market-based trigger initiates conversion based on observable market indicators like share price or credit default swaps, whereas a discretionary trigger allows regulators to mandate conversion during financial distress.
Why did Commerzbank AG serve as a relevant case study?
Commerzbank AG was selected because it represents a major European bank that underwent significant capital structure changes, including government-backed support and subsequent transitions under the Basel III requirements.
- Arbeit zitieren
- Timo Köffer (Autor:in), 2013, The impact of Basel III on convertible bonds – with particular emphasis on contingent convertible bonds., München, GRIN Verlag, https://www.hausarbeiten.de/document/263424
