This post briefly reflects on the contingent capital (CoCos) issued by Deutsche Bank (DB). It argues that there is some uncertainty around when the CoCos might be triggered. It also highlights contractual characteristics of the CoCos that mean that investors might not suffer a loss if the CoCos are triggered and perhaps even if there is a bailout of DB.
Summary of Deutsche Bank CoCos
DB has four outstanding CoCos. In this section, I summarise some of the characteristics of these instruments. These characteristics are important in determining the riskiness of the instruments.
Amount and Currency
Trigger Level in CET1 (%)
Table 1: This table summarises some of the data about the CoCos issued by DB. The data was obtained from Bloomberg and a review of the Prospectus documents used in the author’s DPhil thesis.
Broadly, there are two types of CoCos: convertible CoCos and write-down CoCos. Convertible CoCos are converted into shares when they are triggered. Write-down CoCos, on the other hand, are cancelled when they are triggered. On their face, write-down CoCos appear to be riskier than convertible CoCos because investors do not have an opportunity to receive shares when the CoCo is triggered. However, there are three write-down formats that have developed in Europe:
- Permanent write-down: the CoCo is cancelled once the common equity tier 1 (‘CET1’) (CET1 is, broadly, the amount of equity relative to risk weighted assets held by a bank) ratio falls below the trigger level;;
- Staged write-down: the coupons are cancelled in stages as the CET1 level deteriorates ie an investor might receive 75%, 50%, 25%, or 0% of their coupon entitlement as the CET1 level deteriorates; and
- Temporary write-down: the coupons of these instruments are cancelled when the CET1 level falls below the trigger level, but if the bank recovers then the coupons are reinstated.
DB issued temporary write-down CoCos. As at June 2014, about $32 bn CoCos issued in Europe were temporary write-down instruments. Societe Generale, Credit Agricole, UniCredit, Intesa Sanpaolo, KBC Groep, and Danske Bank have also issued temporary write-down CoCos. The DB CoCos include the following term related to the temporary nature of the write-downs:
“Following a Write-down of the redemption amount and the nominal amount of the respective Notes in accordance with the terms and conditions of the respective Notes described above, the Issuer will be entitled (but not obliged) to effect, in its sole discretion an increase of the redemption amount and the nominal amount of the respective Notes up to their initial nominal amount, subject, however, to certain limitations set out in the terms and conditions of the respective Notes.”
In order for CoCos to count as Additional Tier 1 capital under the Fourth Capital Requirements Directive (CRD IV) they need to have a minimum trigger level of 5.125%. There is some variation in the trigger levels used by banks. All of the DB CoCos have a trigger level set at the 5.125% level. However, there are a large number of CoCos with higher trigger levels. Amongst those banks that have issued temporary write-down CoCos, Intesa Sanpaolo, UniCredit, and Danske Bank have issued CoCos with higher trigger levels (either 6% or 7%). On the other hand, Societe Generale and Credit Agricole have issued CoCos with a 5.125% trigger level, which is the same as the DB CoCos.
In December 2008, Citibank, which was bailed out by the US government, had a reported core equity ratio of 11.8% at the same time that the holding company’s stock market capitalisation fell to around $20 bn or about 1% of its total accounting assets. This suggests that some of the flexibility allowed in calculating CET1 ratios might result in DB CoCos not being triggered, even as it faces a situation of distress and its stock market capitalisation falls significantly.
The Risks Associated With Deutsche Bank
Subject to the forbearance incentives of regulators and bank managers, and the temporary write-down format of DB’s CoCos, there are two risks that could lead to a trigger of DB’s CoCos: first, the $14 bn fine from the US Department of Justice (DoJ), and, second, changes in the underlying performance of DB.
If the DoJ can satisfy itself that DB is able to pay the fine without facing a liquidity or solvency crisis, then the original amount may stand. If, on the other hand, the DoJ considers that the payment of $14 bn would result in DB’s insolvency then it is unlikely to require the bank to require DB to pay the entirety of the fine. It is unlikely that the DoJ would require DB to pay a fine that would result in its failure and which would likely lead to contagion amongst US banks and retard US GDP growth. Given the market reaction to the news, it is more likely than not that the final fine will be less than $14 bn.
It has been suggested that counterparties are limiting their exposure to DB. If the underlying performance of Deutsche suffers because of concerns about its liquidity or its solvency then its CoCos might be triggered. If, on the other hand, the underlying performance of DB is only marginally affected by concerns about its liquidity or solvency then it is unlikely that DB’s CoCos will be triggered. The extent of concerns about DB’s liquidity and solvency will become evident when DB releases its latest financial results.
Uncertainty Related to CoCo Investors Risk
It is not clear whether the trigger of DB CoCos or indeed the bank being placed into resolution will result in a loss for its investors. This is due to complications about how the DB CoCos will be treated in insolvency in a number of ways:
- If the CoCos are triggered and the bank is not placed into resolution, coupons will become repayable if the bank recovers;
- Outside of resolution the CoCos will be triggered at a CET1 level of 5.125% and in resolution CET1 has to be completely cancelled before CoCo investors can bear a loss;
- If the CoCos are triggered, the bank is placed into resolution, and only CET1 capital needs to be bailed in then CoCo investors might benefit from their priority in resolution; and
- If the CoCos are triggered are triggered as part of a resolution and there is a subsequent bailout, the interpretation of Article 60(1)(b) of the Bank Recovery and Resolution Directive might result in a write-up of the CoCos.
The decision to place DB into resolution is politically complex. Entry into resolution is tantamount to admitting that the bank is insolvent and will damage the reputation of the regulator and the reputations of individual regulators. At the same time, prompt action might alleviate some of the reputational damage suffered by the regulator. Another way to put this is that the longer the regulator waits to place DB into resolution, the greater the reputational loss from forbearance.
Watch This Space
What happens with DB will be an important test for CoCos. It will assist in assessing their role in avoiding or minimising the probability of bank insolvency. It will also assist in determining the extent to which regulatory and managerial forbearance militates against the effectiveness of CoCos.
This test of CoCos is subject to what happens in the coming days, weeks, and months. Specifically, it is subject to:
1. The terms of any final settlement with the Department of Justice; and
2. What actions are taken by the bank’s managers and regulators around the next coupon date.
Ayowande McCunn is a DPhil student at the Oxford Faculty of Law conducting research in the broad area of financial regulation.