Precautionary Recapitalization and Cocos

Question 1

What is Precautionary Recapitalization?

Answer 1

Allows member states to support (with public money) banks that EVEN THOUGH NOT INSOLVENT, need an increase of capital according to stress test result.
Only allowed to remedy serious disturbance in economy and to preserve financial stability. Does not trigger resolution of bank

Question 2

Requirements for Pre. Recap.

Answer 2

1) CI not failing or likely to fail
2) there is need to remedy serious disturbance of economy
3) used to preserve financial stability
4) doesnt confer advantage for CI
5( approved under state aid framework (burden sharing principle)
6) temporary nature
7) proporionate to remedy the serious disturbance
8) not be used to absorb incurred or likely future losses

Question 3

Critical issues

Answer 3

No legal definition of “serious disturbance” -> authority have flexibility -> difficukt to assess when exactly it is necessary

Question 4

Burden sharing principles

Answer 4

1) state aid should be minimum
2) burden sharing from SHs and subordinated creditors regardless of solvency of bank
3) need for bank restructuring plan
4) evidence that alternative measures have already been exploited to maximum extent
5) if recapitalisation is needed to preserve financial stability, these can be exceptionally authorised temporarily BEFORE restructuring plan is aproved

Question 5

Cocos: basics and purpose

Answer 5

Basics: convertible bonds that are converted to equity when a trigger event happens (e.g. issuer’s core capital ratio falls below threshold)

Purpose: used to satisfy banks capital adequacy and as remuneration mechanism. should absorb bank losses and helpp avoid need for taxpayer bailout

Question 6

Cocos: main features

Answer 6

After trigger event: bondholders either 1) lose all rights attaching to their investment via a write-off (sudden-death cocos) or 2) lose right to interest payments and instead receive equities

After trigger: additional liquidity for bank and decreased leverage

Question 7

Cocos triggers

Answer 7

1) capital-based triggers based on accounting measures of capital adequacy (Problem: maybe too slow response in a crisis)
2) regulatory discretion-based (problem: my lead to ad hoc decisions)
3) Market-based triggers, e.g. stock price decline or CDS premium increase (problem: susceptible to banking runs and market manipulation)