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About this book

The book provides a comprehensive analysis from mathematical, legal and financial perspectives on the pricing of hybrids.

Table of Contents

Frontmatter

1. The Definition of Hybrid Securities

Abstract
Hybrid securities are fixed income instruments that combine elements of shares and corporate bonds. They are considered to be placed somewhere in between debt and equity, or ‘in the debt–equity continuum’ as credit rating agencies name it. The exact place of each individual hybrid in such a continuum is determined based on each of its characteristics: maturity, subordination and character of coupon deferral. These criteria are commonly used by credit rating agencies to grant an equity credit of a given security. High equity credit marks an instrument that possesses greater loss-absorption capacity, as is typical for equity instruments. Hybrids are qualified as subordinated debt, which means that – in case of liquidation or winding-up of the issuer – they are ranked below all other debt but above equity.
Kamil Liberadzki, Marcin Liberadzki

2. Evolution of Hybrids

Abstract
Preferred shares carry no voting rights. Instead, they offer regular income (on a fixed basis) and have priority over common equity in dividend payments. These characteristics are clearly mirrored by ‘preferreds’ in French law (actions à dividende prioritaire sans droit de vote) and German law (Vorzugaktien). Not all jurisdictions require all preferred shares to be stripped from voting rights, but this is the most common structure. Preferred shares in the United States are more similar to fixed income instruments, while preferred shares in continental Europe pay less attention to regularity of income. Such instruments are designed to give the investors extended share in annual company earnings (i.e. up to 150% of dividends on common stock).
Kamil Liberadzki, Marcin Liberadzki

3. Legal Framework for Financial Hybrids in the Banking Industry

Abstract
Prudent capital requirements are set out in the CRD IV package – the fourth Capital Requirements Directive and Capital Requirements Regulation. These requirements are based on internationally accepted principles of Basel III. They preserve the level playing feld inside the Single Market by achieving a Single Rule Book for all banks in the EU. Financial hybrids play an important role in the tier-based capital structure imposed by the CRD IV package, which will be examined in detail below.
Kamil Liberadzki, Marcin Liberadzki

4. CRD IV Package Legal Framework

Abstract
Under the CRD IV regulatory package, EU banks have to fulfill certain capital requirements, which are grouped inter alia as Tier 1 and Tier 2 financial instruments. Tier 1 instruments constitute the ‘going-concern capital’ of the financial institution, while Tier 2 instruments form the ‘gone-concern capital’. This means that Tier 1 instruments may absorb losses of the institution on an ongoing basis, while Tier 2 instruments absorb losses when a financial institution becomes insolvent or faces liquidation. The core of this system is an instrument known as the Common Equity Tier 1 (CET1). A CET1 must be composed of the highest quality of capital and possess maximum loss-absorption capacity. CET1 instruments are mainly common shares and retained earnings, while hybrid bonds may be assigned to either the category of Additional Tier 1 (AT1) or that of Tier 2 (T2), provided that certain criteria are met. These criteria also may be classified in a manner reflecting the aforementioned dimensions of the debt–equity continuum (Figure 4.1).
Kamil Liberadzki, Marcin Liberadzki

5. CRR Additional Tier 1 Financial Instruments

Abstract
Items categorized as AT1 instruments also serve the purpose of loss absorption on a going-concern basis. These items are capital instruments that meet conditions set out in CRR Article 52 and share premium accounts related to such instruments, as provided for in CRR Article 51. It is important to note that the goal of categorizing items in a Tier-based system is to the separation of those items: instruments qualified as AT1 items do not qualify to be designated as CET1 or T2 instruments.
Kamil Liberadzki, Marcin Liberadzki

6. CRR Tier 2 Bonds

Abstract
Items that qualify as T2 financial instruments provide loss absorption as ‘gone-concern capital’ when the issuer is facing bankruptcy. Then, holders of such instruments will carry the burden of financial losses to a greater extent than other senior creditors. That is why T2 items constitute a category of own funds. Simultaneously, these instruments pose less equity-like features in terms of maturity and deferral. It is worth noting that T2 capital may consist of a broader list of items than AT1: subordinated loans are also potentially T2-eligible, and – to some extent and in specified circumstances – general credit risk adjustments, gross of tax effects or positive amounts and gross of tax effects resulting from the calculation of expected loss amounts (Article 62 CRR).
Kamil Liberadzki, Marcin Liberadzki

7. The Role of Hybrid Securities in the BRRD

Abstract
The BRRD is a cornerstone of the single European bank resolution mechanism. Such a mechanism is urgently needed, as financial institutions conduct their business on a cross-border or even a pan-European basis, while legislation of member states differs significantly on insolvency issues. Financial markets are highly integrated beyond national borders, so the failure of a financial institution will also have cross-border consequences. Therefore, the lack of harmonization in the feld of bank resolution threatens the stability of financial markets – a condition that has been identified as essential for both the establishment and functioning of the internal market (BRRD Recital 4). The BRRD regime equips regulators or resolution authorities with tools, powers and measures that enable them to act both on going-concern and gone-concern bases. It is explicitly mentioned that governmental financial stabilization tools, including temporary public ownership, may be going-concern tools of last resort (BRRD Recital 8). It is also strongly emphasized that the use of tools and powers provided under the BRRD regime may affect the property rights of shareholders and jeopardize equal treatment of creditors. However, it must also be stressed that any difference in the treatment of creditors of the same class can be justified when such different treatment is carried out in the public interest, in a proportionate and non-discriminatory manner (BRRD Recital 13).
Kamil Liberadzki, Marcin Liberadzki

8. Hybrid Securities Issued by Insurers

Abstract
Under the Solvency II Directive,1 EU insurers are required to maintain a specific level of capital which is categorized into levels or ‘tiers’: so-called high quality capital (T1), good quality capital (T2) and finally Tier 3 (T3), which can be described as low quality capital. The concept of tiers is similar to the CRD IV/CRR. Both the CRD IV/CRR and Solvency II classify financial instruments into specified tiers based on the valuation of their pre-bankruptcy and post-bankruptcy loss-absorption features. Loss absorption on a going-concern basis is achieved primarily through dividend cancellation in the absence of profit and profit reserves. The same effect brings about non-cumulative coupon deferral in the case of hybrid securities. Another loss-absorbing feature is the conversion of hybrids into common equity or a partial, if not full, write-down of their principal value. In case of insolvency, senior bonds rank before subordinated bonds. Common equity, in turn, has the lowest recovery rate.
Kamil Liberadzki, Marcin Liberadzki

9. Corporate Hybrids

Abstract
While hybrids are an important part of the regulated capital of banks and insurers, corporations are free from regulatory constraints in deciding about their capital structures. Hybrid securities are attractive to corporations because they offer flexibility without diluting share capital - a cost-effective alternative to issuing equity since coupon payments are generally tax deductible and dividends are not. Unlike financial hybrids, corporate hybrids usually are not convertible into equity, so a company can issue them without risking dilution of equity stakes held by existing shareholders. Common features of European corporate hybrid issuances are:
  • Cumulative coupon deferral with a dividend pusher/stopper;1
  • Long tenors or no maturity date at all. There are moderate incentives to redeem;
  • Certain call options with call dates that typically take effect 5 or 10 years after the date of issuance. The securities are typically valued in the market on the assumption that an issuer will redeem them on the first call date;2
  • Subordination;
  • The absence of a conversion/principal write-down mechanism, which is a feature of financial hybrids.
Kamil Liberadzki, Marcin Liberadzki

10. Issuing Hybrids

Abstract
At the very beginning of CoCo issuance, all corporate consents will have to be granted. Without a doubt, it would be the management board’s role to point out the necessity of raising regulatory capital. The detailed course of action will vary depending on national laws on corporate governance. Generally, we may recognize three scenarios: (i) the management board may solely decide to launch the issue, (ii) the management board will have to gain the supervisory board’s approval, and (iii) the management board will have to gain shareholders’ approval, by means of a general meeting resolution. The first scenario is most likely to happen in case of UK/US companies, where management boards have a lot of discretion on conducting their companies’ business. In fact, these systems of corporate governance make no distinction between a management board and a supervisory board (two-tier board structure), incorporating a single (one-tier) board structure. In such a board, executive members are accountable for company management, while nonexecutive members are responsible for supervision (Mäntysaari, 2010). The second scenario is also very likely to happen in companies with a two-tier board structure, if the explicit consent of the supervisory board is required by provisions of national banking law or corporate law. In general, financial institutions in continental Europe will most probably have to gain shareholders’ approval.
Kamil Liberadzki, Marcin Liberadzki

11. Public Offering and Admission to Trading

Abstract
Obtaining information about the goods the one is about to acquire is necessary for each buyer to make a reasonable decision on the offer and its price. This applies also to all securities, including – of course – hybrids. Investors will require a written presentation on the terms of the security, the business and prospects of its issuer, and any risks attached to the security. In case of the latest generation of financial hybrid instruments being discussed, proper description of the risk attached to the security will be of key importance.
Kamil Liberadzki, Marcin Liberadzki

12. Regular and Timely Ongoing Disclosure

Abstract
The previous chapter demonstrated how the information provided under the Prospectus Directive is used to determine the risk connected with offered securities and, consequently, their price. Only if investors possess such information will they be able to make a decision on the purchase of securities. Once investors purchase a financial hybrid, the issuer raises regulatory capital. With that, the role of the primary market in the process of raising capital is done. Some investors may be willing to keep the debt securities on their accounts until the securities mature (or, in case of perpetual hybrids, until the first call date), collecting coupon payments and waiting for the principal to be repaid (called). However, it would be impossible to raise capital without granting investors the ability to sell their securities. The existence of the secondary market is necessary for the effective operation of the primary market. That is especially true when discussing the equity market, because debt securities are traditionally considered more of a buy and hold investment, so the debt market is less liquid than the equity market. In the case of financial hybrids, recent RBS surveys demonstrate that the liquidity of the instrument is also taken into account by investors. However, we need to note that CoCo investors pay relatively little attention to past volatility of liquidity. Instead, they tend to focus on (i) the fundamentals of the issuing financial institution, (ii) the distance from the trigger point and (iii) the risk of coupon deferral and type of conversion (RBS, May 2014).
Kamil Liberadzki, Marcin Liberadzki

13. Financial Intermediation

Abstract
Legislation on protection of investors against wrongful actions of financial intermediaries is considered to be one of the most important elements of EU securities law. Central to this protection are requirements and rules of conduct set out in Market in Financial Instruments Directive (MiFID). The main objectives of MiFID are to increase consumer protection, transparency and competition in financial services, to raise the effectiveness of regulatory cooperation and to establish a regulation based on principles of conduct (Skinner, 2007). In order to achieve these goals, MiFID brought ‘maximum harmonization’ to the markets, closing all the loopholes that were left open under the previous legal regime, which concentrated on rule of ‘minimum harmonization and mutual recognition’.
Kamil Liberadzki, Marcin Liberadzki

14. Non-EEA CoCos

Abstract
Financial hybrids issued by EEA financial institutions in order to meet Basel III capital requirements are the main subject of this study. These instruments, regulated in detail under CRR and BRRD, were discussed in previous chapters. However, we need to exceed the scope of our study and also focus on the financial hybrids, issued by ‘third’, that is, non-EEA, countries’ issuers for the same purposes of Basel III regulatory capital. The reason behind such study is that almost all CoCos (or ‘Tier 2 CoCos’1) will be listed on Euromarket, and we need to assume that these bonds will be listed on an EEA regulated market or a ‘stock regulated market’ (MTF or OTF).2 Therefore, institutional investors will be able to invest also in non-EEA financial hybrids. This is why at least a brief discussion of that matter is required.
Kamil Liberadzki, Marcin Liberadzki

15. Bonds Credit Risk Modeling

Abstract
In analyzing defaultable corporate bonds, one may generally classify their pricing models into structural and intensity models.
Kamil Liberadzki, Marcin Liberadzki

16. Contingent Convertible Bonds Pricing

Abstract
CoCo pricing models correspond generally with the taxonomy of the defaultable bond pricing models (see section 15.1). With respect to the division between structural (Penacchi, 2011) and intensity approaches (market implied models), the latter category includes credit derivatives and equity derivatives models (De Spiegeleer and Schoutens, 2012).
Kamil Liberadzki, Marcin Liberadzki

17. Structural Model for Corporate Hybrid Valuation

Abstract
The structural approach enables pricing subordinated tranches of debt and therefore will be applied in this chapter. The model presented here was specified by Jaworski, Liberadzki and Liberadzki (2015b).
Kamil Liberadzki, Marcin Liberadzki

18. Hybrid Securities’ Impact on Risk

Abstract
Financial hybrids were introduced by Basel II together with the tier-based structure of capital. This system has failed in the sense that it did not provide a sufficient level of loss-absorption capacity on a going- concern basis. One of the reasons for this was that hybrids did not embed contingent conversion. Post-crisis rules and regulations implemented enhanced levels of capital in general. Apart from quantitative effects, one may point to qualitative gains that have been achieved from the issuance of CoCos. The issuing of CoCos may improve solvability if these bonds are properly structured. We will present a model showing how a CoCo may improve total solvability of an individual issuer, also taking into account the relatively higher interest CoCos pay in comparison to senior debt notes.
Kamil Liberadzki, Marcin Liberadzki

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