The issuance of contingent capital instruments by banks could rise in preparation for next year’s round of stress tests, says Fitch Ratings in a new report.
There is an increasing emphasis on stress testing and recovery planning in European bank supervision, the rating agency observes. Notably, the European Banking Authority announced that the next public EU-wide stress test would be in 2014, it says.
Fitch says that contingent capital instruments, which convert into equity if certain triggers are met, are particularly relevant in stress tests and recovery planning, “as their write-off or equity conversion, once a pre-determined trigger is breached, is designed to absorb losses on a ‘going concern’ basis before fundamental viability is threatened.”
Additionally, it says that, unlike most recovery options, contingent capital does not require a management decision as they are automatically triggered, “so they should be an effective recovery tool.”
Fitch also says that the amount of these instruments banks have could become significant. For example, in a very severe stress scenario, banks with enough of this type of capital may be able to return to viability without hitting senior creditors, it suggests, “meaning the amount of this junior capital could become a key risk differentiator between banks.”
“The usefulness of this loss-absorbing debt would also depend on where the debt sits in a group structure. Different stress scenarios could lead to a variation in the outcome and how a bank recovers or is resolved,” it adds.