Wednesday, 25 November 2009

Mezzanine CoCo Means Even Fatter Banking

Two recent funding initiatives not only fail to introduce openness and transparency in the credit markets, but also add complexity, shroud risk and perpetuate the enormous fees and bonuses inherent in the 'fat banking' model that many are complaining about.

Of course, I'm referring to the new form of 'contingent convertibles' or "CoCos" issued by Lloyds Banking Group and the 'mezzanine' product to be offered by the "Growth Capital Fund".

The £7bn worth of new "CoCos" issued by Lloyds Banking Group pay interest, but convert into equity if the bank's core tier one capital ratio falls below 5%. The tier one capital ratio is itself under a cloud, given its lack of predictive value in 2007 and recent analysis by Standard & Poors that "every single bank in Japan, the US, Germany, Spain, and Italy included in S&P's list of 45 global lenders fails the 8pc safety level under the agency's risk-adjusted capital (RAC) ratio." Furthermore, the ABI says it doesn't like these CoCos being included in bond indexes, because this would "effectively require some bond investors to buy these instruments and subsequently to become forced sellers if and when they convert into equity." It's worth noting that the UK government has had to invest £5.7bn (net of underwriting fees) just to avoid dilution of its 43% shareholding amidst the wopping £13.5bn in new shares. That underwriting fee must be enormous, no doubt made more so by the complexity of the new instrument.

CoCos are a type of convertible bond and are not really new. They started life as bonds that paid interest, but converted into equity if the issuer's share price hit a certain number. Apparently they were first issued by Tyco in 2000. They were popular because CoCos were not included in the diluted earnings per share calculation. However, their favourable treatment was removed and they more or less died out. Some also expressed concern about adequate disclosure of the risk that the contingency would occur, and the future impact of the conversion into equity... seems nothing has changed.

Meanwhile, Messrs Brown and Mandelson have also welcomed the recommendation for new "Growth Capital Fund" to allow medium sized businesses to publicly offer "mezzanine" debt - lending that is often unsecured, and ranks behind bank debt but ahead of equity on insolvency. Apparently, this product "would help address demand side aversion to pure equity, and provide a return above regular bank lending to reward investors". You can guess the reason for the premium to regular bank lending, and why it ranks behind banks. The Growth Capital Fund is designed to plug a "permanent gap" existed for up to "5,000 businesses" looking to raise between £2m and £10m in growth capital." It is noted that "neither banks nor equity investors were likely to fill this gap in the near future." They know that where you rank in an insolvency without security is largely academic, and there remains the very real issue as to how to effectively monitor the ongoing creditworthiness of a mid-tier company. Perhaps the proposed 'single fund manager' might find a solution. But I'll bet it will just sit there gathering money and sending statements to forlorn investors confirming the steady deduction of its fee as a percentage of gross funds under management. Already, Lloyds bankers say they are interested, no doubt hoping to recover some of their recent underwriting fees.

So it's clear that neither of these relatively complex instruments do anything to promote openness and transparency in the financial markets, but instead continue to funnel investment opportunities to intermediaries who can rely on their privileged regulatory position to charge enormous fees.

There are alternatives. At Zopa, for example, we helped figure out an invoice discounting process that is an easily understood, low margin alternative for SME trade finance, open to all - as is the Receivables Exchange. The challenge is marketing such low cost alternatives to busy SMEs amidst all the noise of the usual banking and investment marketing. Low margin financial services providers can't afford fancy advertising campaigns or to arrange open endorsement by Messrs Brown or Mandelson. Yet, to put an end to 'fat banking' and concentrated, poorly understood risk, we need to promote such open investment marketplaces, using instruments that are more easily understood and widely accessible.

Surely that's a challenge the government could help address, rather than lining bankers' pockets.
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