We have seen in the past how some universal banks accepted capital injection from outside investors in what would be described as unfavorable terms for main shareholders. In order to hedge this unfavorable scenario of capital injection, banks are considering the use of a hybrid security known as Contingent Convertible (CoCo) bonds.
CoCos are designed to help a bank meet its capital adequacy and funding requirements, while at the same time achieving favorable tax deductibility treatment. These bonds are typically structured either as contingent notes or as contingent convertible notes. Contingent notes feature a write-down of the principal amount of the notes upon the occurrence of a specific trigger event.
In some cases, the principal can be written down to zero and the note is effectively cancelled; in other cases, the principal write-down is temporary and can be written back up as the bank returns to fiscal health, as explained by law firm Latham & Watkins in 2012.
However, there is less public guidance from the regulators on write-ups and Standard & Poor’s predicts that the CoCo market could grow to USD 1 trillion in the next five to 10 years.
The Islamic finance industry has almost abandoned the development of hybrid securities, choosing the plain vanilla instruments. But with the introduction of Basel III, Islamic banks will be in a disadvantaged position compared with its conventional peers.
When I was trying to develop the concept of CoCo sukuk, I came out with three structures with different Islamic contracts. One noticeable issue that we had to address was the risk exposure that a sukukholder needs to have (versus plain vanilla sukuk structure where repurchase undertaking is available).
In other words, there is an on-going debate about the dilution of the original shareholders’ equity value upon conversion. This is when CoCo holders get a larger fraction of the total number of outstanding shares.
The second challenge we faced was the amount of acceptable Gharar (i.e. a risky or hazardous sale, where details concerning the sale item are unknown or uncertain). In our particular restructuring project, the trigger event has been pre-specified in two of the three proposed CoCo structures.
As a result, the amount of Gharar that affected the validity of the contract was not that high. It would be up to the Shariah scholars to decide whether there should be a pre-specified call option – by the bank – that is linked to the trigger event.
In typical CoCos, there is a price risk involved with equity conversion. Gharar does exist since the market price for the shares will only be known at maturity, but not before that.
To recap, the challenges faced when structuring a CoCo includes:
- How to avoid Gharar and achieve equal treatment of original shareholders?
- Sukuk: Identifying the type of sukuk contract?
- Assets: Identifying the underlying assets?
- Recognizing from where the cash flow will come?
At the moment, regulatory CoCos mandates under Basel III have not been introduced as it requires further deliberation. However, that has not stopped banks from issuing them as they already have indicative parameters on how to possibly treat them within the Tier 1 and 2 capital structures.
At a later stage and when CoCo sukuk become an actual practice, the Islamic Financial Services Board (IFSB) may consider issuing guidelines on when to classify Islamic contingent convertible capital as part of the bank’s capital.
To date, CoCos mandates have received official support from central bankers and regulators of financial markets and institutions in North America and Europe, particularly in Canada, Switzerland and the United Kingdom.
Mohammed Khnifer is an Islamic finance product structurer at Supranational Banking Institution and is certified by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) as a Shariah advisor and auditor.
Disclaimer: Any public opinion or media appearance is my independent personal opinion and should not be construed to represent any institution with whom I am affiliated.
Originally published on www.zawya.com