It is like the difference between cod roe and caviar. The bulk of state investments in banks has been in preferred stock, rather than in the purest form of capital, common shares. The difference may sound small but helps to explain why the first round of Western bank bail-outs in October has needed a follow-up.
Under the original 1988 Basel 1 rules governing bank capital, the bulk of banks’ tier-one capital had to be common equity. This can suffer losses without defaulting, need not receive a dividend and does not have to be repaid. But banks were also allowed to include some preferred stock, which sits somewhere between debt and equity. Such hybrid capital suffers losses only once the common equity has been wiped out and typically offers more secure dividends.
Over time the rules have been bent by banks and national regulators. The October bail-outs may mark the final stage of this lapse. The hybrid capital supplied by governments has usually been classified as tier-one, but often lacks the features intended for tier-one capital: that it is permanent, that dividends can be cut without defaulting, and that unpaid dividends do not accumulate. Alastair Ryan, an analyst at UBS, says the rules have become a “smorgasbord” and that “everyone is arbitraging” them.
Preference stock does have real benefits. It offers governments and taxpayers more security and it reassures counterparties, depositors and debt-holders who are higher up the capital structure and who get a bigger buffer between them and losses. But it is not a substitute for common equity. It makes shareholders more geared, raising share-price volatility. And it does not boost the long-term capacity of a bank to absorb losses without defaulting. As a result it does not increase such banks’ appetite to lend.
More equity is needed. Britain has now swapped its preference shares in Royal Bank of Scotland into pure equity, taking its stake to 70 percent. In most other cases such swaps would also imply public ownership. Were America to exchange its $45 billion of preference shares in Citigroup into common stock at current prices, it would own over 70 percent of the voting capital.
Is there an alternative for governments that are allergic to nationalisation? Germany has issued Commerzbank with hybrid capital that bears losses alongside common stock, but which gets a fixed coupon. Any losses must be recovered before common dividends are resumed. That does avoid nationalisation while creating high-quality capital. But whether taxpayers, who have high exposure to losses but limited scope for gains, are supportive of other such schemes remains to be seen.