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Summary of Dresdner Kleinwort's Comments on Consultation Paper No. 17

Dresdner Kleinwort ("DKIB") has provided detailed comments on the CEBS Consultation Paper No. 17, which outlines a draft proposal for a common EU definition of Tier 1 hybrid capital. The summary is structured to highlight the core content, main points, and key recommendations.

Core Content

The Consultation Paper No. 17 aims to establish a common standard for hybrid Tier 1 capital across the EU, ensuring a level-playing field for banks in different jurisdictions. DKIB acknowledges the importance of this initiative but raises several concerns regarding the proposed rules.

Main Points and Recommendations

1. Allowable Instruments

• Substance over form is a key principle, meaning the legal form of the instrument should not be the sole determinant of its classification.
• Currently, some EU regulators only allow legally-defined instruments (e.g., Silent Participations in Germany, directly-issued preference shares in the UK) to qualify as Tier 1 capital.
• This leads to inconsistencies, particularly in terms of tax deductibility.
• Recommendation: CEBS should require national authorities to accept subordinated debt instruments as Tier 1 capital if they meet EU-level criteria, eliminating local super-equivalence.

2. Limits

• The proposal requires the 15% limit for instruments with an incentive to redeem and the 70% equity requirement to be met at all times.
• This could create a double whammy effect during financial stress, as a decline in equity could invalidate hybrid Tier 1 capital.
• Recommendation: These limits should be adjusted to reflect the equity at the time of issuance, rather than at all times, to avoid unnecessary capital erosion.

3. SPV vs. Direct Issuance

• CEBS notes that credit enhancement should not increase the seniority of hybrid Tier 1 instruments.
• There is a distinction between solo and group/consolidated capital in EU regulations, with indirectly-issued hybrids qualifying as consolidated only.
• Recommendation: CEBS should consider harmonising the treatment of hybrid Tier 1 instruments regardless of issuance method.

4. Early Call Provisions

• CEBS proposes that early redemption is allowed in specific cases (e.g., changes in tax treatment or regulatory recognition).
• DKIB believes this is too restrictive and that banks should have flexibility to manage capital under various adverse circumstances.
• Recommendation: Early call provisions should be permitted subject to regulatory approval, not limited to the specified cases.

5. Perpetual vs. Dated Maturity

• The proposal requires hybrid Tier 1 instruments to be perpetual (undated).
• The UK has proposed allowing dated instruments with lock-in clauses.
• Recommendation: CEBS should consider alternatives, especially in light of possible harmonisation with US regulations, which allow dated Tier 1 capital.

6. Loss Absorption Mechanisms

• CEBS proposes write-down or permanent conversion of hybrid instruments when the Tier 1 ratio falls below 2%.
• Conversion could limit the investor base, as many fixed-income investors cannot hold equity.
• Write-down may also lead to loss of tax deductibility and no interest accrual, which could be problematic.
• Recommendation: Interest should survive into liquidation in a subordinated form, and write-up should not invalidate the seniority of hybrid over equity.

7. ACSM Applicability

• ACSM (Alternative Coupon Satisfaction Mechanisms) is proposed to apply only to optional interest deferral.
• This could undermine tax deductibility for directly-issued hybrids.
• Recommendation: ACSM should be available for mandatory deferral situations as well, to ensure tax efficiency.

8. ACSM – Shares to be Allotted by Hybrid Holders

• CEBS proposes that ACSM should only be subscribed to by hybrid investors.
• This is infeasible due to investment restrictions on fixed-income investors.
• Recommendation: Allow the issuer to market shares to new investors to maintain a broad investor base.

9. ACSM – Execution Timing

• ACSM must be executed immediately upon interest deferral, otherwise interest is cancelled.
• This is not practical, especially during financial distress.
• Recommendation: Allow a reasonable time period for execution to maintain flexibility.

10. Suspension of Dividend Pushers

• Dividend pushers should be waived upon supervisory events.
• However, this could lead to economic benefits being transferred to common equity holders, undermining hybrid seniority.
• Recommendation: Interest should be settled only via ACSM during such events.

11. European vs. Local Regulations

• CEBS proposals aim for consistency, but national supervisors may retain discretionary powers.
• This could dilute uniformity and reduce the benefit of European-wide regulations.
• Recommendation: CEBS should set benchmarks based on Basel II-defined minimum capitalisation to limit national discretion.

12. Coordination with the Basel Committee

• DKIB urges CEBS to coordinate with the Basel Committee to avoid a twin-track approach.
• A unified approach is essential for harmonisation across Europe and the US.

13. Conclusion

• DKIB welcomes the CEBS initiative but calls for caution in implementing specific rules.
• They suggest that guiding principles rather than detailed regulations would be more effective in achieving convergence while preserving flexibility.
• The goal should be to ensure hybrid Tier 1 instruments remain fixed income instruments that are cost-effective and tax-efficient for issuers and accessible for investors.

Key Takeaways

• Flexibility is crucial for banks to manage capital during stress.
• Tax efficiency and investor access should be preserved.
• Harmonisation with international standards (e.g., Basel) is necessary.
• Guiding principles over detailed rules are preferred to maintain consistency and adaptability across EU jurisdictions.