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CEBS Hybrid Instruments Guidelines: Citigroup's Comments Summary

Core Content

Citigroup Global Markets Limited (Citi) has provided detailed comments on the CEBS proposal for a common EU definition of Tier 1-qualifying Hybrid Instruments, including non-cumulative preference shares. The comments focus on the potential negative impacts of specific features proposed in the CEBS Report, such as principal write-down and equity conversion, and suggest that principles-based guidelines would be more effective in promoting convergence and a level-playing field across European jurisdictions.

Main Views and Key Points

1. Principal Write-Down

• Not Necessary or Helpful: Citi argues that a principal write-down requirement does not enhance loss absorption or recapitalisation.
• Regulatory Accounting vs. Economic Reality: While it may appear to improve capital quality under regulatory accounting, it does not change the actual capital quality. Under IFRS, write-downs are unlikely to be reflected on the balance sheet.
• Negative Impacts:
  • May reduce the issuer's ability to make investments and grow the business.
  • Could lead to tax, regulatory, and legal complications in several EU countries.
  • May not be legally feasible in some jurisdictions (e.g., corporate law complications in the UK).
  • May result in adverse consequences for certain corporate types within the same jurisdiction.

2. Equity Conversion

• Unfavorable for Depositors and Senior Creditors: Equity conversion does not improve their position as they already rank senior to Hybrid Instrument holders.
• Negative Impact on Hybrid Capital Market:
  • Would make Hybrid Instruments more equity-like, potentially reducing their marketability.
  • Could lead to arbitrary outcomes depending on the speed of capital deterioration.
  • May result in significant dilution and financial instability for the issuer.
  • Could be detrimental to the US institutional hybrid capital market due to RBC implications for insurance companies.

3. Alternative Coupon Satisfaction Mechanism (ACSM)

• Overly Prescriptive: Citi believes the proposed ACSM requirements are too rigid and may limit financial flexibility without enhancing loss absorption.
• Investor Concerns: Traditional Hybrid Instrument investors are typically fixed income investors and may not be willing to take equity in lieu of cash.
• Marketability and Flexibility: An ACSM is not necessary for tax purposes and may not be required to ensure loss absorption, as deferred payments can be managed without it.

4. Principles-Based Guidelines

• Preferred Approach: Citi suggests that principles-based guidelines would better facilitate convergence and a level-playing field, as they allow for flexibility in national regulatory, legal, and tax frameworks.
• Key Principles: Should focus on the permanence, payment flexibility, and subordination of Hybrid Instruments, as outlined in the Sydney Press Release.
• Avoid Overly Prescriptive Rules: Specific features may create an uneven playing field due to differences in legal and regulatory environments.

5. Convergence Between Banking and Insurance Sectors

• Importance of Harmonisation: Citi highlights the need for convergence between bank and insurance sector hybrid capital instruments.
• Solvency II Considerations: Some insurance issuers have already adopted "best practice" structures to align with future Solvency II requirements.
• Call for Inclusion: Insurance companies and their regulators should be involved in the finalisation of guidelines to ensure a fair and consistent treatment.

Key Information

• CEBS Report: "Draft proposal for a common EU definition of Tier 1 hybrids," dated 7 December 2007.
• Hybrid Instruments: Include innovative and non-innovative Tier 1-qualifying instruments and non-cumulative preference shares.
• Potential Jurisdictional Impacts: Belgium, Germany, Italy, Netherlands, Spain, and the UK all present unique challenges with respect to principal write-downs, equity conversions, and ACSMs.
• Market Implications: Equity conversion and ACSM could reduce investor confidence and negatively affect the hybrid capital market's structure and cost.

Conclusion

Citi supports the CEBS initiative to promote convergence and a level-playing field but cautions against overly specific features that may create inefficiencies or adverse consequences. Principles-based guidelines are recommended to allow for adaptability across jurisdictions while maintaining the essential characteristics of Tier 1 hybrid capital.