April 10, 2014 / 2:27 PM / 5 years ago

CORRECTED-UPDATE 1-Germany gives banks legal certainty on CoCos

(Corrects name of instrument to contingent convertible in par 2)

By Annika Breidthardt and Matthias Sobolewski

BERLIN, April 10 (Reuters) - Germany has given its banks long-awaited legal certainty on the tax treatment of “CoCo” bonds that can be converted into shares to bolster their capital, the finance ministry said on Thursday.

In a decision that clears the way for German lenders to issue the securities, the ministry said banks will be allowed to deduct interest payments on contingent convertible bonds from their taxes.

Also known as Additional Tier 1 (AT1) bonds, the securities are designed to act as reserve capital when a bank runs into trouble. They can be converted into shares, temporarily written down, have their coupon payments suspended, or get wiped out entirely if a bank’s capital falls below a set level.

“The finance ministry, together with the federal states, today created legal certainty on the treatment of instruments of banks’ additional core capital, so-called CoCo-bonds,” the ministry said in an email to Reuters.

“On the basis of existing tax law, banks in Germany can use these instruments with comparable conditions to their European competitors.”

CoCos have proven popular with banks and investors, who receive a high rate of interest to compensate for the risks involved in holding them.

German banking association BDB has described the long-awaited approval as an urgent matter for banks seeking to bolster their balance sheets, saying the delay threatened to put the country’s financial sector at a competitive disadvantage.

Banks in Britain, France, Switzerland, Denmark and Belgium have all issued AT1, after those countries laid the regulatory groundwork ahead of Germany. Bank BBVA was the first Spanish lender to issue AT1 capital last year after Madrid cleared the way.

In Germany, Deutsche Bank alone plans to issue at least 5 billion euros ($7 billion) of AT1 capital before the end of next year, paving the way for other banks.

German property lender Aareal Bank has said it will seek to repay the 300 million euros in state aid it received in the financial crisis by issuing AT1 instruments later in the year.

“CoCos are a type of reinsurance for banks and regulators in case of a catastrophe, such as if a trading loss in the billions causes the capital ratio to plunge overnight,” said Marcus Schulte, regional head of bank debt issuance at Credit Suisse.

“That’s not going to actually happen very often. Normally, a bank would already address its capital ratios starting at 7 percent and possibly raise new capital or introduce other measures.”

Investor demand for AT1 issues has been high, allowing banks to raise cheap capital to fortify their balance sheets and improve their leverage ratios. Banks have been especially keen to raise new capital ahead of a balance sheet check underway by the European Central Bank, which will supervise Europe’s big lenders from the end of this year.

“It’s going to get interesting when these conditions change. That will sort the wheat from the chaff.” Schulte said.

“Then for banks with weaker capital or credit profiles, it’s going to possibly get tougher, or at least more expensive, to issue CoCos.”

Under the bank safety framework known as Basel III, banks can raise 1.5 percentage points of their 6 percent Tier 1 capital ratio using AT1.

“CoCos are not a magic wand to solve all capital problems, rather, one instrument among many. We expect European banks to issue CoCos to optimise their capital structure,” said Marc Hellingrath, head of financials and fixed income fund manager at Union Investment.

Bankers and investors expect German banks to use the same structure as French, Danish and other banks, where if bank regulatory capital falls below a certain threshold, bondholders lose their investment. But investors still have the potential to recover those losses should the bank return to health.

According to recent research by JPMorgan, Deutsche Bank’s AT1 requirement is almost 13 billion euros while Commerzbank may need to raise almost 2.5 billion euros in AT1 capital. (Additional reporting by Thomas Atkins in Frankfurt; Writing by Annika Breidthardt; Editing by Catherine Evans)

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