The impact of Basel III on convertible bonds – with particular emphasis on contingent convertible bonds.

Table of Contents

1. Introduction

2. Basel III

2.1 History

2.2 Implementation and objectives of Basel III

2.2.1 Common equity capital (Core Tier 1)

2.2.2 Additional core capital (Additional Tier 1)

2.2.3 Supplementary capital (Tier 2)

2.2.4 Additional capital buffer

2.2.5 Risk coverage

2.2.6 Leverage ratio

2.2.7 Liquidity requirements

2.3 Comparison of the capital definition of Basel II and Basel III

2.4 Critical consideration of Basel III

3. Hybrid capital

3.1 The market for hybrid capital

3.2 Silent partnership

3.3 Participatory notes

3.4 Subordinated liabilities

3.5 Trust preferred securities

3.6 Convertible- and warrant bonds

4. Contingent capital

4.1 Contingent convertible bonds

4.3 Critical assessment of the suitability as a component of core capital

4.4 The market for contingent convertible bonds

4.5 The features of contingent convertible bonds

4.5.1 The Trigger

4.5.2 Conversion Ratio

4.5.3 The Term

4.5.4 Factors impacting on pricing

4.5.5 Optimal design of contingent convertible bonds

4.5.5.1 From the perspective of regulators

4.5.5.2 From the perspective of shareholders

4.5.5.3 From the perspective of investors

5. Impact of Basel III

5.1 Impact on banks funding structure

5.2 Impact on banks hybrid capital

5.2.1 Impact on convertible bonds

5.2.2 Impact on contingent convertible bonds

5.3 Impact on Commerzbank AG

6. Conclusion

Objectives and Research Themes

This thesis examines the regulatory transformation introduced by Basel III, specifically focusing on how capital requirements impact hybrid capital instruments, with a primary emphasis on the emergence and suitability of Contingent Convertible Bonds (CoCos) as a core capital component.

• Evolution of regulatory capital definitions from Basel II to Basel III.
• Market dynamics and design variations of hybrid capital instruments.
• Functional analysis of CoCos as a mechanism for loss absorption.
• Empirical evaluation of the impact of Basel III on the capital structure of Commerzbank AG.

Excerpt from the Book

Summary of Chapters

1. Introduction: Discusses the motivation behind the Basel III framework following the 2007 financial crisis and introduces the research scope regarding hybrid capital and CoCos.

2. Basel III: Provides a comprehensive overview of the Basel III regulatory framework, including capital definitions, buffers, leverage ratios, and liquidity requirements.

3. Hybrid capital: Analyzes the market for various hybrid financial instruments such as silent partnerships, participatory notes, and traditional convertible bonds.

4. Contingent capital: Details the nature of CoCos, including their design features, triggers, market potential, and their suitability for meeting core capital requirements.

5. Impact of Basel III: Investigates the structural financial impact of the new regulations on banks, with a specific case study analyzing the capital structure of Commerzbank AG.

6. Conclusion: Summarizes the effectiveness of CoCos in improving loss absorbency and discusses the outlook for their integration into global banking regulatory frameworks.

Keywords

Basel III, Hybrid Capital, Contingent Convertible Bonds, CoCos, Regulatory Capital, Core Tier 1, Loss Absorbency, Financial Regulation, Banking Supervision, Commerzbank AG, Risk-Weighted Assets, Capital Buffer, Leverage Ratio, Liquidity Coverage Ratio, Net Stable Funding Ratio

Frequently Asked Questions

What is the primary focus of this thesis?

The work focuses on the regulatory changes brought by Basel III and their impact on the use of hybrid capital in the banking sector, specifically examining Contingent Convertible Bonds (CoCos).

What are the central themes of the research?

Central themes include the transition from Basel II to Basel III, the mechanics of hybrid capital instruments, the design of CoCos, and their role as effective loss-absorption tools.

What is the core research question?

The thesis aims to answer how CoCos differ from traditional convertible bonds and how these instruments contribute to fulfilling core capital requirements under the Basel III framework.

Which scientific methodology is employed?

The research primarily utilizes a theoretical analysis of regulatory frameworks and financial literature, complemented by a practical case study of Commerzbank AG.

What does the main part of the work cover?

The main part covers the historical context of Basel III, the market for hybrid capital, the detailed features and design options for CoCos, and an empirical analysis of Commerzbank's capital structure.

What defines the core capital category in Basel III?

Core capital, or Common Tier 1, is defined by its high quality and ability to bear losses from ongoing operations ("going concern" capital), including items such as common shares and retained earnings.

What differentiates a market-based trigger from a discretionary trigger?

A market-based trigger initiates conversion based on observable market indicators like share price or credit default swaps, whereas a discretionary trigger allows regulators to mandate conversion during financial distress.

Why did Commerzbank AG serve as a relevant case study?

Commerzbank AG was selected because it represents a major European bank that underwent significant capital structure changes, including government-backed support and subsequent transitions under the Basel III requirements.