BASEL SHOULD BEWARE SEEKING HOLY GRAIL FOR HYBRID DEBT / THE WALL STREET JOURNAL ( VERY HIGHLY RECOMMENDED READING )

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AUGUST 20, 2010, 4:15 P.M. ET.

Basel Should Beware Seeking Holy Grail for Hybrid Debt

By RICHARD BARLEY

Regulators and banks risk chasing a mirage: that they can fashion an instrument that acts like debt in good times and equity in bad.

The Basel Committee on Banking Supervision's latest proposals on hybrid capital aim to square the circle but show the problems inherent in the structure. In the crisis, Tier 1 and Tier 2 bonds, which are debt that counts toward regulatory capital for banks, failed to prop up balance sheets and bear losses at troubled banks. The result: As banks were bailed out, equity holders took some pain, but taxpayers in some cases subsidized holders of such bonds.

The Basel committee is rightly trying to avoid this happening again, by making hybrids bear losses before default, as equity does. The latest proposal is that such bonds include a mechanism that ensures they convert into stock or are written off before public cash is injected. The trigger would be a government decision to provide capital or a regulatory decision that a write-down is necessary to avoid a bank's failing.

Some of this makes sense, in particular the requirement for bondholders to suffer before public cash gets injected. That would mean taxpayers get maximum bang for their buck in intervening. But there are a number of problems. This kind of trigger event is harder to predict than traditional default risk. And with recent history showing that government intervention is significantly more likely than a bank default, hybrid securities under the new proposals would be much riskier. What is more, there is a risk of debt suffering losses before the equity is wiped out, contrary to the principle that debt ranks senior to equity. All that would make these securities much more expensive.

Governments and regulators could face headaches in deciding whether to trigger a conversion or not, including whether it would affect other banks, or cause political problems. And any conversion could set off a downward spiral in the bank's own stock as holders rush to sell, potentially causing further funding problems for the bank.

Those thorny issues will be difficult to work out. There simply mightn't be an acceptable substitute for equity that meets the needs of banks, investors and regulators. Banks would be loath to admit that, because raising more equity leads to lower returns, crimping share prices. But the crisis showed that blurring the lines between debt and equity can create the wrong incentives for investors and banks. In trying to find a solution, Basel may end up seeking a Holy Grail for bank capital that doesn't exist.

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