The economic consequences of the COVID-19 pandemic are just beginning. But with more than 26 million Americans filing for unemployment (to date) and much of the European economy in lockdown, it is clear that there will be a substantial negative impact on the financial system. One of the sources of capital to support the banking system are contingent convertible obligations and additional tier one debt. In both cases debt instruments that are intended to be capital backstops if banks face solvency challenges.
Jonathan Ford in the Financial Times a bit over one week ago raised concerns about the real value of these forms of (quasi-)equity. He noted that “European watchdogs have generally failed to resolve failing institutions, even in “good” times and with non-systemic cases.” He further notes that much of the bank balance sheet is based on historical accounting which undoubtedly is not keeping up with the speed of deterioration in the real economy.
His concerns regarding the strength of the capital of the banking system should be heeded. We are in an unprecedented economic deterioration and the impact on banks will be substantial. Clever structures used by banks to avoid the challenge of building strong capital positions will not prevent the reality to come through as banks lose money. Just as with an invisible virus, the underlying weakness of bank capital can be devastating.
