Voodoo Finance

I know, I know here I go again with bank capital.

But what can I do, it´s one of the (perhaps the) most pressing themes in finance these days.

And we just had some pretty interesting news at the local level, with BBVA issuing a path-breaking hybrid bond that qualifies as regulatory capital (so-called “Additional Tier 1” capital to be precise).

The BBVA bond is part of the very notorious and very in vogue CoCo family (“here comes the CoCo!”). Without getting technical, CoCos are Contingent Convertibles, or debt that transforms into equity if certain trigger is reached.

The key with these new instruments (regular convertible bonds had existed for decades) is the trigger. It is based on regulatory capital ratios, that is on Risk Weighted Assets (recall my prior post). In the case of BBVA, if core equity capital goes below 7% of the bank´s RWA the CoCo will trigger (there could be a second trigger at 5% but that´s another story).

But, and here is the tricky part, RWA are calculated by the bank itself and from convoluted internal mathematical models. How is an investor to ascertain the probability of the trigger being reached and thus of his debt investment turning into an equity stake in an, apparently, suddenly undercapitalized bank? How can outsiders have a clue as to what a bank´s RWA will be like? RWA are simply undecipherable black boxes, infinitely manipulable by the bank.

I call this the “voodooization” of finance taken to the extreme. People buy complicated securities endowed with a lot of risk and may not hope to have a clue as to the drivers behind that security. When you buy Apple stock you are buying Apple stock, no mystery there. But when you buy securities where the underlying asset is voodoo, well that´s another thing completely.

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