How does a higher valuation prevent a dilution of equity

Is equity more secure than debt? Upside down world of bank restructuring


"All theory is gray and life's golden tree is green" already knew Johann Wolfgang von Goethe to report in the first part of "Faust". Another fitting saying goes that in theory there is no difference between theory and practice, but in practice there is.

Aphorisms like these come to mind when looking at the current rescue of the British Co-operative Bank. Fundamental liability principles are invalidated. As a result, equity investors are better protected and bear less entrepreneurial risk than debt investors. The case vividly shows how iron principles are suddenly thrown overboard in times of crisis.




The Co-operative Bank (Co-op-Bank) is a not-for-profit cooperative bank. The Co-op-Bank got into trouble due to a bad investment in another financial institution and now has to increase its equity by around GBP 1.5 billion. A significant part of this increase is due to the Exchange of subordinated bonds(Junior bonds) in equity. One speaks here of a Debt to Equity Swap. Bondholders lose their fixed interest and repayment claims. In return, they receive new shares in a not-for-profit bank. The dividend yield will probably be significantly lower than the interest on borrowed capital. The current equity providers will hardly be affected by the restructuring (the possible dilution of their shares contrasts with the increase in equity).



The bankruptcy case - financial institution versus "normal" company

If a company goes bankrupt, the bankruptcy creditors are first satisfied from the bankruptcy estate. Only the assets remaining after the creditors have been satisfied will be distributed among the equity investors. The Equity provider so will subordinated treated and therefore bear a higher risk than the lenders. As a result, they generally have higher return expectations than lenders, from which the following principle follows: Equity for a company is more expensive than borrowed capital.

It is different with a financial institution. Before bankruptcy occurs here, the regulatory Core capital ratiosfallen below. Once this is the case, financial institutions will be forced by regulators to Countermeasures initiate. The bank now has two options: it must either increase equity or reduce debt. In the course of the financial crisis so far, the restructuring has often been carried out using taxpayers' money. Either the state participated directly in the institutes (equity increase), or a so-called Bad bank established that took over non-performing assets at book value. This prevented write-downs in the bank balance sheet. However, the willingness to provide more tax money for bank bailouts is declining across the EU. In the future, banks will therefore be forced to undertake the restructuring on their own. At the same time, however, financial institutions are often considered to be "systemically relevant", which is why bankruptcy should be avoided at all costs.

A voluntary increase in equity will be difficult for a bank that is in trouble. So there is only the possibility of (compulsory) reduction of outside capital. Falling below the core capital ratio “only” constitutes a violation of regulatory provisions. This does not entitle creditors to file for bankruptcy. The Redevelopment therefore takes place outside the framework of insolvency law. There is no legal requirement to involve equity providers in the restructuring. Instead, the renovation is often carried out entirely at the expense of the lenders. One should keep in mind that from the bank's point of view, small savers with their savings books and letters are also among the lenders. Possible debt restructuring are:

Many of these actions will be on a voluntary basis carried out. The lenders are given the choice of accepting the restructuring conditions or risking bankruptcy. While lenders must decide whether they are willing to accept a deterioration in their position, equity providers remain unmolested.

The higher the regulatory core capital ratio, the sooner institutions have to start restructuring. A high core capital ratio thus leads to better protection for equity providers, since the restructuring begins long before the actual insolvency case. The regulatory core capital ratio causes a Reversal of the liability hierarchy: In the case of restructuring, the lenders first have to accept losses. Only when the restructuring fails and bankruptcy actually occurs can the owners become involved.



Outlook and opportunities for discussion in the BC weblog

Reversing the liability hierarchy makes neither political nor economic sense. It is therefore necessary to find ways of how equity providers of a financial institution can be involved in the event of a restructuring. One possibility are forced capital increases with mandatory subscription for existing shareholders. But this would make bank stocks a risky investment with incalculable loss potential.

What is your opinion on this matter? Discuss with the author Christian Thurow in the BC weblog!


Christian Thurow, Dipl.-Betriebsw. (BA), Operational Risk Manager Corporate Finance, London (E-Mail: [email protected])



BC 8/2013