The Financial Conduct Authority (FCA) has announced that retail investors will be restricted from buying the bank bonds known as ‘Cocos’ – contingent capital issued by the banks as an additional buffer against losses.
The reasoning is that the banks have discretion about the rate of return they pay on Cocos which makes it difficult for mom-and-pop buyers to assess the risk and pay the appropriate price. In the FCA’s view only sophisticated investors can make that judgement. But where else do banks have discretion on the rate of return they pay on capital? And the comparison to bank shares doesn’t stop there.
The minimum investment amount for Cocos is £200,000. This is already the case. There aren’t many ‘unsophisticated’ investors with that amount of capital to stake. But what are affordable for retail investors are bank shares. With large chunks of RBS and Lloyds still owned by the government and the HSBC thinking about floating the Midland Bank, there’s going to be one or more retail offerings of a bank at some stage in the next two years. The sale of Royal Mail showed how high a price sellers of similar utility shares can achieve if they sell to retail.
Risk must always be balanced with reward. But the problem with restricting the purchase of Cocos is that, if Coco investors are at risk of losing money when banks fall on hard times, which is what the FCA is worried about, then under the same conditions investors in bank shares will fare much worse. The risk is much higher in bank shares than in Cocos. However, Cocos pay investors a yield of over 5%, whereas you’re lucky if your UK bank share pays you a dividend. So the reward in bank shares is much lower than in Cocos. In other words, the risk to reward calculation is totally against retail investors buying bank shares rather than against buying Cocos.
So what’s the regulatory incentive to restrict the sale of Cocos? Well, it’s the Mark Taber effect. A letter from “investors champion” Mark Taber in the FT seems to be enough to tip the FCA into action. Mr Taber purports to represent investors who bought Permanent Interest Bearing Shares (PIBS) 20 years ago from building societies – building societies that ended up after demutualisation inside banks that failed. Never mind that, over the course of that time, those retail investors were picking up a 12% coupon every year, when interest rates were around 5%, apparently they still were “mis-sold” those bonds, even though they got their money back by around 1997, ten years before any crash. None the less, Mr Taber is the kind of pain a regulator hates to have. The regulatory incentive is not to risk bad headlines.
Nevertheless the net result is that we are restricting retail investors from buying the subordinated product that has a risk-reward structure that is better than bank shares, and at the same time we are worried about competition in banking, which may be boosted for example by new entrants. Inconveniently though, they might need some capital to get started, capital that, in the FCA’s new view, retail investors shouldn’t be allowed to give them.