Rainy-day money

2 November 2009 By Nicholas Paisner

The UK bank plans to swap hybrid bonds for a security convertible into equity when times get tough. Meanwhile, RBS has got rainyday capital from the state. Regulators will be happy that contingent capital is now a reality. Investors will be wary, but may have to join in.

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Lloyds Banking Group announced plans to exchange £7.5bn of existing preference shares and capital securities for Enhanced Capital Notes (ECNs) on November 3. Holders of almost all of Lloyds' Tier 1 Capital Securities and Upper Tier 2 securities, with a combined nominal value of £16.5bn, will be able to participate.

ECNs are a new type of capital instrument that will automatically convert into ordinary shares if the group's core Tier 1 capital ratio falls below 5%. The conversion price is likely to be set close to the current share price.

The exchange will take place on a par for par basis. The ECNs will pay a coupon that is 1.5%–2.5% higher than the instrument tendered for exchange. The ECNs will qualify as Lower Tier 2 capital upon issue.

Lloyds expects that the European Commission will prohibit early redemptions and the payment of coupons in respect of hybrid capital securities during 2010 and 2011. Many hybrid capital instruments have perpetual maturities. Prior to the financial crisis, it was widely assumed that a bond would always be repaid at its earliest redemption date.

Under the terms of RBS's participation in the Asset Protection Scheme, the bank has received a commitment from the UK government to subscribe for up to £8bn of B shares at 50p per share in the event that RBS's core Tier 1 ratio falls below 5%. RBS will pay a fee of 4% for the contingent capital option. The bank does not expect that it will be required.

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