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Understanding The Hybrid Capital as The Investment Option – Part 2

In the part one of the discussion of the hybrid capital I considered quasi-fixed-income instruments as the investment option, explained their speculative nature and left an open question about who is supposed to invest in the mezzanine capital. I rationalized that, due to the very specific nature of the mezzanine capital, investments in the appropriate financial instruments must be considered only by the dedicated entities and specialized investment companies. In this final part of the discussion I will close that issue and consider currently massaged topics of the international transactions tax and resolution fund.

As I explained in the part one, any instrument that belongs to the mezzanine capital is speculative, because everything, that has some features, options and triggers fired by some event, makes it possible to speculate for the event and even pull the trigger consciously or unconsciously. In my discussions about investments in financial institutions I rationalized the perception of banks as financial pipelines and utilities, which used to serve capital markets and real economy. Is it good, when someone speculates about the stability of your gas pipeline or energy utility? I do not think so, because such speculations may trigger a chain of irreversible and fatal events.

That is why the intrinsic speculative feature of the banking mezzanine capital must be mitigated. What that means is that we need to (a) minimize the number of features attached to the hybrid instrument or (b) restrict the circle of investors and limit their ability to speculate for events. The first approach brings us closer to the traditional convertibles and fixed income instruments, thus mitigating our flash of inspiration to create fiscal “mutants”. The latter approach limits the liquidity of instruments and reins in speculation profits. Due to the aforementioned considerations, I will continue with the option (b).

One of the dedicated investors is bank holding institutions. The other parts are the international transactions tax and resolution fund. The purpose of the resolution fund is to support the fiscal system during tough times and secure its stability against shock events. The purpose of the international transactions tax is to fill up the fund. By combining all of these parts we will create the completed resolution scheme, or whatever name you give it. But before proceeding further, we need to change the concept of the international transactions tax slightly and make it a kind of the insurance premium contributed by international banks on a voluntary basis. This allows us to avoid the implementation complexity, to reduce implementation costs and secure constant incoming cash flows as insurance premiums, leave alone the contribution frequency and size.

According to the purpose of the resolution fund, it can be used exactly to invest in the banking mezzanine capital and keep financial “mutants”. Doing this way, (a) the unnecessary speculation around hybrid instruments is mitigated; (b) contributions of international banks will be used to insure stability of the fiscal system and support its development; (c) it will be easier to pull the trigger, to engage the loss absorption mechanism, thus to secure regulatory simplicity and save nerves of regular investors; (d) banks will have incentive to prevent engagement of the loss absorption mechanism and act wisely, because such bailout will grant a stake in their equity to the fund; (e) they also will have incentive to buy back the fund’s stake, after the loss absorption mechanism has been engaged, and the fund will have all chances to profit by such investment exit (as current practices have shown); (f) the general system’s idea “to prosper and get bargains” and concept of making money from money are preserved, which is important. Ultimately, it seems like a win-win case.

The cost of hybrid capital can also be reduced by the fund, if necessary, thus reducing financing cost to the end banks’ consumers and clients. Also, since the fund is a kind of international purse, it can be used to finance other projects and initiatives, say climate change initiatives and alike. So, financial “mutants” can be used to serve good deeds. Who can pretend to the role of the resolution fund? Well, don’t make a puzzle of it. Depending on the appetite and scope, this can be the International Monetary Fund or its brand-new subsidiaries to serve regional markets. It even has the relevant name – just replace the middle word with “Resolution”.

Ultimately, the idea of mezzanine capital can serve well to regulators and bank holding companies. Regular investors, whose rationale of investments in banking capital is not as it is described in my discussion of investments in financial institutions, must be aware of all charms of the banking hybrid capital, though it seems like its nature and behavior are not completely revealed and explained by its inventors yet.