Last checked at 
* Instrument could be used to address US trading risks
* Bankers favour equity convertible structure
* BaFin blessing expected to follow final release of capitalrules
By Aimee Donnellan
LONDON, Jan 31 (IFR) - Deutsche Bank, which announced ahefty quarterly loss of USD3.5bn on Thursday, is consideringusing contingent capital (CoCo) bonds in order meet new U.S.capital rules set to be imposed on the largest foreign banks.
The bond will not be sold to external investors but insteadwill be a reclassification of existing intercompany debt,according to two market sources.
The U.S. Federal Reserve, which is way ahead of its Europeanregulatory counterparts in implementing Basel III capitalrequirements, moved to introduce new capital requirements onlarge foreign bank holding companies in December.
The intention is to mitigate risks to the financial system,and would force foreign banks to group all their subsidiariesunder a holding company that would be subject to the samecapital standards as U.S. holding companies.
The biggest banks will also need to hold liquidity buffers.
Germany's biggest lender, rated A2/A+/A+, is one of theEuropean banks on the Fed's list.
After taking charges to draw a line under a series ofscandals and to clean up its balance sheet without askingshareholders for cash, Deutsche must now address risks on the UStrading side of its business.
"This (CoCo) is certainly one of the options that is indiscussion, and it's one of the options that could be a solutionto some of the topics," Deutsche Bank's CFO Stefan Krause saidon an analyst call.
A NEW DIRECTION
Some European banks have already dipped their toes into thenascent CoCo market with roaring success, but the transactionsthat have come to the market so far have been more about testinginvestor appetite for different types of structures.
The issuers that have printed deals so far, most notablyBelgium's KBC and the UK's Barclays, have also had the backingof domestic regulators who have said they will count suchinstruments as capital.
Germany's bank regulator BaFin is yet to make a decision onhow it views CoCos, but bankers say that once there is moreclarity on how they fit into a bank's capital structure itsposition could change.
"CoCos make a lot of sense in the UK and Switzerland wherethe regulators have embraced the idea and I think BaFin would bemore receptive to CoCos if they could find a place for them intheir Pillar 2 requirements," said a banker.
Deutsche's core tier one capital ratio under Basel III rulesrose to 8% at the end of 2012, from less than 6% at the end of2011.
SOFTENING MARKET
Investors' hunt for yield has allowed European banks toutilise permanent write-down structures rather than the equityconvertible option seen on some earlier CoCos.
Deutsche has yet to disclose any details about the structureof the potential capital note. Given that the bond will not besold to third party investors, the recent widening in financialspreads, which could have made selling a permanent write-downsecurity more difficult, will not be a factor for the bank.
Over the past 10 days, senior spreads have widened by around1bp-2bp per day and bankers are expecting further softening asheadline risk begins to weigh on the market.
KBC's blowout USD1bn 10-year Reg S bond earlier this month,when markets were rallying, had a permanent write-downstructure.
The deal, which attracted USD8.5bn of orders from mainlyEuropean institutional accounts, was touted as the first realtest of investor demand for such instruments in 2013, and the strength of demand provided reassurance to European banks facedwith issuing billions of dollars worth of CoCos.
Prior to KBC, Barclays' CoCo from last November, a BBB-rated Tier 2 10-year bullet, attracted USD17bn of demand andonly paid a coupon of 7.625% despite its aggressive structure.
