To improve financial stability in the aftermath of the financial crisis, regulators have been enforcing stricter requirements on banks to prevent them from failing. Capital requirements have always been an important part of the regulatory process, since banks generally have high leverage and are often looking to hold as little capital as possible. A general argument when lobbying against higher capital requirements is that equity financing is too expensive compared to debt financing. An interesting discussion in itself; some would argue it is more accurate to say that debt is too cheap due to explicit (deposit insurance) and implicit (too big to fail) guarantees by the government. However, in this article, we will focus on something that is both debt and equity. Since the financial crisis, a new financial instrument is increasingly being used by banks to fulfil capital requirements: Contingent Convertibles (CoCos). While CoCos look promising on first sight, we will see that there is much we need to be cautious of in this instrument.
What are CoCos?
CoCos are a type of subordinated bonds that automatically turn into equity when the bank faces significant losses. If these losses are big enough and the bank runs out of equity, the bank fails on its debt. CoCos partly convert this debt into new equity, acting as an extra buffer for the bank’s capital. In good times, CoCos are debt on which an investor receives an interest rate. When the bank faces distress and its capital ratio (capital as a share of risk weighted assets) moves below a certain value, the CoCo is automatically triggered and converts into equity. The mechanism can be slightly more complex. For instance, CoCos can have multiple triggers, or the conversion could be up to the regulator’s discretion rather than occur at a pre-specified value. But the general concept of CoCos is quite simple and effective. It is part of a larger family of financial instruments that act in a similar way, such as write-down bonds (debt is removed below the trigger value) or bonds that contain elements of a write-down and a conversion into equity. In the design of CoCos, the details are in the trigger value, the conversion rate (how many shares are received for the bonds) and whether the process depends on book values or market values.
These details are very important when it comes to capital requirements. Without attempting to go into the various capital regulations too much, a short explanation could be helpful. The Basel capital requirements are split between three classes: Core Tier 1, Additional Tier 1 and Tier 2. This distinction is based on how reliable the capital is in terms of absorbing losses. Common stock, for instance, is readily available and counts as Core Tier 1 capital. Preferred shares are already more troublesome, these count as Additional Tier 1. The same reasoning applies to CoCos. Subordinated debt is usually counted as Tier 2, which means it is not available for meeting the capital requirements in the two previous classes. However, CoCos that are triggered early on (i.e. have a higher trigger value) are eligible under the Basel standards as Additional Tier 1, which means they are preferable from a capital requirements point of view compared to other subordinated debt (see Avdjiev, Kartasheva & Bogdanova, 2013). In the words of the BIS: the issuance of CoCos is primarily driven by the need to satisfy regulatory capital requirements.
For an investor, CoCos are a difficult instrument to price, like so many hybrid products. A comparison to the dreaded financial products that played such a crucial role in the emergence of the crisis is partly justified. Just like mortgage backed securities, the concept of CoCos is fairly simple. The problem is not so much that investors do not understand this product, the problem lies with how to determine its value. In general, its value should be between the value of equity and debt capital, since the price is subject to equity risk and interest rate risk. The exact pricing position is largely dependent on the expectations of the market on whether the trigger value will be reached before maturity. Rating agencies can play a role in this process, although we should then immediately return to the comparison with MBSs and the failure of rating agencies to assess those accurately. Also, many CoCos that are currently issued do not receive a rating. There is a crucial difference in pricing CoCos if we compare this product to ordinary convertible bonds. With CoCos, it is not the investor who decides whether the debt turns into equity, rather it is automatically decided for him by the trigger value. The debt will turn into equity when the bank is in distress, which would not be the investor’s first-best option. As a result, this product is riskier and requires a higher yield. CoCos are also different from bail-ins, where the debt holders make an agreement to convert debt into equity when the bank is in distress. These involve negotiations rather than an automatic process or a unilateral move.
Do we love CoCos?
You could say that CoCos are the best of both worlds. They act as debt when equity is not needed, providing a cheaper financing method than equity. When more equity is necessary, they are automatically triggered and provide an extra buffer. The bank is less likely to fail, which is good for financial stability, and investors gain a new product to finance the bank. For current equity-holders of the bank, CoCos are also beneficial. Since the mechanism reduces the likelihood of a bank failure, it also lowers the cost of debt and increases the bank’s ability to use the advantages of debt financing. The cost of capital (WACC) will decrease accordingly, increasing the value of the company. CoCos are also flexible in their design, allowing for various (combinations of) triggers and conversions. This makes them attractive to both banks and investors. To sum up, CoCos seem like the perfect addition to the regulatory framework, an opinion shared by the Basel committee.
However, as more recent (and early-stage) research indicates, there is enough reason to be skeptical of the increased use of CoCos. Although CoCos create a more stable bank ceteris paribus, the use of CoCos also implies a change in incentives for the bank. The reasoning is that the CoCos add to the bank’s equity in a bad state, meaning that the bank has less incentive to avoid that bad state. The described risk shifting can (should) be internalised into the pricing of CoCos, but that does not necessarily eliminate the increased risk taking (see Koziol & Lawrenz, 2012). If this issue is not adequately addressed when implementing CoCos into the regulatory framework, the increased use of this product may increase systemic risk in the sector instead of promoting financial stability. In particular, the regulator should focus on the conversion rate of the CoCos. The risk shifting argument implies that a high-risk strategy with the potential of conversion is preferable over a low-risk strategy in which conversion is less likely to take place. An unbalanced conversion rate can cause a transfer from debt holders to current equity holders, providing an incentive for equity holders to choose the high-risk strategy. Currently existing CoCos indeed carry the characteristics to create the incentive for risk shifting (see Berg & Kaserer, in press; Hilscher & Raviv, 2014). With the right design, CoCos can enhance financial stability and increase value for banks and investors alike. However, more insight into the correct design and implementation of CoCos is necessary. Financial innovation can be a great thing, but we have seen the consequences if new innovations are not properly understood, priced and regulated. That is a mistake we can avoid this time around.
Avdjiev, S., Kartasheva, A., & Bogdanova, B. (2013). CoCos: a primer. BIS Quarterly Review.
Berg, T., & Kaserer, C. (in press). Does contingent capital induce excessive risk-taking? Journal of Financial Intermediation.
Calomiris, C. W., & Herring, R. J. (2013). How to Design a Contingent Convertible Debt Requirement That Helps Solve Our Too‐Big‐to‐Fail Problem. Journal of Applied Corporate Finance, 25 (2), 39-62.
Hilscher, J., & Raviv, A. (2014). Bank stability and market discipline: The effect of contingent capital on risk taking and default probability. Journal of Corporate Finance, 29, 542-560.
Koziol, C., & Lawrenz, J. (2012). Contingent convertibles. Solving or seeding the next banking crisis? Journal of Banking & Finance, 36 (1), 90-104.
Zähres, M., Speyer, B., & Kaiser, S. (2011). Contingent Convertibles. EU-Monitor 79: Deutsche Bank Research.