Bailouts, Capital, or CoCos: Can Contingent Convertible Bonds Help Banks Cope with Financial Stress?

Bailouts, Capital, or CoCos: Can Contingent Convertible Bonds Help Banks Cope with Financial Stress?

Since the 2008 financial crisis, banking regulators’ capital enhancement efforts have focused on permitting systemically important financial institutions to issue alternative forms of debt and quasi-debt instruments as a means of meeting their Basel III primary capital (Tier 1) and secondary capital (Tier 2) requirements. Among these alternatives are so-called contingent convertible capital securities (CoCos). Financial institutions are able to issue CoCos to investors as bonds with the stipulation that they will convert into equity if the institution fails to meet a given capital ratio.
This policy analysis evaluates two types of CoCos—“write-down” and “going-concern” CoCos—on the bases of the different metrics and mechanisms each uses to convert bonds into equity. It shows that so far, few (if any) of the CoCos that institutions have used to satisfy their countries’ capital requirements—many of which were issued prior to robust research on how to structure CoCos effectively—have met the standards necessary for them to achieve their intended purposes. Most of the CoCos issued to date have been write-down CoCos, which rely on backward-looking accounting measures to evaluate an institution’s creditworthiness and use risk-based capital standards to trigger a bond-equity conversion. Rarer are going-concern CoCos, whose market-based conversion triggers incentivize businesses and bank managers to take on increased leverage and more risk.
This policy analysis draws lessons from recent European experiences with both write-down and going-concern CoCos and concludes that, given their deficiencies, neither includes the design elements necessary to help financial institutions meet Basel III Tier 1 or Tier 2 capital standards. As a result, U.S. regulators should continue to approach CoCos with skepticism and caution. One alternative to CoCos they might consider is a modified version of the regulatory “off-ramp” provision of the 2017 Financial CHOICE Act, which holds the potential to increase bank capital while providing significant regulatory relief.

Robert A. Eisenbeis

Cato Institute

July 30, 2019

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