We’ve previously written about Contingent Convertible (CoCo) bonds as an alternative to traditional debt and a tool to increase financial stability. CoCos are instruments that, while essentially the same as bonds during good times, change once the issuing bank’s capital falls below a certain level.
CoCos come in all flavors. Some have “write-down” provisions that reduce the value of the debt, while others convert the debt to a certain amount of equity (called “going-concern” CoCos). Some have high triggers, while others have low ones. Among “going-concern” CoCos, some convert to a predetermined number of shares, while others convert to a fixed dollar amount. This is just a small sample of the ways these securities can vary.
This complexity is not a problem–the ability to set contracts with very specific parameters allows borrowers and lenders to set terms that best fit their needs. The real problem, as Robert Eisenbeis writes in a new Cato Institute policy analysis, comes when regulators come to rely on these complicated securities as a load-bearing feature of our macroprudential regime:
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).
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.
I won’t go through all of the details of the policy analysis (despite its short length, the density makes it a bit like drinking from a firehose), but here’s the punchline: European banking regulators have allowed CoCos to be included in banks’ regulatory capital requirements, but the history of three European Banks (Deutsche Bank, Banco Popular Español, and Monte dei Paschi di Siena), all of which had outstanding CoCos during times of distress, shows that the execution of CoCos during such periods was messy at best, and resolution during these smaller crises still required government intervention.
Eisenbeis instead recommends something similar to what John Cochrane of Stanford’s Hoover Institution recommends: a sliding scale of regulatory relief for banks based on their levels of equity financing. While the 2017 Financial CHOICE Act extended regulatory relief far too broadly (for banks with at least 10% equity financing), decreasing the regulatory burden as equity financing increases is a responsible way to do it.
Nobody ever seriously suggested that CoCos would be the be-all and end-all of financial regulation. But making complicated instruments that are difficult to implement (especially in a time of crisis) a key component of the macroprudential system is no substitute for clear, consistent rules.