New Research: Contingent Convertible Bonds As a Tool for Financial Stability

New Research: Contingent Convertible Bonds As a Tool for Financial Stability

One instrument that balances banks’ desire to borrow with the benefits of equity for financial stability is a contingent convertible (CoCo) bond. The particulars of these securities vary from bond to bond, but in general, once a “trigger” related to the solvency of a financial institution is met (e.g. a low capital ratio), the bonds are either written down (reducing the amount of principal owed) or converted to shares, where the debt is converted to a predetermined value of equity.

A new study finds that while CoCo bonds aren’t as effective as traditional equity financing, there’s a place for them in a stable financial system:

Following the 2008-9 financial crisis, large banks increasingly issued contingent convertible bonds (CoCo bonds) to increase their capital buffers – a policy supported by national bank regulators. This paper examines whether the issuance of CoCo bonds provides the same reduction in bank default risk as the corresponding issuance of common equity by analyzing the premium reduction in (single name) credit default swaps (CDS) around the corresponding issuance announcement events. We find that the default risk reduction associated with issuance crucially depends on the CoCo bond’s design features: Only CoCo bond designs with permanent write-down features provide a default risk reduction similar to equity. CoCo bonds with equity conversion features come with a lower subsequent volatility of the bank asset value, but are inferior to equity in terms of their default risk reduction.

There are two main advantages of CoCo bonds for banks. The first is that, due to the preferential tax treatment of debt, banks can deduct the interest payments on debt from their tax bill. Second, following the Basel III reforms, systemically important financial institutions were permitted to use CoCo bonds to meet their minimum regulatory capital requirement.

The benefit of CoCo bonds for the rest of us come with a change in banks’ incentives to take risks. If a risky investment leads to undercapitalization (and thus conversion to equity), this creates an incentive to reduce the riskiness of a bank’s portfolio. On the other hand, if the CoCo bond’s terms lead only to a write-down, this just reduces the total debt a bank owes.

The results of the paper confirm this, showing “a strong negative relationship between increases in CoCo capital with equity conversion features (EC) and subsequent levels of realized bank asset volatility.” CoCo bonds with write-down features do not induce this “risk-shifting.”

We shouldn’t go cuckoo for CoCo bonds if greater equity financing is the alternative, but they do represent a good “second-best” alternative for maintaining financial stability.

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By |2018-11-30T06:39:27-08:00November 27th, 2018|Blog, Financial Regulation|