“CoCo” bonds may exacerbate crises, finds study

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Economists at two leading German universities have warned that contingent convertible bonds, often issued to try and mitigate damage in a crisis, could actually make things worse.

Nicknamed CoCo bonds, these financial instruments require bondholders to convert their bonds into the bank’s equity during a crisis situation, allowing banks to include them in estimations of how much equity they hold. If banks fall below their core capital ratio levels, usually set at around 7%, the bonds are converted, forcing owners to convert their securities into bank shares.

This, say the researchers at Technische Universität München (TUM) and University of Bonn, can have the unwanted effect of incentivising banking heads to deliberately make their institution’s situation worse in order to freeze out bondholders and reap the benefits themselves.

These conclusions are in stark contrast to the accepted view of policymakers and regulators, which sees CoCo bonds as “shock absorbers” for averting financial crises. Rather, says the report, if badly constructed, these bonds could become highly detrimental, encouraging banks to push themselves further into a crisis in order to trigger the conditions needed for conversion and so claw back some of their debt.

What’s more, this clawback can be at the expense of investors, since the shares they receive are often worked out at rates highly unfavourable to bondholders. In some cases, they even have to forfeit their claim altogether. Professor Christoph Kaserer, Chair of Financial Management and Capital Markets at TUM, said: “We call these CoCo bonds ‘convert to steal'”.

However, this doesn’t have to be the case. If the bonds are guaranteed to be exchanged at market value, securing more shares for bondholders, banks are instead incentivised to prevent against the conversion.

At a single stroke, there would be a group of new shareholders with significant shareholdings. This would impel existing shareholders to do anything to prevent this happening – in other words, to prevent the core capital ratio not being met,” explains Tobias Berg, of the University of Bonn. “This construction – which we call ‘convert to surrender’ – would consequently have a stabilizing effect on the banking system.”

€ 50 billion of CoCo bonds have been issued so far, primarily in the UK, Spain and Switzerland. Kaserer urges financial regulators to take his findings into account when assessing future issues, particularly by making sure they do not contain a “convert to steal” mechanism.

CoCo bonds are a reasonable option for banks to improve their equity backing,” he said. “But they only help to stabilize the banking system if they are constructed correctly.”