29 October 2018

VoxEU: Contagion in the European CoCos market

This column addresses this dispute empirically, using the dynamics of the CoCo market in 2016. The CoCo market at the time exhibited adverse dynamics that can’t be explained by banks’ fundamentals. Though some of this instability may have been transitory, the findings imply that the market should be monitored as it develops.

The Global Crisis highlighted a number of weaknesses in the banking sector. Excessive leverage, low liquidity buffers, and inadequate levels of capital were seen as the main sources of banks’ fragility. In response, policymakers approved the Basel III regulatory reforms to enhance banks’ resilience. On the capital side, regulation has been tightened by introducing higher requirements.

Under Basel III, banks can meet a fraction of their Tier 1 capital requirement with hybrid debt-capital instruments, such as contingent convertible bonds (CoCos). These instruments allow for the recapitalisation of the bank as a going concern. A CoCo is in fact a perpetual security that pays a non-cumulative coupon and whose principal is automatically written down or converted into equity when its issuer’s CET1 ratio falls below a certain trigger.

There is nevertheless a vivid debate on the convenience of allowing CoCos as capital instruments for regulatory purposes. CoCos’ supporters claim that their contingent debt-equity nature represents a plus – first, as debt instruments, they carry a lower issuing cost relative to common equity; second, as equity instruments, they provide a ‘pre-committed’ capital injection enabling the bank to strengthen its capital position precisely when raising equity would otherwise be difficult.

Sceptics of CoCos in contrast argue against this double nature which – although theoretically appealing – introduces into practice too much complexity, with potential destabilising consequences on financial markets in the case of conversion.

The motivation for allowing banks to also rely on CoCos to meet their regulatory capital requirements is that, while most of the time cheaper than common equity due to their debt features, they should, similarly to equity, provide loss-absorption capacity by enabling the ‘automatic recapitalisation’ of an institution when it is in distress.

Authors‘ results show that, during 2016, the possibility that the coupon payment on the CoCos issued by a single bank might be suspended led to very adverse dynamics in the entire market for CoCos that cannot be totally explained by banks’ fundamentals.

Although they find some evidence that part of the instability in the CoCo market could be transitory, authorities should keep on monitoring the development of this market and its behaviour under stress. The recapitalisation of the banks as a going concern provided by CoCos cannot be detrimental for the stability of the rest of the market.

Should the operational features of CoCos keep on proving destabilising in future stress situations, rethinking their role as bank regulatory capital tools would be necessary.

Full article

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