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Too-big-to-fail is the key term that epitomizes the global financial crisis (GFC) of 2007-2008. In the middle of the crisis, the financial regulators had to accept that bank bailouts are the only form of stabilizing intervention. Other options like putting the bank in resolution was considered too risky for financial stability. It is natural, therefore, that one of the priorities of the international financial regulation reforms after the GFC was to increase banks’ absorbing capacity. Among financial regulators, contingent convertible bonds (CoCos) became a popular tool that permits recapitalization of a distressed bank. The reduction in debt or the increase in equity resulting from CoCo conversions can serve dual roles of recapitalizing a going concern bank and reducing the resolution costs of the gone concern bank.
During the press conference on 19 March 2023, FINMA announced that, as part of the emergency package in response to the loss of trust and the run on Credit Suisse, the contingent convertible bonds that were part of the Credit Suisse Additional Tier I (AT1) regulatory capital, had been written off. The decision by FINMA prompted negative market participant reactions the following Monday 20 March, with the commonly stated view that conversion violated the priority order of claims. Indeed, shareholders of Credit Suisse retain a value of USD 3 Billion, while the CoCo bond principal writedown amounted to a USD 17 Billion loss for CoCo investors. Providing indirect support to the view that absolute priority should be help up, the European Central Bank (ECB) and the Bank of England on the same Monday both made public statements that they do not intend to follow the FINMA approach and that they intend to respect the usual priority order of claims in resolution. How can these divergent views of regulators be reconciled? Why did the Credit Suisse AT1 CoCo bondholders face losses before shareholders were wiped out? What are the lessons for the effectiveness of post-GFC too-big-to-fail reforms?
CoCos are designed to maintain the equity cushion of a going concern bank.
The structure of CoCos reflects their primary purpose to be a readily available source of bank capital amid a crisis (Avdjiev et al., 2013). CoCos are designed to maintain the equity cushion of a going concern bank. In this respect CoCos are distinct from capital instruments that are designed to absorb losses in resolution like total loss absorbing capacity (TLAC) instruments. TLAC are additional loss absorption requirements for global systemically important banks (GSIBs) like Credit Suisse to enable a single point of entry resolution. By contrast, CoCo conversion is designed to take place while the bank is still a going concern or at the point of the bank’s insolvency.
Accordingly, many CoCos have been issued with multiple triggers, combining a mechanical trigger defined numerically in terms of a specific capital ratio, as well as a discretionary trigger, which can be activated by supervisory authorities. When there are multiple triggers, the loss absorption mechanism can be activated when any of these triggers is breached. The activation of the discretionary trigger, which was present in all CoCos issued by Credit Suisse, is exactly what allowed FINMA to trigger conversion on 19 March.
The discretionary trigger requirement, also known as point of non-viability trigger (PONV), was also the key term in Basel III rules on contingent capital to satisfy minimum capital requirements. That is, all regulatory capital AT1 and Tier 2 (T2) CoCos must include a PONV trigger. Not surprisingly, banks included the PONV clauses in CoCos to satisfy the regulatory capital eligibility.
The conversion of CoCos by FINMA is a form of recapitalization of a troubled bank to ensure financial stability and facilitate the commercial solution of the merger with UBS. This should be distinguished from the resolution of an insolvent bank to which the European and the UK regulators refer to in their statements. The ability to improve the capitalization of a troubled bank was the main purpose of CoCo design, and it is exactly what the regulators did in the middle of a bank-run...
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