CoCo Insurance and Bank Fragility

When a financial crisis hits, regulators are often forced to bailout failing financial institutions, especially large ones. The alternative of putting the failed banks through resolution and imposing losses on depositors and other bank creditors has been seen as too destabilizing in the middle of a crisis. It is not surprising, therefore, that regulators were eager to create new instruments that would facilitate automatic bail-ins, i.e., an automatic deleveraging of distressed institutions, following the 2007-2009 crisis.

Contingent convertible capital securities (CoCos), which represent debt obligations that can be written-off or converted into equity when a trigger is breached, rose to center stage as a potentially seamless bail-in device in future crises. The introduction of the Basel III framework, which allows banks to meet part of their regulatory capital requirements with qualified CoCo instruments, created strong incentives for banks to explore CoCo issuances. Between January 2009 and December 2015, banks around the world issued a total of $521 billion in CoCos, through 731 different issues.

Our paper is based on a comprehensive dataset of all CoCo issuances by banks around the globe during the sample period. We present the first analysis of this relatively new market, and thus we first provide an overview of its evolution through 2015. European issuers were early adopters and now accounted for 39% of the CoCo market at the end of our sample. Banks from emerging market economies have experienced more rapid growth in issuance in recent years and represented 46% of the market by the end of 2015. About 44% of CoCos have only a discretionary (to the regulators) trigger; the rest have a mechanical trigger in addition to the discretionary one. The majority of CoCos with a mechanical trigger have had capital trigger levels that do not exceed 5.125% of the bank’s risk-weighted assets, which is the minimum required for a CoCo classified as a liability to qualify as Additional Tier 1 (AT1) capital under Basel III. The two loss-absorption mechanisms, principal write-down and equity conversion, are comparably represented in the sample. However, the issuance of principal write-down has picked up over time due to growing demand from fixed income investors.

We next ask what drives bank CoCo issuance decisions. We show that larger banks and banks with relatively strong balance sheets were among the first wave of CoCo issuers. In contrast, banks with impaired balance sheets that were in greater need of recapitalization have been less likely to issue CoCos. Even though this result is surprising at first sight, it is consistent with the predictions of our theoretical model that issuance decisions are largely shareholder driven and therefore shareholders may pass on a CoCo issue if it does not enhance shareholder value. A CoCo issue by a bank with an impaired balance sheet mostly benefits the bank’s senior, unsecured debt holders. Consistent with this interpretation, we also find that the increased likelihood of banks with strong balance sheets to issue CoCos over those with weaker balance sheets is more pronounced for CoCos that absorb losses via a principal write-down rather than via a conversion into equity. Principal write-down CoCos are, in effect, junior to equity in distress states and, therefore, particularly attractive to shareholders.

We next analyze how CoCo issuance affects issuers’ balance sheets. We estimate the announcement effect of a CoCo issue on the issuer’s CDS spreads and equity prices and explore cross-sectional variations by issuer characteristics and CoCo contract features. The overall impact of a CoCo issue on the issuer’s CDS spread is negative and statistically significant, which is evidence that CoCos are fulfilling their intended role of strengthening the issuer’s balance sheet. When we separately examine CoCo issues by the loss absorption mechanism, we find that the impact on CDS spreads of issuing CoCos that convert into equity is much stronger than the impact of issuing principal write-down CoCos. This is consistent with the hypothesis that a CoCo that converts into equity disciplines risk-taking by shareholders because conversion may dilute existing equity holders’ claims. In contrast, risk-taking is rewarded at the conversion margin when CoCos absorb losses via a principal write-down.

We also examine CoCos by trigger type. We find that only CoCos that have a mechanical trigger (in addition to a discretionary trigger) have a significant negative impact on the issuer’s CDS spread. In other words, the market does not display as much confidence that CoCos with only discretionary triggers reduce bank credit risk. The most likely explanation for this market reaction is that such CoCos are pure “gone concern” instruments, with a lot of uncertainty surrounding the regulator’s conversion decision. CoCos that also have a mechanical trigger combine both “gone concern” and “going concern” features, and hence offer a more reliable source of contingent capital. As expected, the impact of high-trigger CoCos on CDS spreads is stronger than that of low-trigger CoCos.

When we examine at the announcement effects on bank equity prices, we find no significant impact of CoCo issuance on the issuer’s stock price over the full sample. This indeterminacy may reflect the opposing forces of ex post bail-in and ex ante risk taking, as well as the potential dilution from equity-conversion CoCos. Interestingly, however, the one type of CoCo whose main design features are most beneficial to shareholders, i.e., a principal write-down CoCo with a high trigger, does have a positive and statistically significant impact on the issuer’s equity price.

CoCos are no longer a small niche market. Although they are deemed to be complex by many commentators, possibly too complex for retail investors, there appears to be a sufficiently large institutional investor clientele that stands ready to hold them. The change in the mix of CoCo designs is primarily driven by a combination of experimentation, issuer incentives and investor demand. Now that the CoCo market is reaching maturity, our study offers the first evidence on which designs are desirable from a financial stability point of view, and where CoCo design can possibly be simplified with a view to standardizing this market.

The complete paper is available here.