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Symposium 2009

Implementation - Contingent convertibles bonds (Coco)

The Challenge

Many observers blame excessive risk taking and inadequate regulation as the core causes of the current global financial crisis that we have been witnessing.

Many observers blame excessive risk taking and inadequate regulation as the core causes of the current global financial crisis that we have been witnessing.

Lloyds are doing it, Rabobank and Credit Suisse too: in the past few months, they have all issued contingent convertibles or CoCos for short. Also known as mandatory convertible bonds, CoCos are becoming a preferred instrument with which the central banks seek to improve the equity situation in the banking sector.

Particularly during the current Euro crisis, these bonds could be used for restructuring those banks that have failed the stress test or which might need support in the rescheduling of their debt.

CoCos must be converted into equity if an issuer's tier one capital falls below a preset limit. Switzerland is now discussing a threshold of between five and seven percent.

Contingent convertibles bonds A shock absorber for banks

In its Final Report on the Global Financial Crisis in October 2010, the Swiss Central Bank recommended that in future banks should have an equity quota of up to 19 percent of risk adjusted assets of which up to 9 percent should be composed of CoCos.

The 2009 Global Economic Symposium (GES) held in Plön in Schleswig Holstein had already proposed CoCos as a promising instrument with which to combat the weak equity situation of the banks. "Contingent capital can work like a shock absorber for the banks" was the considered opinion of the panel of experts which included Axel Weber, the then president of the German central bank.

The trick in the operation is the mandatory conversion of bonds into shares. In times before the banking crisis creditors used to buy bonds on the understanding that if the worst came to the worst the state would bail out the banks and the issuers of the bonds. And this is exactly what happened in the 2008 crisis triggered by the fall of Lehman Brothers.

But this can no longer be the case with CoCos. If the issuing bank gets into troubled waters, the bonds are automatically converted into shares in the bank – and the bond buyer becomes a shareholder. This means that he or she now must participate in the financial rescue of the bank or risk writing off his or her investment at zero value if the bank fails.

In November 2009 the Lloyds Banking Group changed a total of 12.3 billion US dollars into a CoCo. The new instrument soon set an alluring precedent and in 2010 RBS, Rabobank and Credit Suisse all offered mandatory convertible bonds.

Demand far outstrips supply

The new bond continued to prosper in 2011 as well. When the major Swiss bank Credit Suisse offered new mandatory convertible bonds at the end of February, the issue was eleven times oversubscribed. The bank issued a volume of 2 billion dollars but the market was ready to take up an issue of 22 billion. Analysts also noted the broad range of buyers for the CoCos – stretching from money market funds and major institutional investors to one or the other hedge funds – as a positive development.

"The easy way to rescue banks" was the heading of an article in the leading German FAZ newspaper. It said that this "new type of security, a hybrid of a share and a bond" could well solve "one of the major problems in rescuing banks – the problem of the moral hazard of misguided incentives" which arises when not all of those who caused a banking crisis in the first place are willing to pay for the bailout of floundering banks.

Bankers' bonuses in the form of CoCos now under consideration

Barclays Capital is now even considering converting part of its annual bonus payments to staff into mandatory convertible bonds. This would mean that Barclays bankers would give their own employer a kind of loan that would significantly raise the equity capital of the bank. In return the bankers would receive interest and could cash in their CoCos after a three year period – just as they could do earlier on with shares options. In the opinion of the Financial Regulation Forum "It's a great idea". It would serve the financial interests of bankers being squeezed by regulators and would thus also serve to somewhat reduce the danger of future crises.

In any event, Bob Diamond, CEO of Barclays Capital, is enthusiastic in his support of the new instrument.

And the president-designate of the European Central Bank, Mario Draghi, also came out strongly in favor of the CoCo bond at the last G20 summit in Seoul.

https://perswww.kuleuven.be/~u0009713/ContingentCapital.pdf

    Related Solutions

    Solution
    Symposium 2009

    Consider the creation of “solvency-convertible debt” for systemically relevant financial institutions, ensuring that if such institutions become insolvent, their debt would automatically be converted into equity, on predetermined terms.

    Consider the creation of “solvency-convertible debt” for systemically relevant financial institutions, ensuring that if such institutions become insolvent, their debt would automatically be conver ...

    Consider the creation of “solvency-convertible debt” for systemically relevant financial institutions, ensuring that if such institutions become insolvent, their debt would automatically be converted into equity, on predetermined terms.

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