Mahmoud Fatouh and Ioana Neamțu
Since 2009, contingent convertible (CoCo) bonds have change into a preferred instrument European banks use to partially meet their capital necessities. CoCo bonds have a loss-absorption mechanism (LAM). When LAM is triggered, the bonds convert to fairness capital or have their principal written down, offering extra loss-absorbing capability whereas a financial institution continues to be a going concern. The prevailing literature argues these bonds may improve risk-taking if shareholders acquire on the expense of CoCo holders when the set off is hit. In our two papers, we assess this argument theoretically and empirically. We present that the risk-taking implications of CoCo bonds depend on the path and the dimensions of the wealth switch between shareholders and CoCo holders when LAM is triggered.
The failure of subordinated debt devices in recapitalising failing, however solvent monetary establishments within the 2007–08 international monetary disaster prompted curiosity in CoCo bonds (first instructed by Flannery (2005)).
Because the determine under reveals, along with fundamental properties of any bond (price, maturity and many others), CoCo bonds have two design options:
- The loss-absorption mechanism, below which the bonds would convert to fairness or have their principal written-down.
- The triggering occasion (set off), which might be discretionary or mechanical (book-based or market-based).
Banks topic to Capital Necessities Regulation (CRR) or laws based mostly on the CRR might use CoCo bonds to satisfy as much as 25% of minimal Tier 1 capital necessities. Jurisdictions topic to CRR embody the EU and Norway and the UK has its personal model of the CRR. CoCo bonds are referred to in prudential regulation as extra Tier 1 (AT1) capital. To rely as financial institution regulatory capital, CoCo bonds have to have book-based triggers (based mostly on a Frequent Fairness Tier 1 (CET1) capital ratio). The usage of book-based triggers has typically been criticised by lecturers. It’s because accounting variables might not all the time replicate financial modifications and seize dangers in a well timed method. Moreover, CoCo bond issuers might have the flexibility to window-dress accounting ratios to keep away from conversion. Many of the literature advocates for market-based triggers (eg Bolton and Samama (2014), Berg and Kaserer (2015)). Authors argue that such triggers may also help keep away from issues related to using accounting values (slowness in reflecting financial developments, and issuers’ incentives to window-dress to keep away from conversion). Nonetheless, market-based triggers additionally face criticisms, together with: i) potential manipulation by speculators to power conversion, in what is named loss of life spirals (Pennacchi et al (2014)); and ii) potential multiplicity or absence of equilibrium costs (Sundaresan and Wang (2015)), which may make the share value an unreliable conversion set off.
The danger-taking incentives and CoCo bonds
The issuance of debt devices might incentivise the issuer to take larger ranges of danger. It’s because when danger will increase, a wealth switch from debt holders to present shareholders happens; present shareholders benefit from the acquire if the danger pays-off, whereas everybody, together with debt holders, lose if issues go fallacious (as a consequence of restricted legal responsibility). As well as, CoCo holders face one other potential wealth switch. When the set off is hit, CoCo holders have their bonds exchanged for fairness shares or face a (momentary or everlasting) write-down within the principal of their bonds. Relying on the design and covenants of the CoCo contract, this might trigger wealth to switch from CoCo holders to the present shareholders or vice versa.
The determine under illustrates how the triggering mechanism of a CoCo bond works. A stress which prompts CoCo conversion can have totally different implications relying on whether or not the CoCo bonds are principal write-down or conversion to fairness. In two out of three circumstances (highlighted in inexperienced) the fairness holders acquire, and in a single they lose (highlighted in crimson).
In our theoretical paper, we use a easy arrange much like that of Holmström and Tirole (1998) to look at the affect of CoCo bond issuance on the risk-taking incentives of the issuer, and examine the important thing elements influencing this affect. Our evaluation reveals that whether or not CoCo bond issuance results in larger risk-taking is determined by the path of the wealth switch when the set off is hit. That’s, risk-taking will increase if triggering the loss-absorption mechanism of a CoCo bond is related to a wealth switch from CoCo holders to shareholders. It’s because present shareholders obtain the beneficial properties if the danger pays-off, however share the losses with CoCo holders, even earlier than all fairness capital is wiped-out. Conversely, a wealth switch in the wrong way (from shareholders to CoCo holders) reduces risk-taking incentives. Based mostly on that, CoCo bonds may very well be a great tool to cut back the riskiness of the financial institution actions. Exterior traders can use them to manage risk-taking incentives of the issuing financial institution. This, nevertheless, requires cautious design of the CoCo contracts, particularly by way of conversion price and the implied reputational prices.
Do CoCo bonds improve risk-taking empirically?
In our empirical paper, we take a look at the implications of the implied wealth switch from CoCo holders to present shareholders for risk-taking incentives, and the potential interactions with macroeconomic uncertainty and competitors within the banking system. There’s a potential pattern choice bias, which can deter the validity of our conclusions. That’s, if banks elect to difficulty CoCo bonds desiring to take extra danger, the rise in danger is because of ex-post riskier behaviour, relatively than CoCo bond issuance. We discuss with this as regulatory arbitrage, and use a number of econometric methods to check for it.
We then study whether or not CoCo bonds have elevated or decreased risk-taking in observe by analysing the affect of CoCo bonds issuance in the UK between 2013 and 2018. Particularly, we estimate whether or not CoCo bond issuance is related to larger ranges of danger and whether or not this affiliation is stronger for CoCo bonds which are extra non-dilutive. In our setup, non-dilutive CoCo bonds are these with LAMs that indicate wealth transfers from CoCo holders to shareholders. In the meantime, LAMs of dilutive CoCo bonds indicate wealth transfers in the wrong way, because the determine under demonstrates.
We calculate the anticipated wealth switch from CoCo holders to shareholder per fairness share within the following method:
Anticipated wealth switch per fairness share
= Prob(set off occasion occuring) x (worth fairness sharebefore_trigger
– worth fairness shareafter set off)
The likelihood of the set off occasion occurring is the likelihood that financial institution’s CET1 to risk-weighted asset ratio falls to 7%. Based mostly on this methodology, we discover that every one 46 CoCo bonds issued within the UK are non-dilutive, implying a possible wealth switch from CoCo bond holders to shareholders when the set off is hit.
Empirical evaluation and outcomes
We discover no clear proof of regulatory arbitrage by CoCo bond issuers. All however one take a look at for choice bias attain the identical conclusion: regardless of potential ex-post incentives, banks with a better danger urge for food should not extra prone to difficulty CoCo bonds.
Our evaluation reveals that CoCo bond issuance has a statistically vital constructive correlation with asset danger (asset beta) of the issuing banks. Not surprisingly, the energy of this correlation will increase with the dimensions of the anticipated wealth switch from CoCo holders to the present shareholders. So the extra shareholders acquire from conversion or write-down of CoCo bonds, the upper the danger the financial institution takes.
We carry out the same evaluation on market danger (fairness beta), default danger (credit score default swaps spreads), and accounting-based danger (z-score). CoCo bonds are related to larger ranges of market danger. Nonetheless, the estimated dimension of the wealth switch from CoCo bond holders to fairness holders doesn’t improve danger based mostly on this measure. Default danger is anticipated to have an inverse relationship with CoCo bonds: larger capital means a decrease likelihood of default. Our outcomes affirm this instinct, and but present that if beneficial properties from CoCo conversion are anticipated, then the financial institution is perceived to be riskier (larger CDS spreads). Lastly, we don’t discover any correlation between the accounting based mostly danger measure and CoCo bond issuance. This can be as a consequence of a slower adjustment of accounting measures or too few observations.
Our analyses counsel that CoCo bond issuance is related to larger ranges of asset danger, market danger and insolvency danger. The extent of those dangers look like larger when the conversion (write-down) of CoCo bonds is anticipated to switch wealth from CoCo holders to present shareholders. As such, we argue that the right design of CoCo bond contracts ought to management for this wealth switch/dilution. This may occasionally assist restrict the potential risk-taking implications related to the issuance of those bonds, contributing to the resilience of the banking system. An alternate method to restrict these results may very well be to compensate managers with manager-specific CoCo bonds. These bonds may switch wealth from managers to shareholders, higher aligning managers’ incentives. For instance, they may very well be write-down CoCo bonds with a comparatively excessive set off. Our findings counsel that the issuance of such bonds may improve the resilience of particular person banks and the entire banking system.
Mahmoud Fatouh works within the Financial institution’s Prudential Framework Division and Ioana Neamțu works within the Financial institution’s Banking Capital Coverage Division.
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