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CoCo Market Growth Seen Curbed by Conflicting Regulatory Demands

Demand for contingent capital notes is being hampered by conflicting rules governing buyers and sellers of the bank debt designed to absorb losses in times of stress, according to economists at the Bank for International Settlements.

Banking regulators encourage lenders to issue CoCos to help them satisfy capital requirements and remain solvent during a crisis, while regulators of prospective buyers worry about the potential losses those banks might suffer, Stefan Avdjiev, Anastasia Kartasheva and Bilyana Bogdanova wrote in the Basel-based BIS’s Quarterly Review published today.

CoCos convert to equity or are written down when the capital of the issuing bank falls below a preset level. While demand for the higher-yielding securities has accelerated in the last couple of years, the market remains small with sales totalling $70 billion since 2009. That compares with about $550 billion for other subordinated debt and about $4.1 trillion for senior unsecured debt, according to the report.

“CoCos have the potential to strengthen the resilience of the banking system,” according to the report. “Their ability to do so will depend on the scope for diversification, the capacity for reducing systemic risk and the coordination of their treatment between regulators of issuers and prospective buyers.”

Individual investors and private banks in Asia and Europe are the biggest buyers of the debt, while large institutions remain discouraged by “lack of clarity” on how national regulators will treat CoCos and the absence of complete and consistent credit ratings, according to the report. More than half of CoCos are unrated and until May this year, Moody’s Investors Service didn’t grade them at all, the BIS reported.

The BIS was formed in 1930 and acts as a central bank for the world’s monetary authorities.

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