The Trouble With CoCos
No antidote for financial distress.
Until recently, many financial regulators thought a new financial instrument -- known as a contingent convertible bond -- had a big part to play in ensuring the soundness of the financial system. After the past few days, they might want to think again.
CoCo bonds have been central to European regulators’ efforts to avoid a repeat of the 2008 crisis. They’re supposed to boost a bank’s capacity to absorb losses. In times of stress, payments on CoCos can be halted, and the bonds can be converted into equity. Ideally, this makes it less likely that governments will have to rescue banks at taxpayer expense. That, in turn, should make banks more likely to issue equity in good times, and more prudent in their risk management. Since April 2013, European banks have issued more than $100 billion in a type of CoCos that count toward capital for regulatory purposes.
The theory looked promising, but this week it didn’t work so well. Investors worried that one of Europe’s biggest financial institutions, Deutsche Bank AG, might be forced to miss a CoCo payment. This accelerated a broader selloff in the bonds and stocks of European banks. Deutsche Bank had to scramble to shore up confidence, in part by suggesting it might buy back some of its own debt.
The incident serves to reinforce concerns, expressed by various financial economists, that CoCo bonds may make investors in banks and their debt more apt to take flight when trouble looms. After all, if CoCos protect taxpayers, they do so at the expense of bank shareholders and bondholders. Moreover, CoCos are complicated instruments. In a time of stress, uncertainty over the conditions that trigger conversions may add to the sense of alarm.
Paradoxically, a panic of that kind might eventually call forth a government bailout -- the very thing that CoCos are intended to prevent. That prospect was invoked by John Mack, a former chief executive officer and current senior adviser at Morgan Stanley, in an interview this week on Bloomberg Television. The thought of Deutsche Bank missing a payment was “absurd,” he said, because “the government will not let that happen.”
These flaws underscore the case for simply requiring banks to finance themselves with more equity, which has the advantage of absorbing losses without any special triggers or added anxiety. Regulators will have to push for this, as banks will tend to prefer CoCos: In some countries, the bonds’ interest payments are tax-deductible. Also, CoCos count as debt rather than equity, so in good times they can make banks’ performance (measured by return on equity) look better.
Late last year, global regulators began trying to make banks issue even more "loss-absorbing" debt, as part of a larger mechanism designed to shore up cross-border institutions in the event of distress. If they want to protect taxpayers and make the banking system more resilient, they’d be better off just requiring more equity.
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