CoCo issuance and bank fragility

Summary

Focus

Contingent convertible capital securities (CoCos) are hybrid capital securities that absorb losses when the capital of the issuing bank falls below a certain level. CoCos can absorb losses either by converting into common equity or by suffering a principal writedown. They have a "trigger" which can be either mechanical (that is, defined numerically in terms of a specific capital ratio) or discretionary (that is, subject to supervisory judgment).

CoCos have become an important part of the post-crisis regulatory framework. However, up until now there has been little evidence on how they work in practice. The lack of research on the topic has been largely due to data scarcity.

Contribution

We compile the first comprehensive data set on global CoCo issuance. Our sample covers CoCos issued between 2009 and 2015. It contains 731 instruments with a combined volume of $521 billion.

We conduct two sets of empirical exercises. First, we examine the determinants of CoCo issuance. Second, we evaluate the impact of CoCo issuance on the credit default swap (CDS) spreads and equity prices of issuing banks.

Findings

Our analysis leads to four main findings. First, larger and better-capitalised banks are more likely to issue CoCos. Second, issuing CoCos causes the issuers' CDS spreads to decline. This indicates that CoCos reduce banks' credit risk and lower their funding costs. This is especially true for CoCos that convert into equity or have mechanical triggers. Third, CoCos with only discretionary triggers do not have a significant impact on CDS spreads. Fourth, CoCo issues do not affect stock prices, except for principal writedown CoCos with a high trigger level, which have a positive effect.

Abstract

The promise of contingent convertible capital securities (CoCos) as a 'bail-in' solution has been the subject of considerable theoretical analysis and debate, but little is known about their effects in practice. In this paper, we undertake the first comprehensive empirical analysis of bank CoCo issues, a market segment that comprises over 730 instruments totaling $521 billion. Four main findings emerge: 1) The propensity to issue a CoCo is higher for larger and better-capitalized banks; 2) CoCo issues result in statistically significant declines in issuers' CDS spreads, indicating that they generate risk-reduction benefits and lower costs of debt. This is especially true for CoCos that: i) convert into equity, ii) have mechanical triggers, iii) are classified as Additional Tier 1 instruments; 3) CoCos with only discretionary triggers do not have a significant impact on CDS spreads; 4) CoCo issues have no statistically significant impact on stock prices, except for principal write-down CoCos with a high trigger level, which have a positive effect.

JEL classification: G01, G21, G28, G32

Keywords: CoCos, Contingent Convertible Capital, Bank Capital Regulation, Basel III