The coco solution: contingent convertibles should be part of financial reform efforts.

Authorvon Furstenberg, George M.

It would not be right to claim that contingent convertibles, henceforth cocos, are so familiar as to need no introduction. Recounting their basic features and functions opens the way to examining what is needed to make them grow sustainably to maximum benefit for stabilizing banks by their own means.

COCOS IN A NUTSHELL

Cocos are designed to make banks better able to cope with emergencies outside bankruptcy and to preserve going-concern value whether or not banks are too big to fail. Technically, cocos are that subspecies of contingent convertible bonds that reference a Basel 111 regulatory capital ratio, principally common equity Tier 1 as a percent of risk-weighted assets, as their trigger. When this capital ratio falls to or below the trigger level, one of two things must happen automatically according to their covenant: Either the coco debt instruments are simply written off in whole or part, or they actually convert into common stock as their name implies. The number of shares issued in conversion then is such that its product with the conversion price--a contract variable fixed already at the time of the coco issue--is equal to the face value of the cocos converted. The permanent debt forgiveness associated with conversion of all but write-down, write-up cocos helps with deleveraging and raises retained earnings and hence CET1 even though paid-in capital does not increase.

When cocos with a low CET1 trigger, such as 5 percent of risk-weighted assets, are activated, the issuing bank is likely to be close to the point of non-viability where the relevant national authority would be called upon to resolve the institution. However, high-trigger cocos that are set off at a CET1 ratio of 7 percent or more are "recovery" rather than "resolution" cocos: Their conversion would bring the bank's CET1 ratio again above the minimum required.

Cocos may qualify as additional Tier 1 capital or as less-reliably loss absorbing Tier 2 components of regulatory capital. The minimum CET1 requirement is currently 4.5 percent of risk-weighted assets. Additional Tier 1 cocos may account for at most 1.5 percentage points in the total Tier 1 requirement of 6 percent. Cocos classified as Tier 2 may contribute up to 2 percentage points of the minimum total capital percentage of 8 percent. Hence, if additional Tier 1 and Tier 2 were wholly composed of high-trigger and low-trigger cocos, respectively, the two types of cocos together could amount to as much as 3.5 percent of risk-weighted assets from a national regulator's perspective. U.S. regulators are alone in categorically denying additional Tier 1 cocos credit for satisfying Tier 1 requirements, requiring...

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