Are CoCos from Cloud Cuckoo-Land?

Charles A.E. Goodhart, 10 June 2010

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There are a number of reforms to financial regulation that enjoy almost universal endorsement, at least from the great and the good in the academic fraternity (Acharya et al. 2009). These include:

  • routing most derivative deals through centralised clearing parties;
  • requiring all systemically important financial intermediaries to write “living wills”;
  • imposing tougher capital regulations on assets held in bank trading books;
  • giving incentives to banks to hold a larger proportion of liquid assets; and
  • requiring banks to hold a form of debt that is “quasi-automatically” transformed into equity when the bank gets into trouble. These latter are the conditional convertibles, or CoCos, of the title.

While I have supported the first four (Brunnermeier 2009), I am a sceptic on CoCos. So pervasive, however, are the range and eminence of its supporters that I feel bound to set out the reasons for my reservations.

The intentions and objectives of the proponents of CoCos are excellent, indeed beyond reproach. The main purported benefits are:

  • In the event of an insolvency, they allow loss to be spread more widely amongst bank creditors, rather than assumed by taxpayers, and
  • They enhance stability by providing additional capital in bad times, and, if appropriately designed (more on which later), provide incentives to raise new equity in good times.

It is rather the mechanics of their operation and market implications that may be subject to doubt.

Lessons from history

Let me start by recalling that this is the third version of a quasi-automatic market mechanism for limiting bank losses and facilitating bank resolution that has been proposed in the US. The first two both failed.

The first, which had some considerable success for many decades up until the 1930s, was the imposition of double liability on shareholders. Quite why this was rejected in the 1930s, and why academics have not proposed its reintroduction, (rather than the more complex CoCo scheme), are not entirely clear.1

The second, and more recent proposal, was that for prompt corrective action contained in the FDIC Improvement Act of 1991. This too patently failed in 2008. The main reason appears to be that it was based on accounting, rather than market, values of equity capital. Such accounting values adjust far too slowly, and are subject to accounting gimmicks (Repo 105). Indeed the IMF has shown that the banks that went under in 2008 were beforehand supposedly better capitalised than those that did not! The implication is that CoCo convertibility must be triggered by falls in market, not in accounting, valuations; this brings with it concerns about market dynamics (more on which later). Accounting triggers, such as those included in certain recent issues, e.g. by Lloyds, are deficient.

CoCos’ main purpose

A main purpose of CoCos is to allow loss in the event of insolvency to be spread more widely amongst bank creditors, rather than assumed by taxpayers. While this is a laudable objective, it would be even better to have a recovery rather than insolvency. On this latter front CoCos do not score well.

When a bank, or another systemically important financial institution, gets into real trouble what it needs most urgently is lots of cash up-front. The only benefit the conversion of CoCos brings on this front is the cessation of their interest payments. A much stronger, and simpler, mechanism would be to require the authorities to ban (or to explain why they choose not to do so) all dividend payments, and perhaps all increases in the compensation/earnings ratios, for all banks and systemically important financial institutions once the market value of an index of, say, the equities of the 10 largest banks/institutions had fallen more than X% from its previous peaks. This could conserve far more cash than triggering CoCos. Admittedly the prospect of a cessation of dividends could further depress bank equity valuations in a crisis, but the likelihood of success, and the attractions to banks, of raising new equity at such junctures are fairly minimal at this point anyhow.

What triggers conversion?

At least tying CoCos to equity market valuations should somewhat simplify the vexed question of triggers for the conversion. One concern of some proponents of CoCos has been that the quasi-automatic rebuilding of equity from the conversion might encourage some bank executives to adopt riskier strategies; so the suggestion was that conversion should only be allowed if both the individual bank and the whole banking/financial system were in a state of crisis. But if that required a pronouncement, say by the Central Bank governor, of the existence of such a crisis state, would not the pressure be to delay making such a (market-damaging) pronouncement? Instead, if the trigger was a system-wide decline in equity prices, this would be a transparent, objective basis. Of course, that leaves open the question of what happens when you get a, possibly technical, market collapse, as in 20 October 1987 or 6 May 2010, and of the possibility of market manipulation. Both those concerns can be partially alleviated by relating triggers to average market valuations, over say 20 working days, but this could still leave final-day problems and volatility, let alone concern about the uncertainty, and hence additional volatility, throughout the potential averaging period.

Much depends on the precise terms of the conversion, i.e. what share of the enhanced equity that would go to the CoCo holders. I should confess that originally I assumed that triggering such a conversion would lead to a (possibly sharp) fall in the value of such CoCos. If so, several consequences arise.

  • First, all other banks, and systemically important financial institutions, would have to be banned from holding such CoCos, as triggering them would just spread contagion within the financial system.

Indeed CoCos’ pay-off function, incurring a large loss just when all other assets were also doing badly, would be most unattractive. So they could only be sold to a small clientele at a high yield, i.e. very expensive.

  • Second, the triggering of a CoCo for Bank A would very likely cause a contagious market reaction in the value of CoCos in many other banks, leading to value destruction, though the extent and likelihood of such contagion can be questioned.
  • Finally, CoCo holders would hedge against the possibility of loss from activation of the trigger by shorting the equity of the bank in which they held the asset, leading potentially to the amplification of systemic downwards spirals in the prices both of bank equity and of CoCos in the system as a whole.

One of the weaknesses of some of the analysis of CoCos is that it concentrates on the effect on a particular troubled bank, rather than also exploring the effects on the market dynamics of the financial system as a whole, (one of the key inherent weaknesses of our prior regulatory system).

Indeed, were the conversion terms of CoCos such as to be likely to impose a significant loss on the holders of CoCos, I would be inclined to claim that they were a bad idea, and leave it at that. But the conversion terms can be adjusted so that the CoCo holders get such a large proportion of the resulting enlarged equity base that they even gain at the expense of the pre-existing equity holders, whose position gets diluted into insignificance. This gets us back towards imposing a sudden large loss on original equity holders, if an above zero trigger is reached, (rather akin to the prior double liability arrangement) – altogether a much better idea.

The CoCo suggestion is that equity holders will be incentivised to issue new additional equity early, in order to protect themselves against being wiped out by dilution, and from any manipulation to activate the trigger by CoCo holders hoping to benefit. Indeed, some of the proponents hope that the incentives to raise new issues in good times will be such as to make banks continuously well capitalised and to prevent CoCos being triggered except very rarely (and by the miscalculation of existing equity holders).

This is where I have my doubts. Markets can move rapidly from complacency, in which protective action seems unnecessary, to such fear, that new issues become non-viable, in quite a short period of time. Consider what happened to the assessment of sovereign risk in 2010, or of equities in 2008. To avoid widespread triggering of CoCos at a time when the alternative of new equity issues would be difficult or impossible, the trigger would have to be set to go off well before a serious systemic crisis is upon us. Thus one way or another, the existence of CoCos with such conversion terms would face the bank equity holder with a much higher probability that the valuation of the holding would be significantly diluted well in advance of insolvency. This would make equity holding in banks/institutions less attractive, and would raise the required return that would need to be met, (and at present the return that banks may be able to offer are also under threat from other regulations and taxes).

And if such a CoCo was triggered by miscalculation or misadventure, the adverse effect on equity holders could lead to contagious effects on other bank equity valuations, possibly leading to a domino effect triggering one CoCo after another. If so, it would become impossible to recapitalise banks via new equity issues for some long period. Indeed, all bank equity enhancement might then have to come for some time by way of CoCos converting, not a happy state of affairs. In contrast, supporters of CoCos suggest that, under such circumstances, the conversion of CoCos would indeed be the only way to recapitalise banking systems, but, if they were required to be large enough, they could suffice. But how large would this have to be, perhaps 10% of total bank liabilities, and what then would be the effect on overall bank costs and profitability, especially in the transition period?

Would it not just be simpler and easier to raise equity capital requirements directly, rather than go through this more complicated rigmarole? Here the argument of the proponents of CoCos is that they allow the banks to enjoy the tax shield, that the interest payment (while not triggered) can be offset against tax, so that CoCos plus equity will be somewhat cheaper than just more equity. But this depends on a whole host of other factors as well, such as the liquidity of the CoCo market, the exact terms of each CoCo, the likely market for such instruments, etc. Against their issuance being possibly marginally cheaper for banks than additional required equity, their (required) use would make the system more complex, potentially leading to problematic market dynamics, and they would tend to be oversold as a magic bullet.

So, overall, I am yet to be persuaded that CoCos represent any improvement on a reformed system of, somewhat higher, counter-cyclical requirements.

References

Acharya, Viral, Thomas F Cooley, Matthew Richardson, Ingo Walter (2009), “Real time solutions for US financial reform: A new ebook”, VoxEU.org, 15 December.

Brinnermeier, Markus K, Andrew Crockett, Charles A E Goodhart, Avinash Persaud, Hyun Song Shin (2009), The Fundamental Principles of Financial Regulation, Princeton University Press, 2 July.


1 Under this system all bank shareholders could be legally required, in the event of distress, for a further payment equal to the initial par value of the shares. So long as most banks only had a few wealthy owners, the system worked well; but once shareholding became widely distributed, both the quantum and timing of such extra funding became doubtful.

Topics: Financial markets
Tags: banking regulation, CoCos, financial regulation

Emeritus Professor in the Financial Markets Group, London School of Economics