Can CoCos cure the Too Big To Fail conundrum?
October 9, 2013 - David Buckham CEO of Monocle
It has been interesting to notice over the past several months the invention of new ideas and the reinvention of old ideas that put flesh on the stringent new regulatory demands proposed by world leaders. When Barack Obama proposed the Volcker rule, or when Gordon Brown spoke of reigning in wanton bank practice, there has been a lack of meat on the bone, so to speak, in actual implementation detail. More recently, I’ve noticed that actual, solid, and possibly even implementable ideas are being proposed, one of which is the funkily named CoCo. A CoCo is a bond, to be purchased by bank investors, that converts to equity under conditions where pre-specified capital triggers are breached, in particular the deteriorating capital condition of a bank, or possibly even the banking sector more broadly.
The BCBS, FSA, and the US Fed have all recently punted the issuance of contingent capital bonds, derisively labelled CoCos by detractors, as an automatic ‘top up’ mechanism to bolster tier 1 bank capital in the event of stress. They have traditionally been issued by the insurance industry as a way of provisioning for extreme loss events. Lloyds Banking Group led the way with CoCos that convert into equity should the bank’s key capital ratio fall below 5 per cent. Rabobank followed with CoCos that trigger at 7 percent. UBS and Credit Suisse, although perceived to be well capitalised with tier 1 ratios above 15 percent, have been encouraged by the Swiss regulator to issue CoCos.
An enduring lesson of the financial crisis is that there is no single metric or ratio which is capable of dynamically expressing either the effective risk being taken by any individual bank, or the systemic risk posed by any financial institution. For example, Lehman Brothers had a tier 1 ratio of 11 percent before going bust, and yet was perceived as a source of unacceptable counterparty risk by the market just prior to its chapter 11 bankruptcy filing. The reason was obvious in retrospect – the complete illiquidity of its assets and the nature of its funding mix. With this in mind, the rationale for CoCos seems to be that prevention is better than cure.
Even if a bank’s size conferred on it a ‘Too Big to Fail’ status as a result of the implicit government guarantees, the use of CoCos can be justified. In the case of Lehman, as in the case of other institutions, there appears to have been a temptation to ride out the storm by not even attempting to raise additional capital, and simply hoping for the best – a sort of wait and see and hope for the best mentality that seems to have been Dick Fuld’s strategy, of which now evidence is emerging. This thinking would be obfuscated by a CoCo, which would force a bank to convert debt into equity to pre-committed equity investors at pre-defined triggers based on a range of financial ratios. It would also instil market discipline, since those most likely to lose in the event of a CoCo being realised would be current equity investors, the value of whose stock would be diluted.
Behavioural economics refers to problems of this nature as time inconsistency problems. CoCos seem an elegant solution to the time inconsistency problem observed here. The closer an entity is to default the more unlikely a rights issue becomes, since shareholders do not wish to be diluted, and the issue itself is highly speculative. The most common example used in the literature to elucidate time inconsistency is that of Odysseus’ quandary at the lure of the sirens. Odysseus’ time inconsistency problem lay in his need for a pre-commitment not to be lured, and hence ultimately ruined, by the ineffable beauty of the Sirens’ songs, to say nothing of the sirens themselves. Of course he didn’t issue CoCos, but tied himself to the mast of his ship, instructing his men to plug their ears with wax and pay no attention to his cries. Odysseus recognised the possibility of acting irrationally in the future, and hence limited his own agency by binding himself to the commitment mechanism of the mast.
There remain some caveats to be overcome in the adoption of CoCos, before they can be seen as a panacea to capital adequacy under stress. The problem is to find a price where the initial spread, which is actually the coupon rate, as well as the strike price at conversion, are attractive both to investors and appropriate to the issuing banks. If such a price can’t be found, will regulators insert themselves into this process, and demand a price that is reasonable to investors, but less attractive to banks? Who are regulators to design funding structures or mandate funding choices? Are regulators going to not only regulate banks, but structure them too?
Another point to be considered is that Moody’s has already indicated that CoCos would almost certainly not be considered investment grade, since ratings would depend on the predictability of the events that would trigger conversion. The difficulty of predicting such events would have to be embedded in the uncertainty of price. Of course the ability of ratings agencies to properly identify a remotely appropriate rating on complex financial instruments has been called into question. After all, a AAA rating on a structured investment vehicle surely cannot mean the same thing as a AAA rating on General Electric, can it? Even the markets weren’t fooled, which is why the many thousands of complex instruments with AAA ratings which subsequently failed could earn as much as 200 basis points above General Electric debt.
Yet another consideration is that the legal entities which are potential investors in CoCos may augur in another version of the so-called double default effect. This `effect` is realised when the potential guarantors of the bank, i.e. the owners of these bonds, will themselves be experiencing similar stresses to the banks, thereby reducing the strength of risk mitigation in the guarantees themselves. Had CoCos been in place, one can easily think of instances in which there would have been little value to the issuing banks, given that the new equity holders had themselves experienced such massive reductions in value. It is encouraging however to see some practical ideas emerging from regulatory bodies, albeit the derisively named CoCos, rather than merely broad sweeping statements made by political leaders.
David Buckham, CEO of Monocle