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Contingent convertibles: do they do what they are supposed to do?

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Dr Hui (Frank) Xu

Dr Hui (Frank) Xu

When Lehman Brothers was in deep water in September 2008, the US federal government and the Federal Reserve decided not to bail it out, and several days later, the company filed Chapter 11 bankruptcy protection. Global markets immediately plummeted after the filing of bankruptcy, and both the government and central bank are accused of exacerbating investors’ panic for that decision. However, if they did, they would have been accused for a different reason: using taxpayers’ money to bail out a greedy and aggressive Wall Street giant.

The example illustrates the controversy and dilemma of bailout faced by policymakers. Since the financial crisis, one priority for the regulators has been to design a bail-in, an internal way to recapitalise distressed financial institutions and strengthen their balance sheet. The regulators hope it to become a substitute for the bailout. One way to deliver a swift and seamless bail-in is through the conversion of contingent convertible capital securities (CoCo).

CoCos are bonds issued by banks that either convert to new equity shares or experience a principal write-down following a triggering event. Because Basel III allows banks to meet part of the regulatory capital requirements with CoCo instruments, banks around the world issued a total of $521 billion in CoCos through 732 different issues between January 2009 and December 2015.

That being said, CoCos are still in their early stage in the sense that there is no consensus on how to design a CoCo. Moreover, few research has studied the response from market participants. Studying the response from market precipitants can shed light on the optimal CoCo design.

A recent research project by CCFin/CERF research associate Hui (Frank) Xu studies the response of incumbent equity holders when CoCos are in place. It considers two types of CoCos: CoCos convert to common shares when the stock price falls below a pre-set target, or the market capital ratio falls below a pre-set threshold. Surprisingly, the research shows that if the conversion dilutes incumbent equity holders’ security value, they will have strong incentive to issue a large amount of debt before the pre-set triggering point, and accelerate the trigger of CoCo conversion. The intuition is that since their equity value is diluted at conversion, they will issue a large amount of debt and distribute the proceeds via dividend or share repurchase just before conversion, leaving the new equity holders and debt holders much lower security value. Thus, the incumbent equity holders collect a one-time big payout at the cost of new equity holders and debt holders.

This is certainly contrary to the regulators’ expectations. Regulators expect equity holders to improve their corporate management, risk-taking strategies and financial policies under the threat of CoCo conversion. That equity holders benefit themselves by destroying the firms’ value under the threat of CoCo conversion is the least they want to see. Therefore, the research highlights the complexity of continent convertibles design, and the importance of taking the market participants’ response into account when regulators propose a CoCo design.