Contingent convertible securities: Is a storm brewing?

Contingent convertible securities, otherwise known as 'CoCos', are hybrid securities issued by banks as debt instruments (e.g. bonds) and automatically converted into equity shares if a contractually pre-defined 'trigger event' occurs. Their defining characteristics are a loss-absorption mechanism (conversion or write-down) and an activation trigger, either based on a mechanical rule or on supervisors’ discretion.

CoCos are regarded positively both by the industry and by regulators. Banks appreciate the fact that this instrument allows them to fund themselves and satisfy their regulatory capital requirements at a lesser cost than with equity. Regulators note positively the fact that the instrument is designed to facilitate balance-sheet repair, or the orderly resolution of a bank, without the bank having to seek to issue extra equity under stressful conditions.

Although the size of CoCos issued until now is still small in comparison with other financial instruments, they attracted media attention in early 2016, when they contributed to increasing market volatility around some EU issuing financial institutions. While the 'incident' was contained, its importance should not be downplayed. The possible systemic implications for European markets of a more serious episode should be considered. This raises questions about how investors understand CoCos, as well as the robustness of models that estimate their risks. CoCos are also likely to feature in discussions on possible regulatory changes to banks' capital requirements.

BBC News, 21.02.16: European banks fail to sell Coco bonds http://www.bbc.co.uk/news/business-35625733

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