Banks should issue more CoCos and their design needs to be further refined

Too-big-to-fail is the key term that epitomizes the global financial crisis (GFC) of 2007-2008. In the middle of the crisis, the financial regulators had to accept that bank bailouts are the only form of stabilizing intervention. Other options like putting the bank in resolution was considered too risky for financial stability. It is natural, therefore, that one of the priorities of the international financial regulation reforms after the GFC was to increase banks’ absorbing capacity. Among financial regulators, contingent convertible bonds (CoCos) became a popular tool that permits recapitalization of a distressed bank. The reduction in debt or the increase in equity resulting from CoCo conversions can serve dual roles of recapitalizing a going concern bank and reducing the resolution costs of the gone concern bank.

During the press conference on 19 March 2023, FINMA announced that, as part of the emergency package in response to the loss of trust and the run on Credit Suisse, the contingent convertible bonds that were part of the Credit Suisse Additional Tier I (AT1) regulatory capital, had been written off. The decision by FINMA prompted negative market participant reactions the following Monday 20 March, with the commonly stated view that conversion violated the priority order of claims. Indeed, shareholders of Credit Suisse retain a value of USD 3 Billion, while the CoCo bond principal writedown amounted to a USD 17 Billion loss for CoCo investors. Providing indirect support to the view that absolute priority should be help up, the European Central Bank (ECB) and the Bank of England on the same Monday both made public statements that they do not intend to follow the FINMA approach and that they intend to respect the usual priority order of claims in resolution. How can these divergent views of regulators be reconciled? Why did the Credit Suisse AT1 CoCo bondholders face losses before shareholders were wiped out? What are the lessons for the effectiveness of post-GFC too-big-to-fail reforms?

CoCos are designed to maintain the equity cushion of a going concern bank.

The structure of CoCos reflects their primary purpose to be a readily available source of bank capital amid a crisis (Avdjiev et al., 2013). CoCos are designed to maintain the equity cushion of a going concern bank. In this respect CoCos are distinct from capital instruments that are designed to absorb losses in resolution like total loss absorbing capacity (TLAC) instruments. TLAC are additional loss absorption requirements for global systemically important banks (GSIBs) like Credit Suisse to enable a single point of entry resolution. By contrast, CoCo conversion is designed to take place while the bank is still a going concern or at the point of the bank’s insolvency.

Accordingly, many CoCos have been issued with multiple triggers, combining a mechanical trigger defined numerically in terms of a specific capital ratio, as well as a discretionary trigger, which can be activated by supervisory authorities. When there are multiple triggers, the loss absorption mechanism can be activated when any of these triggers is breached. The activation of the discretionary trigger, which was present in all CoCos issued by Credit Suisse, is exactly what allowed FINMA to trigger conversion on 19 March.

The discretionary trigger requirement, also known as point of non-viability trigger (PONV), was also the key term in Basel III rules on contingent capital to satisfy minimum capital requirements. That is, all regulatory capital AT1 and Tier 2 (T2) CoCos must include a PONV trigger. Not surprisingly, banks included the PONV clauses in CoCos to satisfy the regulatory capital eligibility.

The conversion of CoCos by FINMA is a form of recapitalization of a troubled bank to ensure financial stability and facilitate the commercial solution of the merger with UBS. This should be distinguished from the resolution of an insolvent bank to which the European and the UK regulators refer to in their statements. The ability to improve the capitalization of a troubled bank was the main purpose of CoCo design, and it is exactly what the regulators did in the middle of a bank-run.

We also find that not all CoCos are born alike.

Will CoCo conversion trigger the collapse of the AT1 debt market? Unlikely. In our research (Avdjiev et al. 2020), we provide the first comprehensive analysis of bank CoCo issuance. Our analysis reveals that the cost of issuing a CoCo is primarily driven by the banks’ financial conditions. Banks that are riskier and poorly capitalized took longer to issue a CoCo and had to compensate investors with a higher coupon. But we also find that not all CoCos are born alike. Those that convert to equity rather than are written down offer a superior design from the point of view of reducing bank fragility. In the case of Credit Suisse, all outstanding CoCos were principal write-down, and this is the reason why their investors received no equity stake in the merger with UBS. Had they issued a conversion to equity CoCos, they would have received shares in the merged company.

The collapse of Credit Suisse offers an important lesson for financial regulators. Despite the enormous effort by regulators to set up resolution regimes for GSIBs after the GFC, the complexity and lack of transparency of resolution procedures increase the risk of letting a GSIB like the Credit Suisse fail, so much so that the Swiss regulatory authorities decided that a bailout was safer. Yet the USD 17 billion write down of CoCos reduced the cost of this intervention by USD 17 billion for the Swiss taxpayer.

But was this fair for CoCo investors? Yes. The CoCo instruments were offering a generous yield of 8-10% compared to the rate of around 3.5% on 10y US Treasury notes for carrying this conversion risk. CoCo investors are sophisticated institutional investors like PIMCO that were receiving compensation for bearing this risk. Had they invested in equity conversion CoCos, they would also have had to bear risk, yet they would have received shares after the merger. But their coupon rates would have been lower than for the principal write-down CoCos.

Financial regulation should focus on enhancing the role of contingent capital like CoCos that can be activated prior to a bank’s failure.

Of all the too-big-to-fail tools, it seems that the Credit Suisse CoCos did exactly what they were supposed to do.  Going forward, financial regulation should focus on enhancing the role of contingent capital like CoCos that can be activated prior to a bank’s failure. Furthermore, regulators also need to review the great variety of CoCo designs in terms of their conversion mechanism and their trigger level. Discretionary (PONV) triggers that are widespread in CoCos offer regulators a possibility to act in the middle of the crisis. But the regulatory discretion makes it difficult to price the risk of conversion, and as we show in Avdjiev et al. (2020), reduces the effectiveness of CoCos. One alternative design, proposed by Bolton et al. (2012), is CoCos that give the right to convert into equity to the issuing bank, which offers a more standard, transparent, and flexible form of recapitalization during a crisis, and is robust to price manipulation. Improving and refining CoCo requirements that enable recapitalization of a troubled but viable bank should be the focus of regulators in Switzerland and worldwide in the coming months and years.

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By Patrick Bolton, Professor of Finance and Economics at the Imperial College London and ECGI Fellow and Anastasia Kartasheva, Associate Professor of Insurance Economics at the University of St. Gallen.

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