March 27, 2013

Caution on Cocos

Research suggests that mandatory contingent convertible bonds with a market trigger may not address the problem they were designed to solve.

When the Dodd-Frank Act passed in 2010, one of its mandates included examining banks’ capital structures: could the losses of banks somehow be internalized, absorbed by the banks’ creditors rather than taxpayers? In particular, Dodd-Frank charged regulators with assessing whether banks should be required to issue contingent capital — a type of debt security that can be converted to equity — and, if so, how such securities should be designed to ensure that banks have sufficient loss-absorbing capital.

Contingent capital is raised through the sale of contingent convertible bonds, or Cocos. As the name suggests, there are contingencies under which these debt securities convert to equity. Banks sell Cocos when their balance sheets are stable and, as with regular bonds, pay interest to the bondholder (creditor). But when a bank’s stock price plunges, or it faces some other destabilizing crisis, Coco debt automatically converts into equity capital. As a result, upon mandatory conversion, the bank no longer owes the investor interest on the bond, and the investor holds shares, rather than bonds, in the bank. Thus, Coco investors, transformed from creditors to shareholders, cannot threaten a bankruptcy suit to secure their investment, which can be very costly and disruptive, judging by the bankruptcy of Lehman Brothers, for example.

There are two main proposals for how to design Cocos. Under one proposal, regulators would designate a trigger for conversion based on accounting measures. For example, mandatory conversion can be triggered if the core tier 1 capital (a measure regulators use to determine a bank’s core financial strength) falls to or below 5 percent of the total risk-weighted assets.

Unfortunately, accounting measures are backward-looking and can be easily manipulated. The other main proposal for designing Cocos, then, skirts this problem by using a market trigger. Cocos would convert as soon as the bank’s stock price hits a predetermined low, on the rationale that stock prices are less easy to manipulate because they are forward looking and incorporate the knowledge of millions of investors.

Many regulators and academics embraced the market trigger as a potentially good design for Cocos. “The idea sounded good at the outset,” says Professor Suresh Sundaresan, who, with co-researcher Zhenyu Wang, then Head, Financial Intermediation, at the Federal Reserve Bank of New York and now at Indiana University, participated in a research project initiated by the New York Fed to analyze contingent capital as a way to design the capital structure of banks. “But we quickly discovered a big problem.”

Sundaresan and Wang illustrate their main results by using the well-accepted binomial pricing model. They show that the proposed market trigger design for contingent capital, if implemented, would introduce broad scope for manipulation and high volatility in prices of equity and CoCo bonds both before and at the time of conversion.

Unlike convertible bonds, which give the bondholder the option to convert to equity when and if she deems it prudent, holders of contingent capital are obligated to accept conversion at a predetermined condition, such as when the stock price hits a low trigger level designated by regulators.

“Mandatory conversions of debt to equity don’t allow Coco investors to choose the best time to convert in their own best interest,” Sundaresan says. “That may deliver big disadvantages or advantages to either the holders of contingent capital or to the equity holders. If the conversion dilutes the value of shares, existing equity holders bear the burden while Coco investors gain a big advantage. On the other hand, if the conversion is done so that Coco investors lose value relative to equity holders, Coco investors will be worse off. In either case, there is a transfer of value from one class of investors to another due to mandatory conversion.”

One of the main results of their research is to show that the only way to avoid such problems is to ensure that there is no transfer of value when the mandatory conversion occurs. The researchers discovered that this requirement runs counter to a key provision that regulators wanted: they required conversions to be punitive toward equity holders. “They wanted the conversion ratio to be so high so that when Coco investors’ bonds converted, lots of equity had to be issued, which would dilute share values,” Sundaresan explains. “But if equity holders know they would face dilution at mandatory conversion, they may be incentivized not to take the kind of risks that would prompt the stock price to drop in the first place.”

The implications of mandatory conversions carry broader policy implications. Anticipating value transfers, one class of investors may have an incentive to push the stock price down to increase the likelihood of conversion, whereas the other class of investors may have precisely the opposite motive. That in turn could create greater systemic instability, and taxpayers could find themselves footing the bill for more bailouts.

Informed, in part, by the work of Sundaresan and Wang, regulators around the world are increasingly viewing contingent capital with market triggers with caution. None have yet adopted it as part of their capital prudential requirements for banks.

Sundaresan notes that the Financial Stability Oversight Council (2012) submitted its study to Congress and recommended that “contingent capital instruments remain an area for continued private sector innovation,” and it warned that “market-based triggers can exacerbate the problem of death spiral.”

Sundaresan and Wang, meanwhile, are thinking about alternate designs for securities that will address the problems of manipulability and touching off market instability. “Designing effective and efficient bank capital structure — including contingent capital — remains a work in progress,” he says.

You can listen to Sundaresan discuss his research in this Columbia Ideas at Work podcast:

 

Suresh Sundaresan is the Chase Manhattan Bank Foundation Professor of Financial Institutions in the Finance and Economics Division and academic advisory board member for the Program for Financial Studies at Columbia Business School.

Read the Research

M. Suresh Sundaresan, Zhenyu Wang

"On the Design of Contingent Capital with a Market Trigger"

View abstract/citation 
View Research