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Contingent Convertible bond literature review: making everything and nothing possible?

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Abstract

Contingent Convertible (CoCo) bonds are subject to a considerable theoretical and practical debate. This article presents a systematic literature survey from five databases between 2002 and June 30, 2018, based on a content analysis approach. I do so by analyzing the multidisciplinary linking points of 244 CoCo-related publications from 27 countries. This literature review considers—in addition to peer-reviewed journal articles—first-tier gray literature in order to receive the most comprehensive picture possible. Although CoCos that qualify for Basel III have various advantages such as less social costs due to optimal capital regulation and equilibrium leverage, lower default risk, cheaper financing and enhanced returns for issuers, they cause at least as many undesirable effects in the field of moral hazard such as the preference for higher risk-taking of management and equity holders or the acceptance of elevated asset volatility as a result of the high wealth transfer risk for CoCo holders. The explanations for the established CoCo design are multifaceted and vary greatly. In academia, caution needs to be exercised on the tendency to over-engineer the possible future design of CoCos and the myriad of outcomes.

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Data source: Bloomberg, March 2, 2018 for ISINs XS0979444402 (AT1 CoCo), ES0213790027 (Tier 2 CoCo), XS1169791529 (Senior unsecure bond) and ES0413790355 (Covered bond)

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Notes

  1. Knightian uncertainty is referred to as the formalized distinction between risk and uncertainty made by Knight [25]. Whereas the former has a predictable variation and the odds of unknown outcomes can be calculated, there is a lack of information needed to estimate odds on certain outcomes and hence an unpredictable variation in the case of uncertainty.

  2. Details on the transaction can be retrieved from Danske Bank Group [36], page seven. Note: The first publicly traded CoCo was issued by Lloyds Banking Group in November 2009 as cited in many research articles [37,38,39,40].

  3. Underinvestment (also called debt overhang) is an agency problem where equity holders refuse to invest in low-risk assets to maximize their wealth at the cost of straight debtholders. During a phase of overinvestment, management excessively invest in too many and probably unprofitable projects that could damage the interests of shareholders [63].

  4. More specifically, Basel Committee on Banking Supervision [105] created a hypothetical portfolio benchmarking exercise for 32 large international banking groups from 13 jurisdictions and asked to calculate the risk based on their IRB. Translated into capital impact at the bank level, the capital ratios of 22 banks were calculated within one percentage point or a 10% risk-based capital ratio benchmark. However, ten banks delivered risk weight variation outliers by as much as 20% in each direction or 40% in total.

  5. Notably, the Dutch Rabobank has issued a 6.875% CoCo as per March 19, 2010, where a cash call of 25% has been foreseen in the case of a principal write-down (75%) event. Such a design will create additional liquidity pressure [131] and do no longer qualify for contingent capital under the current regulatory framework.

  6. A moving 90-day average of the trigger ratio of market value of equity relative to assets of at least 8% was proposed by Calomiris and Herring [20] as this should offer enough time for policymakers to respond. Squam Lake Working Group [138] proposed the usage of an average stock price over a period of 20 days. Coffee [45] made an example for a brief period of “three or more trading days.” The idea and the discussion on advantages and disadvantages of averaging a CoCo trigger was first brought forward by Flannery [5].

  7. The pecking order theory is often referred to Myers and Majluf [257] and postulates that companies prioritize their sources of financing by its cost and the latter increases with asymmetric information making equity to the least preferred source of financing.

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Acknowledgements

This publication is written as a part of the Doctor of Philosophy study at the Zeppelin University Friedrichshafen. The author gratefully acknowledges the financial support from the Lucerne University of Applied Sciences and Arts.

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    Philippe Oster

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Oster, P. Contingent Convertible bond literature review: making everything and nothing possible?. J Bank Regul 21, 343–381 (2020). https://doi.org/10.1057/s41261-019-00122-z

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