CoCo Loco

While many markets have been subject to volatility and turmoil during the early part of this year, one sector has taken what can only be described as a “systematic beating”, namely that for contingent capital bonds (fondly referred to as CoCos, and usually forming part of a bank’s Alternative Tier 1 capital, or AT1) issued by banks as a part of their regulatory capital base.

Readers will recall that CoCos are a creature of the Great Financial Crisis, during which regulators discovered that many capital instruments that were supposed to be loss absorbing were in fact nothing of the sort, and one factor in the series of systemic or individual “bailouts” that took place at the expense of taxpayers.

Their premise is theoretically quite simple in that their terms are supposed to ensure that if a bank which has issued them becomes seriously stressed and approaches what is now happily termed the “Point of Non-Viability” (PONV), the instrument will either convert to equity or be written-off in part or in full to absorb losses.

So, what could possibly go wrong?

One issue that has become evident during the recent pounding that many banks’ CoCos experienced is that of what one may call “regulatory tweaking”. Because of their purpose, many CoCos contain terms that give the relevant regulator (say the ECB or Bank of England) the ability to decide not only whether a coco should be converted or written down, but also whether or not the coupon payable on a particular bond should be paid. Recent announcements from both the ECB and the European Banking Authority (EBA) have given investors pause for thought as they imply that coupon deferral may occur sooner than originally anticipated. No investor enjoys seeing such ex post facto uncertainty, with Deutsche Bank’s capital instruments taking a particularly brutal beating because of the relatively obscure basis on which payment capability is determined.

Of course, once clarifications are issued and banks demonstrate (and analysts confirm) that the situation is not quite as dire as markets believe, calm is restored and prices recover. Nevertheless, the episode is further evidence of how vulnerable large, complex and relatively opaque institutions such as regional and multi-national banks are to market panic and “runs”, because no investor wants to be left holding an instrument that just might become impaired or worthless in circumstances different from original expectations. Therefore, one should expect nervousness to continue.

Paradoxically, in trying to “clarify” the circumstances in which a CoCo might convert or be written down, regulators have actually made the situation worse, because they have made it clear that, ultimately it is their decisions and exercise of discretion which will affect outcomes. There is nothing new in that, but clearly it was not what investors had focused on.

At Awbury, we pay close attention to such matters, because we have a significant franchise in helping banks manage their risk exposures and capital. So, if your CoCo has recently gone “loco” and you wish to consider some less volatile alternatives sources of capital and contingent capital, you should give us a call.

The Awbury Team

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