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'Contingent Convertibles: A Potent Instrument for Financial Reform'

By George M. von Furstenberg

World Scientific

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Credit: World Scientific Publishing, 2014

Cocos are bonds that strengthen the resilience of banks by shoring up their equity capital. They are a new instrument to preserve going-concern value in a crisis. For systemically important financial institutions, issuing cocos promises less reliance on bail-outs and more on private sector involvement through self-insurance. Cocos that trigger automatically when their common-equity ratio to risk-weighted assets is still high are particularly effective. They merit interest deductibility and credit toward regulatory capital requirements everywhere.

What use are cocos which the author, Dr George von Furstenberg, now retired from Indiana University, has hailed in a series of studies almost from the beginning?

They are a new instrument, first issued in 2009, that was to help financial institutions regain confidence by adding a capital buffer in the work-out phase of the 2007-2008 financial crisis. Since then they have not yet been fully embraced in some national jurisdictions, in particular not in the United States. In the US, interest deductibility and regulatory recognition as capital of the highest ("tier 1") quality have so far been denied for cocos or left unsettled.

Yet cocos have already proved that they are not a niche product of merely negligible appeal. For instance, in publishing the results of the 2014 EU-wide stress test on October 26 of this year, the European Banking Authority reported that, between January and September 2014 alone, European-Union banks raised €39 billion through issuing contingent convertible instruments. This amount was practically the same as what was raised in the same period from their equity issues net of repayments and buybacks.

In designing cocos, their issuers, in conjunction with the relevant national regulator, may first choose the trigger definition and set its level, often at 7%, of what now usually is the ratio of common equity tier 1, CET1, to risk-weighted assets, RWA. Because risk-weights on the different components of capital generally fall between 0 and 1, RWA may be as little as 40% (in the USA) or even 20% (EU) of the total assets which form the denominator of the leverage ratio. That ratio is correspondingly much lower that CET1/RWA.

The second important choice is to set the conversion price in relation to the price per common share that is expected to prevail after the announcement of conversion. By fixing the conversion price in the cocos covenant, investors would know beforehand how many shares would be issued in relation to the face value of the cocos converted. This would facilitate hedging.

Although the first cocos issued (by Lloyds Banking Group) set the conversion price equal to the stock price prevailing around the time of cocos issue, it was soon recognized that the stock price that would prevail in the event and after the announcement of conversion would be much lower. Hence the conversion price per share since has tended to be set well below the market price around the time of issue to support the expectation of significant recovery from the shares of common stock received by cocos holders upon conversion.

Cocos conversion provides for, usually final, debt cancellation. This finality is what boosts retained earnings and hence stockholders' equity. Writedown-only cocos, that do not convert into anything in spite of their name, have also been issued, almost from the beginning. When they "convert", their zero recovery rate could leave a deep hole in the portfolios of their holders. Some of these, like hedge funds, could be bank clients so that risks could spill back. There have even been write-down write-up cocos which do not relieve debt overhang and achieve little more than any preference shares whose dividends are optional and non-cumulative. Any writedown of these ill-advised cocos would not be final. Hence there are principled choices to be made which can benefit from this work's comprehensive analysis.

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More information on the book can be found at http://www.worldscientific.com/worldscibooks/10.1142/9300. It retails at major bookstores for US$98 / £65. The book is co-published by NOW Publishers.

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