Research finds CoCos better replace debt than equity in banks
A new European Central Bank working paper develops a model of contingent convertible debt (CoCos), concluding they perform better when replacing corporate debt than common equity. The research highlights the instrument's considerable complexity and questions its role as a crisis solution.
CoCos: A post-crisis capital solution
Contingent convertible debt emerged in the aftermath of the 2008 financial crisis to enhance bank stability and loss-absorbing capacity without requiring immediate equity issuance.
By converting into equity during distress, CoCos help maintain a bank's capital adequacy.
This paper develops a model involving a government and banks, where the government ensures bank operation even if private shareholders abandon them due to unprofitability.
Shareholders prioritize wealth maximization and can exit, while the government acts as a welfare-maximizing agent, enforcing a symmetrical tax system before intervention.
The model analyzes equity, debt, and CoCo claims under various scenarios, aiming to assess CoCos' effectiveness in their current form.
Replacing debt, not equity
Numerical simulations reveal that CoCos create more value when they replace vanilla corporate debt compared to common equity.
While CoCos increase the probability of financial distress due to coupon suspension possibilities, their conversion into equity makes default less likely, ultimately increasing the bank's value.
However, equity holders prefer issuing debt in good times, followed by CoCos, and then equity.
If solvency regulations prevent debt issuance, CoCos are preferred as they behave like debt in favorable conditions.
For the government, CoCos represent the least favorable financing solution due to increased financial distress and tax treatment.
A complex, unfulfilled promise
The paper critically highlights the considerable complexity of CoCos, which stands in stark contrast to their intended role as a solution to crises often triggered by simpler securities.
Despite their design, AT1 CoCos have largely failed to act as true going-concern instruments, converting only at the point of resolution rather than preventing it.
This fundamental design flaw has led to market confusion and calls for a significant redesign of their conceptual foundation.