Contingent Convertibles (‘CoCos’) are debt instruments that either convert into equity or are written-down when they are converted. In this paper, I argue that European CoCos issued as regulatory capital were designed by regulators to absorb losses prior to resolution to create incentives for stakeholders to monitor. However, CoCo stakeholders have incentives to forbear (delay triggering CoCos). These incentives mean that CoCos may be triggered as part of resolution (or other insolvency process) rather than being triggered in advance of resolution.
Broadly, there are two types of CoCos. First, write-down CoCos which have three distinct formats: permanent write-down, temporary write-down, and staged write-down. Each format reduces the amount payable to CoCo investors and therefore creates an incentive for CoCo investors to monitor.
Second, convertible CoCos convert into shares. The value of shares that they convert into determines whether CoCo investors or shareholders have an incentive to monitor. If the value of the shares is less than the amount paid for CoCos then CoCo investors suffer a loss from the conversion and have an incentive to monitor.
CoCo investors as well as shareholders and regulators have an incentive to forbear and avoid a CoCo being triggered. First, regulators have an incentive to forbear in order to protect their institutional or individual reputation. Second, bank managers have an incentive to forbear in order to gamble for resurrection without alerting the market and regulators to their distressed situation (eg, to protect their bank managers’ stock options from dilution). Third, CoCo investors have an incentive to promote forbearance because their payoff in resolution might be higher than their payoff outside of resolution because, inter alia, as part of resolution they incur losses after shareholders rather than, for instance, being written-down whilst a bank has a positive Common Equity Tier 1 level (see Article 48(1) of the Recovery and Resolution Directive 2014/59/EU). The incentives for shareholders are more complex, given two factors: first, there is a difference between financial dilution from conversion and governance dilution from the issue of new shares; and, second, if markets are not fully efficient the news that a CoCo has been triggered may not be correctly priced.
There are at least three regulatory responses designed to ensure that CoCos are triggered prior to entry into resolution (or alternative insolvency process): minimum trigger levels; discretion to cancel coupon payments; a requirement to disclose a trigger event write-down; or convert a CoCo in accordance with its terms. Each mechanism gives discretion to either regulators or bank managers to trigger a CoCo. Given that bank managers and regulators have incentives to forbear; these mechanisms are unlikely to result in CoCos being triggered prior to resolution. Instead, it is likely that CoCos will not be triggered until a bank is placed into resolution.