CoCo- A New Kid on ‘Banking’ Block

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CoCos: A New Kid on ‘Banking’ Block

A proposal by Britain’s Barclays to use CoCo as a remuneration

tool is being watched closely by peers.

Exclusive Analysis by

Amy, Chief Editor

www.businessviewsreviews.blogspot.com

http://www.businessviewsreviews.blogspot.com/






Jargon-free reports for easy understanding from www.businessviewsreviews.blogspot.com

Don’t confuse it with a new Swiss candy or a soft drink brand.

CoCo is a bold, new concept which is being explored by banks in

Europe as a revolutionary tool to revamp their compensation

mechanism (read: bonus). The British financial giant, Barclays is

reportedly looking to issue CoCos, subject to regulatory approval, to

its senior employees in a bid to overhaul its compensation strategy

that could help it navigate any crisis-like situation, such as the

global financial crisis of 2008, better. Crisis-hit big European and

US financial institutions (remember AIG) had recently come under

scathing attack from the regulators and experts for issuing fatbonuses to their senior management even as they had to be bailed

out by their respective governments. Now by using CoCo as a

„bonus currency‟ (as some experts call it), the issuers might hope to

buy peace with critics. However, the utility of CoCos goes beyond as

a mere compensation tool as several banks in Europe are looking to

issue such bonds to recapitalize them to meet tougher Basel III and

regulatory norms in their own nations.

CoCos or Contingent Convertible bonds are a kind of hybrid

instruments. According to David Bishop, Ethan Zuofei Liu, Patrick

Murray and Téa Solomonia of State University of New York,

“Contingent Convertible bonds (CoCos) are debt instruments that

must transform into shares of equity or are written off upon a

triggering event.” The trigger event, they suggest, could be

determined either by regulatory assessment or objective bank

losses. So, the bonds become effectively worthless if the financial





viability (a major trigger) becomes questionable. That means the

employees have every incentive to make sure their institution‟s

remain financially strong. It also serves as an effective

recapitalization tool if the issuer‟s tier-I capital falls below a

threshold or specified limit.

So far, two financial institutions which have issued CoCos include

Lloyds Bank and another by Rabobank. In case of Lloyd Bank

which issued these bonds in November 2009, the conversion is

contingent upon the trigger event of Core Tier 1 leverage ratio falling

below five per cent, while in case of Rabobank, in case trigger event

happens it would lead to write-off of 25% of the principal amount.

“[They] are interesting as a pay device on two counts,” FT quoted a

leading European banker as saying, who further added, “They

(CoCos) give an employee downside and don‟t incentivize strategies

that would ramp the share price in the short term, as equity can. At

the same time, they could count towards core capital.”

As regulators and bankers across the globe look for preemptive

measures to prevent a repeat of the 2008 financial cataclysm,

CoCos appear as a ray of hope. But will they deliver? “An inherent

problem within banking finance is the risk of panic: when a bank

needs to convert hybrid debt into equity, it sends a clear signal to

investors that the bank is in trouble. These investors are then

tempted to withdraw their investments, making the initial problem

much worse. CoCo bonds are emerging as the most concrete new





idea for solving these inherent problems,” comments

peo.cambridge.org.

However, CoCos do suffer some drawbacks. A major concern aboutCoCo‟s effectiveness is about the trigger event. According to Prof.

Theo Vermaelen of the prestigious INSEAD, France, is that “how

should the trigger be set?” “In the case of Lloyds the trigger is based

on regulatory capital ratios, which are only computed once every

quarter. Such a mechanism will not work in a situation where a

bank capital structure deteriorates rapidly,” he writes in his article,

“Message to Basel: Another way to avoid bank bailouts,” published

in Wall Street Journal. “For example, Citibank had a Tier 1 capital

ratio that was measured at 11.8 per cent in December 2008, at the

height of the financial crisis. This means debt holders are not likely

to get their money back, which makes the bonds very expensive,

and reduces their attractiveness as an alternative to simply issuing

equity.” He proposes a new framework, Call Option Enhanced

Reverse Convertible or COREC in which the trigger is based on

market values, and not "old" capital ratios and also, the design

protects equity holders against dilution caused by manipulation

and/or market panic.

Whatever, European banks, for now, it seems, are liking CoCos.









Source: IMF, “Contingent Capital: Economic Rationale and Design Features,” January 25, 2011.

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CoCo- A New Kid on ‘Banking’ Block