An airbag for banks that just may explode
Banks tapped a new source of capital with issuing Contingent Convertibles ('CoCos’) something which has proved very popular among investors. 'CoCos seem to increase the resilience of banks, but they bring great risks with them for the financial system’, says UvA-researcher Stephanie Chan (30) who did a study on CoCos.
Stephanie Chan feels a bit like a lone voice in the wilderness. The Philippines-born student who is doing her PhD with UvA-professor Sweder van Wijnbergen at the University of Amsterdam, published a highly critical article on banks in September 2014, together with her supervisor. ‘We've gotten little response from the academics. If banks, regulators and other researchers got frightened by our conclusions, they’ve kept quiet about it. On the other hand, when the paper was presented at the IMF, we found that they shared some of our concerns.’
In the first of three articles of what will eventually become her PhD thesis, Chan has cast a critical eye on a new form of bank capital: CoCos, or ‘Contingent Convertibles’. CoCos are a new form of bonds and are widely sold by banks to investors and each other since the crisis. The peculiar aspect of these bonds is that they don’t have to be repaid if the bank gets into trouble. As the capital of banks in bad times drops below certain minimum limits, the regulator requires that the CoCos are converted into shares of the bank, or that they are simply written off - depending on the type of CoCo. In the first case, the bondholders receive shares of the issuing bank, which may not be worth much at that time. In the second case, investors lose their money.
‘In theory, it seems like an effective tool to strengthen the bank buffers’, Chan says. ‘When they are issued there is no dilution of the share capital, but the CoCos are nevertheless counted as bank capital by the regulator. Investors get the CoCos at a much higher interest rate than ordinary bank bonds, which makes them popular.’
Yet Chan and Van Wijnbergen are concerned. ‘At the moment the supervisor requires that a CoCo from a particular bank should be converted into shares or should be written off, problems will arise. Depositors of a bank will take this as a negative signal and retrieve their funds en masse. Not only from the affected bank, but very possibly also from other banks. Which then leads to liquidity shortfalls, decline of the share price and possibly a series of bank failures.’
Meanwhile about €100 bn in CoCos have been issued, exclusively by European banks. Banks like Lloyds and HSBC are leading among the issuers. In the Netherlands only Rabobank has issued them for now. The interest rate on a CoCo is tax deductible in most countries. This recently became the case in the Netherlands as well.
In their discussion paper 'CoCos, Contagion and Systematic Risk' Chan and Van Wijnbergen warn especially about the 'signalling function’ that turns the CoCo's into a time bomb placed under the financial system. ‘The fact that CoCos can be exchanged or written off, will give banks some breathing room initially, but that provides no comfort to depositors. CoCos are by definition subordinated to deposits, so the conversion doesn’t contribute anything to savers directly as long as no fresh money flows into the bank. All there is for depositors is this signal that things are going wrong on the asset side of the bank. A bank run can be the result.’
According to Chan the signalling is not limited to the depositors of the
affected bank only. The fact that the CoCos are converted means that returns on
the assets of the bank are under pressure. So other banks with similar assets
could be in similar trouble. The distress signal that a particular bank is in
trouble may then trigger depositors in other banks to take their money out too.
‘So CoCos form an additional and new source of systemic risk’, says Chan.
Chan claims that CoCos have yet another negative side effect. Many of the CoCo’s provides an incentive for shareholders to take on more risk. This is particularly true for CoCos that are written off when times are bad. ‘Shareholders then actually benefit if a CoCo is written off as it reduces the repayment obligation of the banks. Then shareholders have an incentive to wait In bad times for the moment that a CoCo is actually written off. Only at a very late stage, if at all, will they support the bank by issuing new equity’, says Chan. ‘That moment may come too late, especially if depositors already ran for the exit because of the negative signal given by the conversion of the CoCos.’
Chan does not know exactly what the subject of her next study will be, but it is certain that it is about financial regulation. Meanwhile she keeps an eye on the development of CoCos in the market. ‘Our discussion paper is one of the very few which asks critical questions about CoCos. For now banks, investors and regulators still seem to feel positive about CoCos.’ However, this does not dampen Chan's hopes that regulators soon will see the light and stop the issuance of Cocos in their current form.