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Meta Zhres
+49 69 910-31444

Bernhard Speyer

Technical Assistant
Sabine Kaiser
Deutsche Bank Research
Frankfurt am Main
Fax: +49 69 910-31877
Managing Director
Thomas Mayer

Following the recent financial crisis the minimum requirements of
debt instruments that may be counted towards regulatory capital are
being adjusted. In January 2011 the Basel Committee on Banking Supervision
presented rules supplementing the Basel III regulations on capital adequacy and
liquidity requirements. These stipulate that only hybrid capital instruments with full
loss absorbency count towards regulatory capital.
The banks will have to bring their capital management into line with
the new regulatory requirements. Recently, different forms of contingent
capital have begun to emerge that could be integrated into banks' funding
structures but do not yet, or no longer, meet the criteria for regulatory capital.
Contingent convertibles (CoCos): The next generation of subordinated
bonds? The term CoCo is used to describe a new type of convertible bond that is
automatically converted into a predetermined amount of shares when a predefined
trigger is breached. Since this type of bond is transformed into equity upon con-
version, it would be available for further loss absorption and therefore satisfies the
new regulatory requirements of hybrid capital instruments.
The right structuring is essential for the marketability of CoCos.
Depending on the choice of trigger and the conversion rate, CoCos can be used
to pursue different aims from a regulatory and financial point of view. Their
structuring must take account of this.
Investor interest: Still uncertain. Given that CoCos are a new type of
instrument in which the conversion rights are not placed in the hands of the
investors, who would moreover tend to become shareholders at an unfortunate
time, the capacity for placement of these bonds remains an open question that is
difficult to assess. Ultimately their marketability will hinge on whether it is possible
to find sufficient particularly institutional investors willing and able to hold these
The future of CoCos stands and falls with the regulatory initiatives.
The possibility of counting CoCos towards regulatory capital under Basel III acts
as an incentive to issue instruments of this kind. Going forward, the concept of
mandatory convertible bonds could thus gain ground; in the long run CoCos could
replace the previous subordinated bonds. So far, however, regulators such as the
Basel Committee provide for conversion at the behest of national regulatory
authorities. This could cause difficulties with the placement of CoCos in that it
creates uncertainty over the timing and circumstances of conversion. It makes the
likelihood of default more difficult to assess and CoCos (even) more difficult to
May 23, 2011
Contingent Convertibles
Bank bonds take on a new look
EU Monitor 79
2 May 23, 2011

Contingent Convertibles
May 23, 2011 3
The recent financial crisis has highlighted the importance not only of
the absolute amount of a bank's equity position but also the quality
of the capital it holds available to absorb losses. In response to this,
the Basel Committee on Banking Supervision has now tightened up
its requirements of the quality of core capital. What will be decisive
in future under these new regulatory intentions is the hard, core Tier
I capital, i.e. common shares and retained earnings, since this can
be used fully and immediately to absorb losses. With regulators
pressing for higher loss absorbency for hybrid forms of capital, only
very few of the old hybrid capital instruments are to be recognised
as regulatory capital. This applies in particular to subordinated debt.
The aim is to have subordinated creditors participate in the recovery
phase, and hence in the costs of crisis management, just like
providers of equity capital. During the financial crisis bondholders
escaped largely unscathed since banks that were technically
insolvent were bailed out by their governments owing to their
significance for the financial system; even holders of subordinated
bonds retained their entitlement to payment. Investors in sub-
ordinated bank bonds were held liable only in the event of a gone
concern. The moral hazard problem to which this gave rise is now to
be reined in by involving subordinated creditors at an early stage,
the intention being to reflect the risks entailed in subordinated bonds
adequately in their pricing and to close the door on investors bene-
fiting from the assumption of risk taking by the government while the
taxpayer is obliged to foot the bill. It is therefore planned to have
investors in subordinated bonds assume liability for losses once
banks are no longer able to obtain private funding.
Driven by these motives, two fundamental approaches have evolved
to improve bondholder liability. One is a new hybrid capital
instrument in the form of fixed income securities serving as an
equity buffer in times of financial distress and termed contingent
convertibles (CoCos); the other is bond creditor "bail-ins. The two
ideas differ in terms of their basis: CoCos are market-based
instruments, while bail-ins rest on the principle of discretionary
intervention. They share in common the wish to strengthen the
stability of the financial system a consideration that, in principle,
also enjoys the support of the financial industry.
Contingent capital: A definition
The banks will have to bring their capital management into line with
the altered regulatory requirements and the new standards applying
to their core capital. Issuing bonds that are available to absorb
losses under the new rules thus forms a necessary part of forward-
looking capital management by the banks. Various alternative ways
of including different types of contingent capital in their capital
structure have already been devised, but it is not yet clear whether
and how these instruments will count towards regulatory capital.
Essentially the term contingent capital is used very generally to
describe a kind of put option enabling the issuer to issue new equity
at pre-negotiated terms. As a rule issuance is triggered by the
occurrence of certain risk-based events defined ex ante in the
contract conditions. Many constructions and terminologies currently
in circulation can be subsumed under the heading contingent
capital; CoCos are also a variant. Often, however, constructions
EU Monitor 79
4 May 23, 2011
resembling contingent convertibles and called CoCos prove, on
closer inspection, not to qualify as such, although they are a type of
contingent capital:
Write-down bonds: write-down instead of conversion
Write-down bonds are a market-based financing instrument.
Rather than being converted, as is the case with CoCos, their
value is written down instead. The difference is that no additional
capital is made available; the liabilities are simply reduced as a
result of the valuation adjustment. So while the company's
financial position looks better on paper, equity is "created only to
the extent of the write-down made, since "release of the
liabilities generates exceptional gains that can be allocated to
retained earnings.
Temporary write-down bonds
Temporary write-down bonds also known as step-up, step-
down bonds are debt instruments which, on the one hand, can
have their liabilities reduced once a pre-determined trigger event
occurs but, on the other hand, also have upside potential. In
other words, a valuation adjustment can also step up their value
proportionately, meaning that the bonds are written down only
Bonds structured this way already exist in the marketplace. So
far, however, accounting regulations have prevented bonds of
this kind from being counted towards regulatory capital ratios.

Rather, the Basel proposal provides for permanent, partial loss
absorption, which is not the case with temporary write-down
Call Option Enhanced Reversible Convertibles (COERCs)
So far this is nothing more than a theoretical proposition
describing a bond that is automatically converted when a pre-
determined trigger is met. The conversion rate is below the price
that triggers conversion and the bonds feature a buy-back option
for existing shareholders, i.e. a kind of subscription right. To what
extent instruments of this kind are fit for purpose is an open
issue. Nor is their regulatory recognition clear.

In view of their features, CoCos (in the narrower sense) are
attracting a great deal of attention in the current debate on
recognition as regulatory capital. In the following we examine what
is behind them and just how promising the new type of bond is.
Contingent Convertible Bonds
Contingent convertible bonds (CoCos) are long-term subordinated
debt securities with a fixed coupon rate that can be converted
automatically from debt into equity when certain predetermined
triggers are met, turning what were previously providers of debt
capital into shareholders. Given that these hybrid bonds can be
converted into liable capital as required, they have the ability to
improve the issuer's capital resources under adverse circumstances

The recognition of temporary write-down bonds in earnings should be adjusted
and could be justified with the prudential filter mechanism. Prudential filters ensure
that funds recognised as regulatory capital serve the purpose of acting as a risk
buffer even when banks base calculation of their consolidated own funds on IFRS.
Pennacchi et al. 2010.
Contingent Convertibles
May 23, 2011 5
and to absorb losses. If the conversion trigger is not met CoCos are
simply "normal bonds that are redeemed at maturity.
The recapitalisation achieved takes place on the capital market and
thus through the private sector. Upon conversion the banking
institution immediately receives fresh equity, while at the same time
reducing its interest payment obligations. It is important here to
differentiate between liquidity and capital: Although CoCos do not
introduce any fresh cash into the company they transform a debt
instrument into new common stock, enabling better absorption of
(future) losses. Converting CoCos is tantamount to an immediate
improvement in the quality of the company's capital. Conversion is
carried out at a time when the bank, although still deemed to be a
going concern, is nonetheless prevented by the market situation
from strengthening its equity base by issuing new shares. Indirectly,
this could also facilitate access to other sources of private sector
funding, which would ultimately make government intervention
unnecessary or at least less likely.
From the point of view of financial stability, CoCos have the further
advantage that, unlike shares, they do not profit from the earnings
potential of high risk. And since the risk premium for CoCos is likely
to increase with a bank's risk, the convertibles could also have a
disciplining effect.
The conditions at which a CoCo is converted comprise the
conversion ratio and the price and time at which conversion takes
place. They are laid down in the bond terms. The specific features
are determined by the individual credit institution.
Conventional convertible bonds are related to CoCos, but with the
difference that the traditional version does not convert automatically.
As a rule the conversion right and option rest with the investor (see
table for a comparison of the different convertible bond types).

Different types of convertible bonds

Conventional convertible
A fixed income security that grants the holder the right to exchange the bond for
common stock of the issuing company during a conversion period at a pre-
determined ratio.

Exchangeable bonds A bond granting the investor the right to convert the debt at any time into a fixed,
given number of shares. In contrast to the convertible bond, the issuer of an
exchangeable bond is not the company that issues the underlying stock but typically
a (principal) shareholder.

Mandatory convertible bonds A version of the conventional convertible bond in which the investors' rights are
restricted. Whereas investors in conventional convertible bonds have the option until
maturity of the debt to convert into stock or not, mandatory convertibles feature an
obligation to exchange for the underlying common stock before or on maturity.
Consequently the risk of yield losses in the event of falling share prices is greater
with mandatory convertibles. The requirement to convert, which takes place through
the issue of new shares, means that mandatory conversion constitutes an indirect
capital increase with the attendant dilution effect for existing shareholders.

Contingent convertibles
Convertible bonds that convert automatically into common stock at a predetermined
ratio during their maturity when a pre-arranged trigger is met.

Bonds with warrants
In addition to the customary legal claims (entitlement to the payment of a coupon
and to redemption of the bonds), warrant bonds also carry a warrant conferring a
right to subscribe to shares in the issuing company. As with issues of mandatory
convertibles and (non-)contingent convertible securities, the issue of warrant bonds
is also contingent on a conditional capital increase. But in contrast to conventional
bonds, warrants may be detached from the bonds with which they are issued and
traded separately.

EU Monitor 79
6 May 23, 2011
Specific design at individual bank
level is essential for the marketability
of CoCos
The trigger level also decides on the
purpose of CoCos
Success depends on the set-up
Basically, for a CoCo structure to establish itself successfully in
the market three groups pursuing different interests need to be
reconciled. First are the regulators, who must be convinced that the
CoCo bond has full loss absorbency in the recovery phase. Second
are the shareholders, whose stock is diluted by the automatic capital
increase and who are therefore eager to avoid dilution where
possible or keep it to a minimum; and third investors, who do not yet
really know what to expect or whether they will even be able to hold
these instruments. Consequently, both shareholders and investors
still have mixed feelings about CoCos. This makes it essential that
the individual banking institutions get the individual design of their
bond terms just right, difficult as this may be. For even though an
established price formation mechanism exists for the two basic
elements of CoC os, i.e. subordinated bonds and equity, pricing
CoCos themselves presents a real challenge.
The choice of conversion trigger and the terms on which a CoCo
bond is converted are the crux in any discussion on the practicability
of these bonds. There is no single one-size-fits-all structure for
designing their features. A decision must always be tailored to the
individual company's situation.
Choosing the trigger: when to convert?
The trigger denotes the event that sets off conversion. Meeting the
trigger is thus the key criterion for automatic conversion to stock. But
it is precisely in determination of this trigger that the difficulty lies.
The complex structure of CoCos may provoke information
asymmetry between the issuing bank and investors. For this reason
the trigger should be as simple, transparent and easy to understand
as possible. Also important is the trigger level, because this
determines how "soon conversion occurs. Basically, a distinction
can be made between high and low conversion triggers.
A high
trigger (such as falling below a core capital ratio of 7%) means that
the bonds can be converted relatively quickly when a bank suffers
losses. Already, contingent capital with a high trigger and hence
CoCos too have a positive impact with rating agencies and on
ICAAP stress tests. On the other hand, a low trigger (e.g. falling
below a 5% core capital ratio) would result in conversion taking
place only in an "emergency; in that case CoCos would act as
insurance against hard times. This kind of instrument would appeal
more to institutional investors as it clearly targets exceptional crisis
situations and is thus easier to assess.
The trigger level can therefore also be used to help fine-tune the
purpose of CoCos: are these convertibles intended more as
catastrophe bonds providing capital insurance in systemic crises
(low trigger) or as a "continuous pre-emptive buffer in hard times
(high trigger)? There is another factor, too: the higher the trigger, the
more expensive the CoCo because from the investor's point of view
a higher trigger implies a greater conversion risk. Market interest
rates rise with the conversion risk. A low trigger, by contrast, would
have the merit of making conversion less likely, and the risk
premium for CoCos would therefore presumably be lower.

In this context a high trigger means that the threshold on which conversion is
contingent is reached relatively quickly, i.e. comparatively little needs to happen
before conversion becomes necessary. With a low trigger precisely the reverse
applies, with conversion not taking place until relatively late.
Contingent Convertibles
May 23, 2011 7
Leaving the decision on conversion
to regulators introduces uncertainty
into the default probability
Triggers could be based on:
book values / balance sheet values;
risk-weighted assets / capital ratios;
market prices / share prices.
Then there is also the possibility of combining different triggers. One
example is a dual trigger that must satisfy two conditions at the
same time, e.g. the institution's share price and an industry-wide
index. With a dual trigger, conversion would take place if the bank's
share price dropped below a certain level and simultaneously a
broad, bank-based index, for example, fell short of the pre-set
trigger. Essentially this dual trigger permits the recapitalisation of all
issuing banks during a crisis whilst also allowing individual financial
institutions to go bankrupt in "normal periods. Whether a trigger
linked to an industry-wide index makes sense for CoCos is
questionable in the context of the current debate since triggers of
this kind do not seem crucial to systemic stability. Indeed, it is far
more likely that even a trigger specific to an individual bank would
lead to all banks distressed by a crisis having to convert. What is
more, since CoCos are an institution-specific instrument the
decision to convert should also be taken individually.
n addition to triggers geared to a company's value or to the market,
it would also be possible to place the decision on conversion in the
hands of regulators. However, that harbours the danger for investors
of adding an element that is very difficult to assess to their analysis
of the probability of conversion risks materialising. It would
complicate assessment of precisely these conversion risks and
create additional volatility in the bond markets.

Trigger: simple and transparent
So which trigger is best suited to supporting the optimal functionality
of CoCos? Basically, the choice is between triggers based on
market values with the attendant downside that these are subject to
stochastic processes, and triggers based on balance sheet ratios
entailing the disadvantages of potential manipulation.
Whilst balance sheet ratios relate directly to the state of the
company, as a rule they are reported only quarterly rather than on
an on-going basis. Since this means that the firm's financial situation
becomes apparent only every three months, the trigger is likewise
updated quarterly. A special audit would be possible at any time, but
it would have to be conducted very quickly and independently.
Another crucial disadvantage of balance sheet figures is that they
always depend on the underlying accounting methods, which may
be exposed to political pressure and subject to arbitrage.
A trigger
based on book values thus always depends on the availability and
quality of the balance sheet information.
Another possibility would be to use the risk-weighted equity or
capital ratios. Again, risk-weighted assets are determined only at the
end of each quarter, but here too a special audit would always be
possible. This method would have the added advantage of making
conversion a more risk-appropriate event.
A third possibility would be to use market prices, e.g. in the form of
share prices. Bearing in mind that triggers should be as simple and
transparent as possible, share prices would have the edge
inasmuch as they can be followed and monitored regularly by

The US Shadow Financial Regulatory Committee (SFRC).
McDonald (2010), p.13.
EU Monitor 79
8 May 23, 2011
The danger with share price
manipulation lies in the artificial
generation of conversions
Share price volatility can negatively
impact a market-based trigger
investors as well as by the bank. The use of share prices also
means that recapitalisation is an event in conformity with the market
and not dependent on regulatory assessments. The downside,
however, is that share prices are subject to stock market volatility.
What is more, it would be possible to influence the conversion
trigger through stock price manipulation.

Possibilities to manipulate share prices could create incentives to
profit from the price movements generated by manipulation.
could be attractive for investors wishing to mount attacks on
companies, for instance. They could try to provoke an 'artificial'
conversion with the aim of profiting from the resultant dilution of the
share capital. If traders hold positions in market-triggered CoCos in
addition to stock positions, an arbitrageur could buy a contingent
convertible and short-sell shares in the institution to drive the price
down towards the trigger level, whereupon conversion would take
place. The arbitrageur would then benefit from the gain on the newly
converted shares once the stock recovered to its 'correct' level.
However, these manipulation possibilities can be avoided, or at least
contained, by setting ex ante the number of shares into which the
bond would convert. If the number of shares that investors receive
on conversion is fixed in advance it is not 'worth' influencing prices
in order to provoke conversion artificially.

As regards stock price volatility, the trigger could be negatively
affected if stock prices behave irrationally or collapse unexpectedly
for reasons unrelated to the situation of the company as happened
with the May 2010 "flash crash. n that instance, extreme stock
volatility might have led to the conversion of market-triggered CoCos
even though no crisis or deterioration in the market situation had
Weighing the pros and cons described above, triggers based on
risk-weighted equity or on capital ratios would appear to be the most
Setting the conversion rate: how to convert?
The conversion rate stipulated in the bond terms determines the
value and number of shares that investors receive for a correspond-
ing amount of bonds following conversion.
As with the trigger level, the value of the conversion rate can also
decide on the purpose of CoCos: For example, a conversion rate
below the nominal value of the bonds can help reduce the possibility
of manipulation, particularly if a market-based trigger is used.

Conversely, a conversion rate above par value could hold out a
greater incentive to the issuing bank to avoid conversion by taking
timely corrective action, as conversion would seriously dilute the
stock and upset the previous investors.
Another important positive

An added drawback is that no stock market quotations are available for non-listed
Bank of Japan Working Paper (2010).
The alternative would be conversion at a fixed sum of money. This would result in
a flexible number of shares, determined on conversion with reference to the
aforementioned cash sum. That might offer investors an incentive to drive down
the price in order to receive a larger quantity of stock in return for the same (fixed)
amount. Setting the quantity also corresponds to customary practice with
(previous) convertible bonds.
McDonald 2010, p.7.
A lower conversion rate limits the inherent danger of share price manipulation at
least partly since conversion of the CoCos takes place in such a way that it is not
worth bringing it about "artificially.
The US Shadow Financial Regulatory Committee (SFRC).
Contingent Convertibles
May 23, 2011 9
Conversion advisable at
par value at least
Potential and rationale for issuing
CoCos to employees
Rationale: In the course of discussion on the
difficulty of finding buyers for CoCos, attention
is increasingly focusing on banks' staff as
potential "investors, the idea being to issue
CoCos to employees as part of their variable
compensation. From a regulatory point of view
this would have the added positive side-effect
of coaxing staff incentive structures in the
desired direction since it would be in the
employees' interests to act with a sense of
risk awareness in the medium to long term as
well, in order to avoid conversion of the
bonds. The theoretical background for this is
the principal-agent-theory: the incentives to
the risk takers in the bank are aligned with
those of the bond creditors and not with
those of the shareholders, i.e. the stability of
the bank rather than its (short-term)
profitability determines the amount of
Potential: Whilst the proportion of staff entitled
to receive CoCos as part of their variable
compensation would probably account for a
fraction of the potential CoCo market, overall
it would be too small to represent large market
shares. Depending on the scenario, the
variable compensation could absorb roughly
10-25% of the potential CoCo market.
Problems could also arise with the practical
implementation of assigning CoCos to
employees as part of their variable pay
packages: Were compensation to revert to the
bank as the result of an employee (who would
in this case also be an investor) departing the
company prematurely as a "bad leaver (and
consequently also exiting the investment), the
bank would have to consolidate the trust and
take the CoCos onto its balance sheet. The
consequence would be a withdrawal from the
regulatory capital towards which the CoCos
would previously have at least partially
effect of a higher conversion rate would be to increase the attraction
for investors which could ultimately result in a lower risk premium.
Conversion at least at par value would therefore be advisable both
from the banks' point of view and from a regulatory perspective.
Besides the conversion rate and trigger, maturities also have to be
set for CoCos. These should accommodate the different investor
groups and their interests. According to the IIF, the most important
groups of investors expect maturities of between three and seven
years. However, CoCos could conceivably also become part of a
long-range financing structure with maturities of at least 30 years,
for example.
The Credit Suisse CoCo bonds successfully placed in
February 2011 featured a 30-year maturity. But it must be borne in
mind that such long maturities also imply a correspondingly long
commitment on the part of investors. At all events, it should be
possible in principle for a company to issue different CoCos with
different maturities and triggers.
Investor interest: An element of
Finding sufficient customers prepared to hold CoCos remains the
biggest problem. Institutional investors such as investment funds,
insurers, pension and provident funds, and other fixed income
investors or banks spring to mind as traditional bond purchasers. At
present, however, the way the instruments are designed is still
deterring these types of bond investor, not least because it is not yet
clear how the bonds will be treated for accounting purposes. If
CoCos had to be reported in future as shares (instead of as bonds)
many previous bond investors would be prevented by their
investment guidelines from purchasing them. Fixed income
investors in particular would have problems holding CoCos once
they were converted. And many institutional investors have been
barred thus far by their guidelines from including mandatory
convertible bonds in their portfolios. One instance is funds
specialising in subordinated debt hitherto the main clientele for
bonds. Their investment guidelines explicitly do not provide for
commitments in convertible instruments.
And in future insurers are likely to rethink their investments in bonds
anyway, especially in the context of Solvency II requirements, with
the new rules making it more difficult and expensive for them to
invest in instruments such as CoCos, lower Tier II bonds or senior
bank bonds.

Ultimately, though, participation by traditional bond investors, most
importantly investors in fixed income, will be vital to create a
sufficiently large potential market for CoCos to tap. Another decisive
factor will be whether traditional bond investors with a low to
medium appetite for risk, such as pension funds for instance, will be
prepared to venture into riskier territory with CoCos.

von Furstenberg (2011), for one, is in favour of such long maturities.
Under Solvency II insurers must hold more capital than previously against stock
and bond investments, particularly against shares and corporate bonds.
EU Monitor 79
10 May 23, 2011
New target groups with higher
risk/return profile, such as hedge
funds, will emerge

To be included in bond indices,
CoCos must be rated
Alongside traditional bond investors, some of whom may not be in a
position to hold CoCos, new target groups with a higher risk/return
profile than investors in previous hybrids are also likely to emerge as
potential buyers of CoCos. These include hedge funds or high-net-
worth individuals utilising CoCos to diversify their portfolios, and
similarly the expanding market for responsible investments.

All told therefore, CoCos have three potential customer groups:
traditional bond investors, hedge funds / high-net-worth individuals
and the banks' staff. This could give rise to an investor base that
would also permit the placement of CoCos on a larger scale. That
said, initially CoCos will not be able to tap the previous bond market
to the extent previously customary for subordinated bonds.
Rating agencies & bond indices: impact on marketability
For fixed income investors in particular, their ability to invest
depends partly on whether CoCos can be included in debt security
indices. But since contingent convertibles also contain equity-like
features, the jury is still out on whether they are admissible for
inclusion as debt securities in the leading bond indices. Until
clarification, index-based financial products are likewise still
Normally, eligibility for inclusion in bond indices is contingent on a
rating. The way that rating agencies treat CoCos is therefore an
important factor in marketability of the instruments. Difficulties could
arise with calculation of the conversion probability, changes in this,
and the issue of the extent to which these changes depend on
adjustments in the issuers' ratings.
Particularly for institutional
investors traditionally the main target group for fixed income bonds
rating is essential as they are (so far) permitted only to hold rated
Ratings could thus help improve the market eligibility of
CoCos for potential investors.
In principle altered risk constellations for CoCos make lower ratings
likely relative to conventional bank bonds. In late 2010 the ratings
agency Fitch announced that its ratings on hybrid capital securities
issued by banks in compliance with the proposals by the Basel
Committee would be notched from its existing unsupported Issuer
Default Rating (IDR) regime.
As a guideline Fitch quoted a

von Furstenberg (2011), p. 13.
At present there is a regulatory drive to improve the role of ratings.
The reason given was that capitalisation at the security loss or at capital
conversion is tantamount to a default, even if there is no de facto default. The
criterion applied: "Rating Hybrid Securities, December 29, 2009.

Equity Share
Risk / margin of fluctuation
Return and risk of corporate financing instruments
Source: Brsenzeitung 1
Contingent Convertibles
May 23, 2011 11
downgrading by at least three notches on the IDR, (Fitch, November
8, 2010).

Theoretical approaches: impact on marketability
A theoretical possibility to increase investors' interest in CoCos and
make it easier to place these instruments in the market would be to
set up special purpose vehicles that would take over the shares
after conversion.
Similar, in the sense that creditors of the original bonds would hold
the bonds but not the converted instruments, is the proposal to have
CoCos feature a buy-back option from the outset.
The option to
buy back the converted shares from the previous bondholders at the
conversion price would create a kind of subscription right for existing
shareholders. From the shareholders' point of view this implicit call
option can "reverse the dilution effect caused by conversion of the
bonds into stock and possible welfare transfers are neutralised. It
would have the positive side-effect of also reducing the risk for
providers of external funds. This risk reduction would make the
instruments more tradable, improve their market eligibility for fixed
income investors, and lower risk premiums. As a necessary
incentive for existing shareholders to exercise the call option,
however, the conversion price would have to be well below the
share price that activates the trigger. This incentive is given for at
least as long as the share price including all dilution effects is higher
than or equal to the conversion price, because non-repayment
would then lead to massive dilution for the existing shareholders and
to a welfare transfer from the shareholders to the providers of debt
But it is questionable just how realistic the implementation of such a
buy-back option is, because the existing shareholders' interest in
buying the converted debt, and their willingness to do so, depends
to a very large extent on how liquid and inclined to invest they are at
the time of conversion; most importantly, the existing shareholders
themselves could also be affected by the crisis. As a general rule,
the incentive structure underpinning the above reasoning will pre-
sumably apply only to financially strong institutions whose share-
holders assume that the faltering financial situation at the time of
conversion will ultimately see a return to profitability. Shareholders of
financially weaker banks, on the other hand, may lack the incentive
to acquire (more) shares at a time when the company's situation is
Underlying national law: restriction on marketability
Another factor, aside from investor interest, that may restrict CoCos'
marketability is the possibility of constraints resulting from relevant
national legislation. In Germany, for instance, national legislative
framework conditions could restrict the issuance of CoCos since the
German Joint Stock Corporation Act (AktG) limits stock issues ex-
rights which would be the case with CoCos to a maximum of 10
percent of the share capital. Moreover, the AktG makes it
compulsory to grant investors an option.
It is therefore vital to

By way of illustration, Fitch assigned a BBB+ rating to the CoCos issued in
February 2011 by Credit Suisse, four notches below Credit Suisse's DR.
Pennacchi et al. (2010).
With CoCos the option could be made feasible by integrating an out-of-the-money
call option, for example, in which the price of the underlying security (in this case
the CoCo) is below the strike price in other words, the price at which the
underlying security can be purchased.
EU Monitor 79
12 May 23, 2011
CoCo scenarios to help estimate the
size of the market
Taking the first steps
November 2009: The Lloyds Banking
Group floated Enhanced Capital Notes
(ECNs) in exchange for existing hybrid
bonds. The ECNs convert if the core
capital ratio drops below 5%. The
conversion rate was set ex ante based on
the observed share price. The ECNs have
the same priorities as conventional
supplementary Tier II capital and
maturities of between 10 and 15 years.
The premium on the hybrid bond coupon
is between 1.5% and 2.5%. When
assessing this markup, however, it must
be remembered that at the time of the
issue Lloyds was partly nationalised and
therefore not permitted to redeem any
bonds or pay interest. In these
circumstances the swap for ECNs offered
a key advantage in that ECNs carried a
higher coupon and, once converted into
ordinary shares, could be sold and turned
into cash. It is not therefore clear how
representative the coupon offered is.
March 2010: The Dutch Rabobank issued
Senior Contingent Notes (SCN). This type
of bond makes allowance for the
problematic feature of CoCos, which by
definition have only downside and no
upside potential. Unlike the Lloyds
exchange, Rabobank's SCN are a new
issue. Their core characteristic is that if
Rabobank's equity ratio falls below 7%
before the notes mature the par amount
and unpaid coupons will be written down
by 25% and the investors paid off in cash.
However, the SCN are not covered by the
Basel proposals and do not therefore
count towards regulatory capital. The
coupon was set at 6.875% and demand
was twice as high as planned. These
SCNs are an exceptional case inasmuch
as Rabobank is the only bank with AAA
rating, meaning that investors' appetite for
its debt is likely to be correspondingly
higher than for other banks.
A different type of bond featuring upside
potential in its reimbursement structure is
the step-down, step-up bond. The idea
behind it is similar to the SCN and has
been used by Barclays, among others.
Investors accept a haircut of as much as
30% if the bank's core capital ratio falls
below 7%. f the bank's performance
improves such that it is able to pay a
dividend again, a higher coupon rate is
possible. In September 2010 Intesa
SanPaolo floated a bond with similar
features. But in the present environment
this bond would not qualify as regulatory
capital either, since the Basel proposal
stipulates permanent partial assumption
of losses, which is not the case with step-
down, step-up bonds.
Sources: Reuters, Bank of Japan
observe the relevant corporate legislative framework when
implementing regulatory reforms into national law.
CoCo scenarios in Europe
Going forward, the mandatory convertible bond format could gain
ground as the hybrid capital utilised so far is no longer recognised
for regulatory purposes on the customary scale. In the long run
CoCos could replace the previous hybrid bonds. In the following we
therefore examine scenarios for the potential size of the CoCo bond
market. The intention is to get a feeling for roughly how large the
market could become, making it easier to assess the investor
demand needed.
Switzerland offers an example that could be used for this purpose.
There, a progressive capital component equivalent to 6% of the risk-
weighted assets has been set as an additional capital buffer,
consisting entirely of CoCos with a relatively low trigger. The
construction thus constitutes a basic insurance against hard times.
Further components of the Swiss capital requirements are a non-
risk-weighted leverage ratio and a loss-absorbing capital buffer of
8.5%. 5.5 percentage points of the 8.5% must be made available
from hard equity and up to a maximum of 3 percentage points may
consist of CoCos with a relatively high trigger. The systemically
important Swiss banks would thus each be faced with having to
assemble a share of up to 9% of their risk-weighted assets by
issuing CoCos to strengthen their equity base.
Since Switzerland is something of an exception owing to the size of
its banking sector relative to GDP
, in the model for Europe as a
whole it would seem plausible to factor in a maximum ratio of 6% of
risk-weighted assets (RWA). CoCos could then gradually make up a
part of this buffer. The scenarios considered in the following are
based on the following assumptions:
the calculations are based on the RWA forecasts taking Basel III
into account;
the 25 biggest banks in Europe must hold up to 6% of RWA in
addition to the new Basel III capital rules;
depending on the scenario, the share of CoCos in the additional
buffer equals 1.5, 3, 4.5 or 6 percentage points of the RWA;
CoCos pay interest of 9%.
On the basis of these assumptions the CoCo market could
ultimately grow to between EUR 138 bn (1.5% scenario) and
EUR 550 bn (6% scenario).
By way of comparison, the volume of
hybrid bonds in the current Tier I capital of the 20 largest banks in
Europe amounts to roughly EUR 150 bn. In this light, the more
conservative estimates of the potential CoCo market (1.5% and 3%
scenario) do not appear implausible. This does, however,
presuppose that investors will take up CoCos as readily as they
have so far hybrid bonds.
The first CoCo-like bonds have met with quite a good market
reception so far (see sidebar). Just how indicative these issues are
of the market as a whole is, however, open to question. One of the
banks involved, Lloyds from the UK, was partly nationalised at the
time of issue, as a result of which it was not allowed to redeem

The total assets of the two big banks UBS and Credit Suisse add up to a multiple
of Swiss GDP.
For detailed results see table on page 14.
Contingent Convertibles
May 23, 2011 13
Cost of equity capital vs. debt capital
As a rule the cost of debt is less than the cost
of equity. One reason for this is the tax bene-
fits with interest payments, which can act as a
powerful incentive to issue debt securities
rather than equity.
In Germany, for example, tax advantages
result because corporations can claim their
interest payments on debt capital as operating
expenses. Unlike dividend payments, interest
payments are not liable to corporation tax.
Issuing debt capital thus avoids one of the two
taxes that would be due when granting equity.
This effect is at least beneficial in cases where
interest and dividends are subject to the same
rate of income tax for the shareholder.
The same principle would be applied to
CoCos, but only if they were treated as debt
capital for tax purposes.
subordinated debt or pay interest.
The other example refers to
Rabobank, one of the "best-rated banks in Europe, meaning that
the underlying terms of the issue cannot be considered

Successful CoCo placement by Credit Suisse in February 2011
Credit Suisse's placement of CoCos in February 2011 shed some
light on the situation. Under the new Swiss capital regulations (see
above) CoCos were placed in the market in a comparable way for
the first time, as opposed to previous issues of bonds similar in
nature to CoCos. The CoCos featured a 30-year maturity, a coupon
of 7.875% and a trigger deemed to have been met if the core capital
ratio drops below 7%. Conversion may also be made if the national
supervisory authority is of the opinion that the bank would reach the
point of non-viability without such a swap. Fitch assigned the
instruments a BBB+ rating.
The successful Credit Suisse placement signals that CoCos do
realistically have the potential to be taken up by the market at an
acceptable price. Even so, it must be borne in mind that Credit
Suisse also benefited from having at its disposal strategic investors
and a network of high-net-worth individuals to whom it could sell the
CoCos. This leaves open the question of whether sufficient also
traditional bond investors would be available for the placement of
a substantial volume of such debt on acceptable terms for the
Factors impacting on pricing
If CoCos, like subordinated bonds so far, are to be used to
strengthen regulatory capital, it is relevant from a bank's perspective
whether they are more cost-efficient than equity. So basically the
cost of equity capital to the bank can be taken as the upper limit on
the cost of CoCos. Since contingent convertibles convert
automatically once the trigger is met and investors thus bear the risk
of becoming shareholders at an inconvenient time, it may be
assumed that CoCos will generally carry a higher coupon than
traditional bank bonds. From an investor perspective, on the other

At the time of issue, "in return for government aid being granted to the banks the
European Commission demanded the suspension of payment on coupons and
other discretionary payments on subordinated bonds and a waiver on exercising
call options on hybrid capital within a two-year period. By exchanging subordinated
bonds for CoCos that promised a fixed remaining maturity and the payment of
coupons it was thus possible to "get round the European Commission's
restrictions. Von Furstenberg (2011), p. 11ff.
























over 3 up to and including 4 years
over 4 up to and including 5 years
over 5 up to and including 6 years
over 6 up to and including 7 years
Interest rates head sharply
Current yields on German bearer debt
securities in %
Source: Deutsche Bundesbank
1.5% 3.0% 4.5% 6.0%
CoCos CoCos CoCos CoCos
CoCo scenarios in Europe
EUR bn
Source: DB Research
EU Monitor 79
14 May 23, 2011
hand, the crux lies in the risk/return constellation. Whilst the
relatively high risk premium demanded by the market for CoCos will
make the bonds an attractive option for investors, especially in the
present comparatively low interest rate environment (see chart 3),
issuing these instruments will be relatively expensive and thus
unattractive for the banks particularly those that view their own
financial future optimistically. The higher the CoCo coupon the
market requires, the closer the costs will approach those for
additional equity, in which case CoCos might not then be financially
worthwhile for their issuers.
With the placement of CoCos, and hence the likelihood of their
being successful and fit for purpose, depending on the issuer's
individual situation and capital structure, pricing must take different
factors into account the most central being the coupon rate.
Detailed results of the CoCo scenarios
EUR m*

RWA RWA forecast
CoCos CoCos CoCos CoCos

End-2010 under Basel III rules
1.5% 3.0% 4.5% 6.0%

BNP Paribas 601,000 685,483 10,282 20,564 30,847 41,129
Socit Generale 334,800 369,527 5,543 11,086 16,629 22,172
Credit Agricole 371,700 441,700 6,626 13,251 19,877 26,502
Natixis 148,000 181,900 2,729 5,457 8,186 10,914
Deutsche Bank 346,000 529,000 7,935 15,870 23,805 31,740
Commerzbank 268,000 279,017 4,185 8,371 12,556 16,741
Intesa SanPaolo 354,970 365,570 5,484 10,967 16,451 21,934
Unicredit 453,478 492,426 7,386 14,773 22,159 29,546
Nordic countries
DnB NOR 117,037 140,140 2,102 4,204 6,306 8,408
Danske 113,293 120,512 1,808 3,615 5,423 7,231
Nordea 214,760 236,240 3,544 7,087 10,631 14,174
Sv. Handelsbanken 59,174 78,285 1,174 2,349 3,523 4,697
SEB 79,633 82,758 1,241 2,483 3,724 4,966
BBVA 313,327 378,942 5,684 11,368 17,052 22,737
Banco Santander 604,885 699,005 10,485 20,970 31,455 41,940
Credit Suisse 173,474 261,756 3,926 7,853 11,779 15,705
UBS 157,748 265,722 3,986 7,972 11,957 15,943
Barclays 468,526 645,106 9,677 19,353 29,030 38,706
HSBC 840,155 1,018,393 15,276 30,552 45,828 61,104
Lloyds 478,381 484,121 7,262 14,524 21,785 29,047
RBS 544,573 648,166 9,722 19,445 29,167 38,890
Standard Chartered 135,202 162,434 2,437 4,873 7,310 9,746
ING 321,103 332,101 4,982 9,963 14,945 19,926
Dexia 140,834 122,858 1,843 3,686 5,529 7,371
KBC Group 132,000 151,000 2,265 4,530 6,795 9,060
7,772,052 9,172,162 137,582 275,165 412,748 550,330

* For national currencies other than EUR, exchange rate = 2010 average. Source: OANDA

Sources: Deutsche Bank, company data
Contingent Convertibles
May 23, 2011 15
All regulatory initiatives so far
include intervention by supervisory
One of the most important determinants of the coupon rate is the
trigger point and the conversion risk associated with it. The higher
the conversion risk, the higher the risk premium. In turn, the
conversion risk is influenced by the following factors:
The institution's business model and the attendant volatility in its
earnings: The higher the volatility, the greater the conversion
probability and, by corollary, the higher the risk premium on the
The Tier I capital: The lower the Tier I capital, the more likely
conversion is to occur and consequently the higher the risk
premium on the CoCos.
At present many European banks do not yet appear to have
formed sufficient core capital to provide CoCo investors with a
sufficiently comfortable buffer above the trigger level. In other
words, banks would first need to build up more core capital to
make a CoCo issue economically worthwhile. The situation is
compounded by the fact that the eligible (hard) core capital will
be reduced significantly due to the more stringent deductions
under Basel III than under Basel II.
The degree of probability that CoCos actually will be converted:
The many (new) discretionary intervention rights available to
national regulatory authorities, which can step in very early on
(e.g. if the regulator considers certain business models too risky),
could ultimately make it very unlikely that CoCos will be utilised
at all. nstead, CoCos would be a "theoretical construction, i.e.
the more convincing the supervisory prevention, the more
unlikely conversion becomes and the lower the risk premium on
the CoCos.
Pricing could also lead to spin-off effects on further areas of funding
costs. For instance, the successful placement of CoCos could have
positive implications for the costs of senior debt. The reduced
probability of insolvency resulting from the use of contingent
convertibles would also lessen the risk of default with the upshot
of lower rates of interest on senior debt.
Coupons of 8% to 9% expected
It is not yet clear how high the risk premium required by the market
for CoCos will ultimately be, and it will differ from bank to bank. At
present it is assumed that CoCos will pay coupons of between 8%
and 9%.
Regulatory approach: bail-ins
In response to the recent financial crisis, in recent months we have
seen the emergence of the first concrete regulatory initiatives
addressing alterations in lender liability. So far the initiatives all
contain a regulatory approach involving 'bail-ins', with (national)
supervisory authorities intervening in emergencies to rope bond-
holders into waiving claims. In a bail-in a company is e.g. refinanced
through a debt for equity swap.
These constructions are agree-
ments in which claims on a borrower are converted into shares in
the company. For the borrower it means a liability is converted into
equity, while the lender undertakes to repay part of the debt in
exchange. A bail-in could be a last-ditch option to stave off

An alternative would be a simple waiver of claims.
EU Monitor 79
16 May 23, 2011
A buffer for the buffer?
If CoCos are made mandatory as part of a
capital buffer by the regulator, it is important to
know what is to happen after they have been
converted. Were it compulsory to hold CoCos
as a buffer, the cushion would be "used up
once they had to be converted. Therefore,
rules would either have to be established in
advance on replenishment of the buffer,
specifying the time by which it must be
stocked up again after conversion, or the
banks would effectively have to hold a buffer
for the buffer in order to comply with the
(actual) buffer even when conversion had to
take place. Which of these two versions is
chosen is evidently also of relevance to the
size of the (potential) CoCo market.
insolvency, i.e. only after the company has exhausted all business
avenues. The long-range objective is to recapitalise the bank so that
it can be restructured and/or sold off.
Difference between CoCos and bail-ins
Bail-ins are in line with new intervention rights for financial market
regulators, with a supervisory authority deciding on the right time for
a haircut that would then affect all bondholders alike. No automatic
triggers are used. As a rule bail-ins are implemented in the course of
restructuring a company rather than as part of an early rescue
CoCos, on the other hand, are a novel type of convertible bond, an
innovative financial market product. They feature predetermined,
legally set, automatically triggered, observable and transparent
conversion terms and conditions, i.e. new bonds on fixed terms are
issued ex ante enabling the company to strengthen its capital base
ad hoc as the necessity arises. Only the CoCos would be affected in
the event of conversion.
Two factors are thus key to differentiation between bail-ins and
CoCos: the timing of and responsibility for the measure. CoCos are
an independent, ex ante precautionary measure, while bail-ins are
subject to a statutory process and constitute an ex post measure.
Bail-ins: Current regulatory initiatives
A European Commission Communication (EU COM 2010/579)
explores a resolution framework making it possible for the debt of a
credit institution in distress to be converted into equity in order to
restore the institution's equity base and thereby maintain the entity
(either temporarily or permanently) as a going concern.
In Germany bank bonds are already subject to new regulations.
Where a bank is in imminent danger of failure (and not just once it
has de facto already become non-viable), the German Bank
Restructuring Act (Bankenrestrukturierungsgesetz) that came into
force at the beginning of 2011 permits regulators to make bond-
holders share in the institution's losses by having them write off
claims. The 'Reorganisation Procedure' (Reorganisationsverfahren)
permits intervention in creditors' rights, e.g. by means of haircuts,
and in shareholders' rights, e.g. through the conversion of debt into
In January the Basel Committee set the minimum requirements that
debt instruments must in future meet in order to count towards
Additional Tier I and Tier II capital. These rules supplement the
Basel III capital and liquidity requirements finalised in December
2010. The new minimum requirements stipulate that in order still to
be recognised as regulatory capital hybrid capital, instruments must
share fully in absorbing a bank's losses at the point when the
institution becomes non-viable. This is to be implemented in the
form of a write-off or conversion at the behest of the regulator in the
relevant national jurisdiction. As the "trigger event for this, the Basel
Committee takes the point at which the bank would no longer be
viable without recourse to the hybrid capital. The Basel Committee's
timetable provides for the requirements to enter into force at the
beginning of 2013. This means that bonds issued on or after
January 1, 2013 must satisfy the new criteria in order to count
towards regulatory capital. Bonds issued before the appointed date
that do not comply with the requirements will be phased out over a
Contingent Convertibles
May 23, 2011 17
In the medium to long term the
market for bank bonds will undergo
major structural changes
Two types of CoCo could evolve in
the medium to long run
period of ten years in a portfolio approach by disallowing all non-
qualifying instruments in ten-percent stages.

Conclusion: Impact on the bond market
For banks, the bond market will undergo a structural sea change in
the coming years. Risks will alter, and with them the risk premiums
on the banks' subordinated bonds, as the provisions governing
default risks have to be adjusted. The new regulatory initiatives will
make the previous types of hybrid capital less important. Room
could be made for new types of bonds, such as CoCos. In the
medium to long term their loss-absorbing capacity would give
CoCos the potential to act as a substitute for the hybrid debt that
has counted towards the banks' regulatory Tier II capital so far. This
could give rise to a whole new generation of bank bonds which, in
turn, could at least partially be counted towards regulatory Tier I
capital. It is not clear at present what form the new-look bondholder
liability will ultimately assume. Regulation has an important part to
play here: Firstly, it can be seen as the driving force behind the
issue, at least partially; and secondly, targeted design of the
regulatory framework can help new instruments such as CoCos,
for example gain market credibility and acceptance.
It is right to make subordinated bondholders share the costs of
bailing out an institution. And ultimately it is essential that the banks
themselves should bear the brunt of relevant moves to stabilise the
financial system. It is however open to question whether the right
way to achieve this is by letting bank regulators alone decide when
a conversion-triggering event has occurred. From the perspective of
potential investors, placing the decision on conversion in the hands
of a supervisory body rather than leaving it up to market
mechanisms introduces a discretionary element into the probability
of default occurrence that is very difficult to assess. This is likely
further to complicate the calculation of risk premiums. And the Basel
Committee's decision to entrust regulators with the conversion right
will also hinder the placement of CoCos.
If only bonds that can be converted by order of the regulator count
towards regulatory core capital, there will be no CoCos featuring a
purely market-based or equity-oriented trigger. Instead, there will be
bank bonds that can be converted at any time the regulatory
authority deems necessary. This runs counter to the aim of more
risk-related bond valuation and can be expected to create un-
necessary volatility in the banks' funding.
If, on the other hand, scope is given to the creation of CoCos with a
market-based or equity-based trigger, over the medium to long term
two types of contingent convertibles could evolve to suit investors'
different interests. One type would be "going-concern CoCos with a
high trigger that kick in early enough to prevent a bank ever
reaching the point at which it can no longer operate as an
essentially viable business. CoCos with a high trigger would
presumably appeal to investors only if issued by stable banks. The
second type would be CoCos with a relatively low trigger that was
fairly unlikely to be met. But if the trigger were met, it would mean
that the bank had reached a point at which it could no longer
engage in normal business, in which case attention would focus on

This could conflict with existing EU law, as the amendment to the Capital
Requirements Directive (CRD II) that recently came into force contains ten-year
grandfathering provisions.
EU Monitor 79
18 May 23, 2011
preventing government funds having to be used to bail it out. CoCos
with a low trigger could be easier to issue as they would be geared
clearly to the default risk and would hence be more calculable. How-
ever, this would only be the case if the decision on conversion was a
transparent event that did not rest with the regulatory authorities
alone. Recent developments on the regulatory firmament do not
suggest that this aspect is receiving sufficient attention.
Given the still-prevalent uncertainty at present, all that should be
required by law is the issuance of instruments serving to absorb
losses. Definition of the terms and conditions should be left up to the
issuers themselves, because ultimately CoCos only ever make
sense when tailored to the issuers' individual situation, capital
structure and the national regulatory framework in which they
Meta Zhres (+49 69 910-31444,

Contingent Convertibles
May 23, 2011 19
Selected literature
Flannery, M. (2002). No Pain, No Gain? Effecting Market Discipline
via "Reverse Convertible Debentures. Working Paper.
November 2002.
Flannery, M. (2009). Stabilizing Large Financial Institutions with
Contingent Capital Certificates. Working Paper. October 2009.
IIF Working Group on Definition of Capital (2010). Straw Man
Industry Contingent Capital Considerations. May 2010.
Kamada, K. (2010). Understanding Contingent Capital. Bank of
Japan Working Paper Series, No. 10-E-9. October 2010.
McDonald, R. L. (2010). Contingent Capital with a Dual Price
Trigger. Working Paper. February 2010.
Pennacchi, G., T. Vermaelen and C.C.P. Wolff (2010). Contingent
Capital: The Case for COERCs. Insead Business School
Working Paper. August 2010.
Plosser, C. I. (2010). Convertible Securities and Bankruptcy
Reforms: Addressing Too Big to Fail and Reducing the Fragility
of the Financial System. Conference on the Squam Lake
Report: Fixing the Financial System. June 2010.
Sundaresan, S. and Z. Wang (2010). Design of Contingent Capital
with a Stock Price Trigger for Mandatory Conversion. Federal
Reserve Bank of New York. Staff Report No. 448. May 2010.
Squam Lake Working Group on Financial Regulation (2009). An
Expedited Resolution Mechanism for Distressed Financial
Firms: Regulatory Hybrid Securities. Working Paper. April 2009.
The US Shadow Financial Regulatory Committee (20010). The
Case for a Properly Structured Contingent Capital Requirement.
Statement No. 303. December 2010.
von Furstenberg, G. M. (2011). Contingent capital to strengthen the
private safety net for financial institutions: Cocos to the rescue?
Deutsche Bundesbank Discussion Paper, Series 2. Banking and
Financial Studies. No. 01/2011. January 2011.

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