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Julian D. A. Wiseman
Abstract: mandatorily converting a randomly-chosen 4% of CoCos each year would compel investors to believe that conversion can happen, and give them experience of it happening.
Publication history: only at www.jdawiseman.com/papers/finmkts/20110304_coco.html. Usual disclaimer and copyright terms apply.
Contents: Introduction; Adding randomness; Avoiding avoidance (Hedging); Transitional arrangements; Random decisions; Conclusion.
The first quotation is taken from Remarks by Paul Tucker, who is the Bank of England’s Deputy Governor for Financial Stability. The remarks were made as part of a discussion of Lord Turner’s Lecture, “Reforming finance: are we being radical enough?” at the Clare Distinguished Lecture in Economics, Cambridge, given on 18th February 2011. On the subject of bank capital Paul Tucker says:
First best would be equity. Indeed, Adair has argued this evening that ideally Basel 3 would have set a higher equity requirement. But that did not happen. In practice, we are going to have to be open-minded, but also principled, about quasi-equity instruments contributing to GLAC [Greater Loss Absorbing Capacity] for SIFIs [Systemically Important Financial Institutions] …. Currently, the leading candidate is so-called Contingent Capital bonds (CoCos), which convert from debt into equity in certain states of the world. It seems to me that to serve the purpose of GLAC for large and complex firms, such instruments would need to convert when a firm was still fundamentally sound, which is to say that they should have high capital triggers. For a large and complex firm, a low capital trigger would be dangerous, as funders and counterparties would be likely to flee before reaching the point at which the firm would be recapitalised through the CoCos’ conversion.
Moreover, high-trigger CoCos would presumably get converted not infrequently which, in terms of reducing myopia in capital markets, would have the merit of reminding holders and issuers about risks in banking.
The next quotation comes from an interview of Oswald Grübel, chief executive of UBS, published in the Financial Times on 2nd March 2011:
Mr Grübel was even more outspoken about the innovative bonds – contingent convertibles, or cocos – backed by regulators, particularly in Switzerland, which he described as “a very dangerous instrument”. Cocos work by converting from debt into equity if a bank’s capital ratios fall to a pre-assigned level and are supposed to make a bank safer.
But unlike Credit Suisse, which recently launched a successful $2bn coco issue, UBS has been highly sceptical. “As soon as you get near these trigger levels – you don’t have to hit them – what do you think shareholders will do?” he said. “They will get the hell out of that stock, so fast, because you know it will halve in value if it’s triggered.”
CoCos: BoE Deputy Governor Paul Tucker loves them; UBS Chief Executive Oswald Grübel hates them. Both are right, and both can be satisfied.
As Paul Tucker hints, because trouble happens rarely, when it happens, it is extra bad. So let us consider a new rule: each year some CoCos are chosen at random, whether the issuers be good or bad, and mandatorily converted. The “some” needs careful definition, but for the moment assume that it is 4% of CoCos per year. What would be the consequences of such a policy?
A large proportion of debt issued by financial entities is held by other financial entities. This gives a route for contagion that is very visible to regulators. For this reason many market participants don’t fully believe that the debts will be allowed to cease paying. Because of this (partial) lack of belief, financial entities do not make themselves fully robust against such accidents, which strengthens the incentive on regulators not to enforce the moral hazard penalty. The taxpayers write a huge cheque for fear of writing a still huger one. But if at least 4% of CoCos will convert every year, then it is really going to happen. Buyers know this, and buyers will have experience of the conversion mechanism. It is not implausibly scary; instead it is practiced, and almost ordinary, even if unwelcome.
Further, some investors sometimes believe that they would be able to act swiftly ahead of difficulties. They believe in their own talents. Making (at least some) conversions unambiguously random would force investors, even egotistical investors, to believe that this could happen to them.
This satisfies Paul Tucker’s “reminding holders and issuers about risks”. The zero-stigma ordinariness also neutralises Oswald Grübel’s “get the hell out of that stock”.
Of course the UK regulators can determine, for UK-regulated banks, what counts as capital. They can and should require that CoCos must be under the law of a UK jurisdiction, and can require that CoCos include language permitting such forced conversions, “as and when required by the FSA, which might be determined randomly”.
But issuers’ tricks would undermine the effect of carelessly written rules.
One possible trick is, rather than issuing a £1,000,000,000 security, to issue a million separate £1,000 securities. The law of large numbers then makes predictable the size of each holder’s mandatory conversion. Owners of a CoCo with a pre-fixed conversion ratio could hedge 4% equity one year forward, 7.8% two years forward, 11.5% three years forward, etc. This is not good: investors could still be thought vulnerable to a short-notice 100% conversion.
So the regulators should clump together each UK-regulated bank’s CoCo issuance into not more than a dozen sets, constructed so that each set holds similar CoCos. For each set, mandatory conversion then applies to the whole or to none.
Investors would respond, doubtless helped by the bank issuers. Each could hold a portfolio comprising an equal proportion of all UK CoCo issuance, knowing that ≈96% would survive each year. Hedging would be less precise than before, because there would still be uncertainty about how much of which banks’ shares an investor is about to own, but an approximate hedge could be constructed.
This is prevented with a change to the “4%”. Each year a proportion of UK banks’ CoCos are to be mandatorily converted. That proportion is itself random: a half-half chance of 8% or of zero. Investors really would have to be robust against unhedgable conversions.
The UK authorities should be extremely reluctant to undermine existing contracts. So there should be an exception for existing CoCos, which are not to be mandatorily converted. However, if existing CoCos are re-opened, then they cease to count as capital, and hence would never be reopened. (For a similar problem with re-openings, though in a different context, see EU5: outstanding debt, current instruments, 14th November 2010).
There is a real problem with random decisions: regulators’ prissiness.
This scheme work best if the randomness is really thought random. So on live television a senior FSA or BoE official is to toss a coin, with tails being 8% and heads being nothing. Some regulators might think that this would diminish their dignity.
Then, if the coin is tails, there would have to be a random selection of CoCo securities, or sets of CoCo securities. The obvious means of doing this would be to use equipment much like that used for the National Lottery. Again, difficulties with prissiness.
Solving this problem requires the relevant senior officials—Paul Tucker himself?!—just to do it, such that it becomes ordinary.
Random conversions would make them commonplace, and so compel CoCo investors to ensure their own robustness.
|— Julian D. A. Wiseman
4th March 2011