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are redesigning the international framework for bank capital from the ground up updating and upgrading nearly every aspect of the old regime. We already have higher capital ratios and more buffer categories, as well as tougher rules for risk-weighted assets and tighter standards on what counts as capital. The work continues on July 19, the Basel Committee on Banking Supervision launched a new consultation paper on extra capital buffers for global systemically important banks (G-Sibs), which include detailed comments on both the design and role of contingent convertible securities, or CoCos. After a positive start, recent regulatory statements on CoCos have been more cautious. In its July consultation, the Basel Committee supported CoCos for national super-equivalence, such as the Swiss Finish, which uses contingent capital to such an extent that it has attributes of an effective resolution regime, as well as a strong capital regime. According to the fourth Captital Requirements Directive (CRD IV) the European Commissions proposed text implementing Basel III, published on July 20 CoCos will also be used for additional Tier I and Tier II capital in Europe, which are substantial capital buckets. But the Basel Committee also rejected CoCos for use in the G-Sib surcharge. Instead, it proposed the surcharge should be composed entirely of common equity, and expressed concerns over the untested nature of CoCos. Some commentators have seen this as the death knell for a once-promising capital market, but we believe that view is misguided. The fundamental economic attractions of CoCos remain compelling low-cost, high-quality capital in potentially significant size and will give them staying power while the regulatory debate continues. But we expect the driver of growth to come increasingly from a different area: bank resolution reform. The Financial Stability Board (FSB) also issued a paper on July 19 that strongly advocates bail-in, an approach to resolution that avoids sovereign bail-outs by shifting the burden to private investors. In a bail-in, bondholders can have part of their holdings converted to equity to stave off a disorderly bankruptcy. We believe bond investors will respond to these changes by seeking stronger levels of private capital including CoCos to protect themselves. In other words, investor pull could replace regulatory push as capital providers begin to seriously examine the implications of the new regime.
Contingent capital role and structure

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Wilson Ervin, Credit Suisse

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CoCos are debt instruments that convert into equity if a trigger is breached, providing extra loss-absorbing capital in stress situations (see figure 1). The recent Basel document set out some key requirements in a straw man structure that can be used as a baseline to consider the pros and cons of CoCos: the trigger should be 7% common equity Tier I (or higher). It should also include a non-viability failsafe (to ensure conversion where the Tier I ratio is fine, but the institution is nevertheless unable to survive); loss absorption should be provided by either permanent write-off or conversion to shares, with all necessary authorities to be fully maintained by the issuer. There should be a cap on potential shares issued (to avoid a death spiral). CoCos operate by contract before there is a need for regulators to seize control of an institution and initiate resolution. In this way, CoCos are different from a bail-in, which is a resolution tool based on a statutory power. Both bail-ins and CoCos use debt-for-equity conversion to recapitalise a bank quickly without taxpayer funds, but they operate under different authorities and at different points in time.

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After initially embracing CoCos, regulators ardour seems to have cooled with some banks fearing excess caution could limit a promising source of bank capital. But even without a further supervisory push, investor demand for bail-in protection can make CoCos a hit, argues Wilson Ervin

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A new pull for CoCos

Are CoCos high-quality capital?

For regulators and senior creditors, the critical debate on CoCos boils down to the question of their loss-absorbency and reliability in a crisis. We believe a well-structured bank capital regime consisting of both CoCos and common equity would provide equal or greater capital strength than a homogeneous regime consisting of an equivalent amount of common equity. Figure 2 outlines why CoCos might be considered weaker, equal to, or stronger than equity as a form of reliable, highquality capital. The first category equal covers the primary attributes of CoCos. The proceeds are in the bank, and dont have to be paid back if a distress trigger is breached. CoCos can turn into equity without instigating any gone-concern problems that caused such panic in the crisis (put simply, they convert into equity while the institution is viable, avoiding a bankruptcy process). Conversion into equity occurs with certainty in the three critical endgame stress scenarios low capitalisation, a non-viability determination, and in the case of state aid. Because holders of CoCos know the instruments will convert in all these downside scenarios, they will be seen as loss-absorbing by market participants today, in the same way as equity. The two other columns stronger and weaker are where the debate on CoCos has been waged. In the weaker column, there are two legitimate but minor issues: first, higher coupons, which can drain some resources if conversion occurs late in a slow crisis; and, second, rollover risk, which can make CoCos less effective near maturity. The third topic market capacity was a large initial concern for many, but

2 Contingent capital versus common equity

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1. Higher coupon could drain 510% of capital before conversion 2. Rollover risk: dated host CoCos have less capacity at maturity 3. Market capacity: is it enough? 4. Signalling: adverse signalling effects could arise from conversion

Contingent capital is also fundamentally different from the old generation of hybrid capital instruments. These have been rightly criticised for their poor loss-absorption in the recent crisis, which was hampered by design flaws such as dividend pusher clauses, step-up calls and other issues. The new Basel III rules disallow such features, and require all Tier I and Tier II capital to absorb loss at the point of non-viability. We see contingent capital as a strong and relatively simple instrument that learns from the hybrid episode, and addresses these issues comprehensively and clearly.

1 How CoCos work

Contingent capital: in most scenarios, it makes regular debt payments. In the event of extreme stress (bank hits the trigger) it converts to equity Each year ~8% coupon State of bank 1. Normal Final value Par

2. Stress (trigger event)

Cost-effective, going-concern capital

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1. Funds are in the bank 2. Absorbs loss as going concern 3. Conversion in all three critical endgames: a. CET1 % < 7% b. non-viability, or c. state aid 4. Given 13 are correct, CoCos will be seen as loss-absorbing now

we feel it has been removed by market developments and recent experience, such as the heavy demand for the Credit Suisse CoCo issue in February, which was more than 10 times oversubscribed. The fourth item relates to negative market signals and possible feedback loops more colourfully dubbed death spirals and is probably the most widely publicised concern. CoCo critics have hypothesised a range of different adverse signalling effects. Lets analyse each in the context of highly distressed bank: Adverse news: The trigger event itself might be seen as alarming new information about the issuer. CoCos are indeed triggered by bad news such as a decline in capital or non-viability but they are not the cause of that news. This information would need to be disclosed regardless, even in an all-equity structure, so there is no additional impact from CoCos. Manipulation risk: Certain hypothetical structures (notably those with uncapped share issuance or a market value trigger) could be subject to manipulative attack.

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Investors could sell equity to depress the market price and thereby capture more shares on conversion, possibly starting an adverse feedback loop. These problems are tackled directly by current real-world structures through measures such as a cap on potential shares, and avoiding market value triggers with short averaging periods. Counterparty behaviour: CoCo holders might sell equity as a rough hedge, driving the price down, leading to counterparty flight and triggering a repeat of the 2008 panic cycle. Accurate hedging of a CoCo through short selling is somewhat difficult, because the triggers are not purely price-related like traditional options. Its reasonable to suppose that some lesser amount of selling may still occur, but it is unlikely to sow counterparty panic when the cause is known and where the event itself leads to better capitalisation. Similar short selling can materialise from debt-holders and around rights offerings and typically doesnt lead to great concern. Indeed, CoCos should be less risky than rights issues in this respect, as they are pre-

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Equity (via conversion or write-down) Stronger 1. Crisis incentives: management will be incentivised to raise capital earlier 2. Risk incentives: management will moderate risk to avoid nearing trigger 3. Market discipline: CoCo prices will provide useful information & discipline effects risk.net/risk-magazine

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The presence of a layer of CoCos in the capital structure will encourage management to be more active, and recapitalise early in times of stress
point is a legitimate concern, to which well return. Now lets consider the advantages of CoCos relative to common equity. The presence of a layer of CoCos in the capital structure will encourage management to be more active, and recapitalise early in times of stress. This would have had a major impact in the last crisis, even if it merely reduced dividends and buybacks somewhat earlier. Second, we believe most management teams will adopt strategies that constrain risk and leverage in good times to levels that are unlikely to trip the CoCo trigger. Finally, CoCo trading levels would also provide useful market information to management and regulators offering them clear information about tail risk and enhancing the power of market discipline.

Assessing the arguments

We believe the arguments for equality with common equity cover the most important issues the funding is received now, and conversion will occur in the key situations where extra loss capacity and early recapitalisation are required. We believe participants will therefore see CoCos as loss absorbing today. The most serious drawback is one subset of the death spiral argument that conversion can reveal strategic weakness if a CoCo triggers. We believe this concern is more than offset by the benefit of incentivisation, or motivation for early capital raising. In fact, these issues are really two sides of the same coin the incentive for managers to act rests significantly on the

institution would automatically rebound to a 10% ratio. That figure is measured in Basel III terms and would equate to perhaps a 15% Tier I ratio under Basel II calculations, given the tougher measurement standards in the new regime. That level of capital is considerably higher than any major bank pre-crisis, and surely not a cue for a run on the bank. Further assurance for regulators and investors but also for the banks counterparties could come from additional layers of downside protection in the event the CoCo conversion was insufficient to restore the firm to health. One approach would be to have a second layer of lower-strike CoCos (as in the Swiss system) that would assure counterparties additional ammunition remained in reserve. An alternative way to achieve a similar benefit would be to establish a well-designed going-concern resolution that protects key counterparties, such as that recommended in the recent FSB release. This would provide additional assurance to counterparties that a run is not rational, even in the event of further deterioration, thereby changing the dynamics of 2008, where counterparty panic was unfortunately an all-too-rational reaction.

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Other concerns: effectiveness in a systemic crisis

Some observers agree contingent capital would work for an individual bank under stress, but question how it would operate if a crisis hit multiple institutions at the same time. We think contingent capital can work effectively for both a singlebank and a systemic crisis.

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placed, pre-approved and pre-funded. Strategic circumstances: In our view, the most serious signalling issue is the fact that a conversion reveals strategic weakness. Management will generally want to avoid CoCo dilution, so if conversion occurs, the market will know they did not have the means to forestall the event. They didnt have a merger partner, a major equity investor or divestiture strategy that could provide a better outcome. While we believe most of the death spiral arguments are largely groundless for current CoCos, this last

dilution and signalling costs that occur in the event of failure. We would argue that supervisors should welcome this trade-off on a net basis that stronger incentives for early capital raisings help strengthen the system overall. Two other elements can help tilt this balance further towards a positive result. One is to make the CoCo layer fairly thick, so the amount of pro forma capital is significant and market-calming. If a bank had a 3% layer of high-trigger CoCos that converted at the 7% Tier I threshold, investors would know the

First and foremost, it would support the capital of each institution. If a group of banks dipped below a Tier I trigger or became non-viable due to serious capital or liquidity problems the CoCo layer would trigger automatically. This essentially constitutes a large-scale pre-placed rights issue for the weaker banks in the system. Second, it would strengthen the capital of a banks trading counterparties, which was a key source of concern in the 2008 crisis (and was sometimes caricatured as Im not worried about you Im worried about your counterparties). Third, as mentioned, the existence of a CoCo layer would incentivise a banks management to conserve capital and undertake early rights issues. For example, the US Troubled Assets Relief Program (Tarp) supplied the top 20 banks with around $200 billion of government capital, as part of the effort to stabilise the US banking system. Over a period of a few years, a CoCo layer of equal magnitude could be established, providing a pre-placed, privately funded version of Tarp, while eliminating the need to involve the government. Even if additional, extraordinary measures were ultimately needed, the CoCo layer would reduce the dollar-for-dollar cost of such a decision just like common equity.

Other concerns: market depth

The Credit Suisse buffer capital notes issued earlier this year provided a chance to test market depth for CoCos in the real world. Our transaction meets the requirements of the Basel Committees straw man structure, and incorporates limited regulatory discretion (over non-viability) that some observers worried would disrupt demand. It attracted interest from a broad cross-section of investors and regions and as noted above was more than 10 times oversubscribed (see table A). CoCos will not be suitable for all investors and all banks, but we believe they can be cost-effective for many institutions, both large and small. They can open up a huge source of additional capital by accessing a different investor base more fixed income and convertible in nature. We are convinced a healthy, risk-aware and deep market is there to support new issues.
Push and pull: where CoCos are heading

Where do CoCos fit in the world of regulation? At present, only common equity can be used for minimum capital,

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A. Overview of recently issued CoCos

issuer instrument Host bond ranking issue size Coupon Maturity Trigger Lloyds LT2 enhanced capital notes (ECNs) Subordinated Total of $13.7 billion 6.38516.125% 1022 years Core Tier I < 5% Converts into fixed number of shares (currently at a discount to par) 65.4135.6% 8.911.2% Issued via forced exchange in 2008 Rabobank Senior contingent notes (SCNs) Senior 1.25 billion 6.875% 10 years Equity capital < 7% Rabobank Tier I perpetual capital securities Deeply subordinated $2 billion 8.375% Perpetual NC5 Equity capital < 8% Credit Suisse Tier II buffer capital notes (BCNs) Subordinated $2 billion 7.875% Bank of Cyprus Convertible enhanced capital securities (CECS) Deeply subordinated 890 million 6.5% Perpetual NC5 Core Tier I < 5% Total capital < min Non-viability

Outcome post-contingency Current price Trading yield Comments

75% principal write-off; immediate repayment of 25% 100% 6.9%

Principal write-off pro rata with membership certificates 107.8% 6.5%

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102.1% 7.4%

Converts into shares at prevailing market price (min $20)

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AAA mutual bank with no public shares

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30 years NC5,5 Core Tier I < 7% Non-viability Also $6 billion Tier I CoCo (private issues)

Converts into shares at 80% of prevailing market (min 1) Not traded Not traded Holders can convert if share price > 3.3

AAA mutual bank with no public shares

Source: Offering Circulars/Bloomberg as of July 26, 2011

the capital conservation buffer, and the G-Sib surcharge although the Basel Committee indicated the issue is under continued review. However there is explicit support for using CoCos in national super-equivalent regimes and, in addition, other Tier I and Tier II capital will need to have CoCo features in many jurisdictions. For example, under CRD IV, additional Tier I instruments in Europe would be required to write down or convert into equity if an issuers common equity Tier I ratio is below 5.125%. These requirements will support the development of the CoCo market. As mentioned, however, we believe market incentives have the potential to overtake regulation as the main driver of issuance. In the old world, creditors often looked first to the sovereign support framework as the foundation of the investment decision. This assumption is being uprooted by efforts to avoid government bail-outs and find a workable private approach to bank resolution that is credible even for large institutions. The concept of bail-in is one that many investors increasingly recognise and anticipate. We believe senior unsecured creditors will get comfortable with these new risks, providing the new resolution regimes are well designed. However, these investors are likely to become increasingly sensitive to the amount of going-concern, loss-absorbing capital protecting them from bail-in risk, or from major losses if a bail-in is imposed. We believe they will look to CoCos as a tool that can provide an important layer

of protection. We also think CoCos are likely to be seen as stronger than alternative capital instruments such as preferred stock or subordinated debt that can only help in resolution, not by helping to avoid resolution. The FSB noted this view in its recent consultation: The existence of statutory bail-in within resolution tools does not prevent firms from issuing instruments that write-off or convert contractually, nor do they prevent national authorities

and economic expansion. Contingent capital can help reconcile these tensions by accessing a different and deep investor base, creating strong, effective goingconcern capital more quickly and at a lower cost. Regulators are understandably cautious. But while CoCos are unproven, they are also not particularly complicated a proper understanding is well within the realm of careful analysis. The industry and regulators should work together to

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Conclusion

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We think CoCos are likely to be seen as stronger than alternative capital instruments such as preferred stock or subordinated debt
resolve any remaining concerns given the potential upside. At the same time, we believe the development of credible bail-in resolution regimes will create a powerful new market-orientated pull for banks to issue CoCos, beyond regulatory requirements. In some ways, creating a practical means for large banks to succeed or fail based on their own choices while avoiding the systemic fallout that could force sovereign intervention could be the smartest long-term approach to capital regulation. We believe this will spur the development of reliable, efficient and well-considered capital tools, and be a growing driver of the CoCo market.
Wilson Ervin is senior adviser to the chief executive of Credit Suisse

from requiring them. It may create incentives for firms to issue such contractual instruments which might reinforce the capacity of firms to recover from distress without going into resolution. Market pricing for CoCos and senior unsecured securities will ultimately determine the most cost-efficient capital/ funding mix. But we may be switching to a regime where bank capital ratios are determined more by investor pressures than by regulatory minimums. Around the world, regulators are demanding banks address the mistakes of the last cycle and build stronger capital bases. The sums involved are huge, putting pressure on capital markets, as well as on credit availability

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