By Martien Lubberink*
The Bank for International Settlements has just published an interesting report on CoCos.
I hear you say “CoCos, isn’t that the simple, neighbourhood restaurant serving homestyle Italian food on Karangahape Road?” Or that high end designer boutique situated in the heart of Wellington?
Nope, CoCos, in banking, are contingent convertible capital securities. These are risky securities that “absorb losses” when a bank gets in trouble. Absorbing losses means that the holder of a CoCo runs the risk of losing her entire investment in these securities. Sometimes CoCos are sold to retail investors as if they are safe saving products, see the nice picture below:
Unfortunately, CoCos are not at all safe and should not end up in the hands of retail investors, let alone young kids. (Note the sign on the desk that says: “School Savings Bank, Branch No. 1” - How wicked is that!)
Our Reserve Bank apparently sides with the retail investors: its second capital review paper informs us about the badness of CoCos. Unfortunately, that review paper is biased. So much so, that I decided to submit seven pages of comments on RBNZ’s plans to liberate New Zealand from the cacodemonic CoCos.
With strong opinions on CoCos, the question that needs to be answered is “how bad actually are CoCos?” The recent report of the Bank for International Settlements answers that question. And the answer is nuanced and positive. One finding in particular stands out: “issuing CoCos causes the issuers' CDS spreads to decline."
"This indicates that CoCos reduce banks' credit risk and lower their funding costs. This is especially true for CoCos that convert into equity or have mechanical triggers.”
And this one: “All in all, we find that CoCo issuance has generally contributed to reducing bank fragility.”
To me this reads as: RBNZ, choose your CoCo battles wisely.
(NZ banks have issued CoCo-type securities. There's more detail here).
*Martien Lubberink is an Associate Professor at the School of Accounting and Commercial Law at Victoria University. He previously worked for the central bank of the Netherlands where he contributed to the development of new regulatory capital standards and regulatory capital disclosure standards for banks worldwide including Europe (Basel III and CRD IV respectively).