Contingent Convertible Bonds and the Stability of Bank Funding: The Case of Partial Writedown

Abstract

This paper adds to the growing body of literature on the design of Contingent Convertible Bonds (CoCos). We discuss how the design of the loss absorption mechanism affects the stability of bank funding and distinguish between Conversion-to-Equity (CE) CoCos, Principal WriteDown (PWD) CoCos with a full writedown feature and PWD CoCos with a partial writedown feature. As we show, the first two loss absorption mechanisms unambiguously improve a bank’s stability of funding position. By contrast, the latter type of loss absorption mechanism can increase solvency risk and, moreover, is identified as a source of uncertainty regarding a bank’s ex post solvency position. Bank managers, investors as well as supervisors and regulators should be aware of these potentially destabilizing effects. In this context, one important aspect is the regulatory treatment of PWD CoCos with a partial writedown feature.