Do CoCos serve the goals of macroprudential supervisors or bank managers?

Abstract

Using a hand-collected, comprehensive sample of contingent capital bonds (CoCos) issued by banks over the 2009–2019 period, we identify shifts in CoCo design features that nullify their putative salutary macroprudential benefits. Increasingly, CoCos are issued without punitive wealth transfers from shareholders to bondholders, thereby removing incentives for bank managers to take preemptive, risk-reducing action in order to prevent the CoCo from triggering. That is, CoCos are overwhelmingly issued with conversion ratios of zero (principal writedowns) that do not mitigate bank risk taking. Further, CoCo issuance can be used to circumvent supervisory discretion over bonus and dividend payouts. That is, CoCos issued as Additional Tier 1 capital relax regulatory constraints, particularly for banks close to the Maximum Distributable Amount (MDA) threshold. Bank managers are aware of these loopholes and exploit them to the detriment of financial market stability and macroprudential objectives.