How Do CoCo Bonds Impact a Bank's Shareholder Wealth?

Abstract

Basel III has been agreed to strengthen banks’ capital. Raising additional capital in common equity is costly. Banks wonder whether capital can be raised less expensively. To this end, Contingent Convertible (CoCo) bonds have been designed to absorb banks’ losses in times of crisis. This paper examines the impact of Debt-to-Equity CoCo bonds on a bank’s capital structure. For the first time, leverage ratios based on non-risk-weighted-assets are used as equity conversion triggers instead of capital ratios based on risk-weighted-assets. We find that CoCo bonds generally increase shareholder wealth by reducing their bankruptcy risk, except when the dilution effect offsets this positive effect. We also highlight the importance of defining different parameters properly when designing CoCo bonds. When these parameters are appropriately chosen, CoCo bonds are able to fulfill their function as “going-concern” capital, while bank shareholders are capable of reconciling their financial interests with the regulators’ risk prevention objectives.