How do CoCo bonds impact a bank’s shareholder wealth?

Abstract

The 2008 crisis highlighted the fragility of the banking system. To address this deficiency, the Basel committee agreed on the Basel III Accord to strengthen banks’ capital requirements. However, raising additional common equity funds is costly. Facedwith this problem, banks and regulators wonder whether capital can be raised lessexpensively. To this end, Contingent Convertible (CoCo) bonds have been designedto absorb banks’ losses in times of crisis. Might CoCo securities be an effective prevention and/or rescue solution? This article examines the impact of Debt-to-EquityCoCo bonds on a bank’s capital structure. For the first time, leverage ratios based onnon-risk-weighted-assets (NRWA) are used as equity conversion triggers instead oftraditional capital ratios based on risk-weighted-assets (RWA). We find that CoCobonds generally increase shareholder wealth by reducing their bankruptcy risk, except when the dilution effect offsets this positive effect. By boosting banks’ capacityto absorb losses while giving regulators more time to find a rescue solution, CoCobonds strengthen financial stability. We also highlight the importance of definingdifferent variables and parameters properly when designing CoCo bonds. Whenthese variables and parameters are appropriately chosen, CoCo bonds are able tofulfil their function as “going-concern” capital, while bank shareholders are capableof maximizing their wealth.