Abstract
In times of financial distress, banks struggle to source additional capital from reluctant private investors. Sovereign bailouts prevent disruptive insolvencies, but distort bank incentives. Contingent convertible capital instruments (CoCos) – securities which possess a loss-absorbing mechanism in situations where the capital of the issuing bank reaches a level lower than a predefined level – offer a potential solution. Although gaining in popularity in developed economies, CoCo issuance in Africa is still in its infancy, possibly due to pricing complexity and ambiguity about conversion triggers. In this paper, the pricing of these instruments is investigated and the influence of local conditions (using data from three major African markets and an all- African index) on CoCo prices is explored. We find that the African milieu (high interest rates and equity volatility compared with the situation in developed markets) makes CoCos particularly attractive instruments for the simultaneous reduction of debt and the enhancement of capital. If CoCo issuance becomes a viable bank recapitalisation tool in Africa, these details will be valuable to future investors and issuers.
Highlights
The financial crisis that caused large-scale disruption in global financial markets in late 2007 had its origins in the asset-price bubble, which contained new types of financial instruments that masked risk (Baily, Litan & Johnson, 2008)
The issuance of Contingent convertible (CoCo) has been popular in developed economies, with banks in the United Kingdom (UK), the United States (US) and the Eurozone enjoying some success in issuing these securities
The same is evident in the Egyptian data where the probability that the CoCo trigger is breached at a share price of R34 is close to 0 per cent when volatility is 10 per cent and increases to 60 per cent when volatility is 30 per cent for the same share price
Summary
The financial crisis that caused large-scale disruption in global financial markets in late 2007 had its origins in the asset-price bubble ( the American house-price bubble), which contained new types of financial instruments that masked risk (Baily, Litan & Johnson, 2008). CoCo instruments have been designed and implemented in developed economies to accomplish this, with their inherent risk-mitigation properties helping banks to absorb losses in times of financial distress. CoCo instruments are lossabsorbing debt instruments issued as bonds which convert into equity when a predetermined “credit event” occurs Despite their ever-increasing popularity in developed economies, the African market for CoCos remains in its infancy (KPMG, 2013). The issuance of CoCos has been popular in developed economies, with banks in the United Kingdom (UK), the United States (US) and the Eurozone enjoying some success in issuing these securities. As a result, these products have gained in popularity in the developed world.
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