How do CoCo bonds impact a bank’s shareholder wealth?
Keywords:Banks’ regulatory capital requirement, Basel III, Contingent Convertible (CoCo) bonds, Shareholder wealth, Option pricing, Barrier options
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. Faced
with this problem, banks and regulators 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. Might CoCo securities be an effective prevention and/or rescue solution? This article 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 (NRWA) are used as equity conversion triggers instead of
traditional capital ratios based on risk-weighted-assets (RWA). We find that CoCo
bonds generally increase shareholder wealth by reducing their bankruptcy risk, except when the dilution effect offsets this positive effect. By boosting banks’ capacity
to absorb losses while giving regulators more time to find a rescue solution, CoCo
bonds strengthen financial stability. We also highlight the importance of defining
different variables and parameters properly when designing CoCo bonds. When
these variables and parameters are appropriately chosen, CoCo bonds are able to
fulfil their function as “going-concern” capital, while bank shareholders are capable
of maximizing their wealth.