How to make CoCos safer

Author: | Published: 11 Jul 2011

Contingent convertible bonds, or CoCos as they have become known, are a debt/equity hybrid instrument holding the promise of reducing the risks to the financial system posed by the failure of financial institutions, in particular systemically important financial institutions.

However, the way in which CoCos are structured can itself pose new risks which could undermine the CoCos efficacy and lead to unintended consequences for the firm which issues them.

The CoCo trigger

From a legal perspective, Cocos can be broadly described as a debt instrument issued by banks with the potential to either convert to equity or take a write down of principal should the bank face severe financial distress. They thereby provide an automatic mechanism for increasing the equity element of the balance sheet and reducing the debt element in times of stress.

Considering CoCo variations along the spectrum of financial stress faced before they are triggered, there...