A contingent convertible bond (CoCo), also known as an enhanced capital note (ECN), [1] is a fixed-income instrument that is convertible into equity if a pre-specified trigger event occurs. [2] The concept of CoCo has been particularly discussed in the context of crisis management in the banking industry. [3] It has been also emerging as an alternative way for keeping solvency in the insurance industry.[ citation needed ]
The concept of "No Fault Default" was proposed by Professor Robert Merton in 1990 as a guarantee that gives holders "contractual right to seize the firm's assets (or its equity interest) whenever the value of assets is below the value of its guaranteed debt." [4] The specific idea of "Contingent Convertible Bonds" as an avoidance mechanism for financial distress was proposed by an Olin Fellow [5] at the Harvard Law School, and published in the Harvard Law Review in 1991. [6] These concepts may have served as inspiration to the instrument used during the 2007–2008 financial crisis.
A contingent convertible bond is defined by two elements: a trigger activation and a loss-absorption mechanism. The trigger activation is the pre-specified event that causes the loss-absorption process. It can be either based on a mechanical rule or on supervisors' discretion. The loss-absorption mechanism consists either of conversion into a pre-specified amount of equity or of writing-down the nominal value of the coco bond. [7] The trigger, which can be bank specific, systemic, or dual, has to be defined in a way ensuring automatic and inviolable conversion. [8] [9] A possibility of a dynamic sequence exists—conversion occurs at different pre-specified thresholds of the trigger event. [10] Since the trigger can be subject to accounting or market manipulation, a commonly used measure has been the market's measure of bank's solvency. [11] The design of the trigger and the conversion rate are critical in the instrument's effectiveness. [12]
Contingent convertible bonds can take a variety of different forms such as a standby loan, a catastrophe bond, a surplus note, or a call option enhanced reverse convertible. [13] [14]
Pricing contingent convertible bonds is challenging, especially because of several regulatory aspects that have to be taken into account. The relevant regulatory framework for CoCos is set out in the fourth European Capital Requirement Directive (CRD IV), the Capital Requirements Regulation (CRR) and the Bank Recovery and Resolution Directive (BRRD) regulatory accords. In empirical terms, the following variables have been shown to have an influence on the spreads of contingent convertibles (sign of the effect in parentheses): the bank's Tier 1 capital ratio (+), the issuing bank is a globally systemically important financial institution, i.e., a systemically important bank (G-SIB) (-), the issuer is headquartered in a Southern European country (+), having an equity-conversion vs. a permanent write down as loss-absorption mechanism (-), having a low-trigger vs. a high-trigger (-), the bank's credit default swap (CDS) spread (+), the bank's past stock returns (+), and the bank's stock-return volatility (+). [15] Further, with respect to regulatory variables, also the distance‐to‐maximum distributable amount (MDA)‐threshold has been shown to have a negative, economically relevant, and statistically significant influence on CoCo spreads. [16]
In the context of crisis management, contingent convertible bonds have been particularly acknowledged for their potential to prevent systematic collapse of important financial institutions. [17] If the conversion occurs promptly, a bankruptcy can be entirely prevented due to quick injection of capital which would be impossible to be obtained otherwise, either because of the market or the so-called recapitalization gridlock. [18] In addition, due to its debt nature, a contingent convertible bond constitutes a tax shield before conversion. Hence, as compared to common equity, the cost of capital and, consequently, the cost of maintaining a risk absorbing facility are lower. In case the trigger event occurs, conversion of debt into equity drives down company's leverage. [19] [20]
Also, contingent debt is said to have the potential to control the principal-agent problem in a two way manner—engaging both the shareholders and the managers. The greater market discipline and more stringent corporate governance are exercised as a result of shareholders’ direct risk of stock dilution in case conversion was triggered. An argument has been made that making managers’ bonuses in a form of contingent convertible debt instruments could reduce their behavior of excessive risk taking caused by their striving to provide investors with the desired return on equity. [21]
A critical benefit of contingent convertible debt that distinguishes it from other forms of risk absorbing debt is the effect of "going concern conversion". When the trigger is well chosen, automatic conversion reduces leverages precisely when the bank faces high incentives for risk shifting. Accordingly, this feature ensures a preventive effect on endogenous risk creation, unlike any other form of bank debt. [22] On the other hand, contingent capital in a form of convertible bonds remains a largely untested instrument causing fears as to its effects especially during periods of high market volatility and uncertainty. [23] The appropriate specification of the trigger and the conversion rate is critical to the instrument's effectiveness. Some argue that conversion could produce negative signaling effects leading to potential financial contagion and price manipulation. [24] Lastly, the instrument's marketability remains doubtful. [25]
When the acquisition of Credit Suisse by UBS was announced on 19 March 2023, Swiss regulator FINMA stated that CHF16 billion ($17 billion) of Credit Suisse additional tier one (AT1) bonds would be written down to zero. [26] Only AT1 bonds issued by the two Swiss banks allow for such in their terms; most such securities have more protections. [27] The Single Resolution Board, the European Banking Authority, and the ECB Banking Supervision to release a joint statement confirming that, under the EU resolution framework, AT1 instruments cannot be written down before the full use of CET instruments to absorb losses. [28] An expert from Swiss Lindemannlaw firm representing individuals and legal entities who sufferred damages from writing down of the Credit Suisse AT1 bonds, indicated they have a 5-year term (until 2028) to initiate arbitration proceedings due to the provisions of the Swiss expropriation law. [29]
A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any form of financial instrument, even though the underlying legal and regulatory regime may not have such a broad definition. In some jurisdictions the term specifically excludes financial instruments other than equity and fixed income instruments. In some jurisdictions it includes some instruments that are close to equities and fixed income, e.g., equity warrants.
In finance, a convertible bond, convertible note, or convertible debt is a type of bond that the holder can convert into a specified number of shares of common stock in the issuing company or cash of equal value. It is a hybrid security with debt- and equity-like features. It originated in the mid-19th century, and was used by early speculators such as Jacob Little and Daniel Drew to counter market cornering.
Preferred stock is a component of share capital that may have any combination of features not possessed by common stock, including properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferred stocks are senior to common stock but subordinate to bonds in terms of claim and may have priority over common stock in the payment of dividends and upon liquidation. Terms of the preferred stock are described in the issuing company's articles of association or articles of incorporation.
Credit Suisse Group AG is a global investment bank and financial services firm founded and based in Switzerland as a standalone firm but now a subsidiary of UBS. According to UBS, eventually Credit Suisse will be fully integrated into UBS but while the integration is not complete both banks are operating separately. Headquartered in Zürich, as a standalone firm it maintained offices in all major financial centers around the world and provided services in investment banking, private banking, asset management, and shared services. It was known for strict bank–client confidentiality and banking secrecy. The Financial Stability Board considered it to be a global systemically important bank. Credit Suisse was also a primary dealer and Forex counterparty of the Federal Reserve in the United States.
In corporate finance, capital structure refers to the mix of various forms of external funds, known as capital, used to finance a business. It consists of shareholders' equity, debt, and preferred stock, and is detailed in the company's balance sheet. The larger the debt component is in relation to the other sources of capital, the greater financial leverage the firm is said to have. Too much debt can increase the risk of the company and reduce its financial flexibility, which at some point creates concern among investors and results in a greater cost of capital. Company management is responsible for establishing a capital structure for the corporation that makes optimal use of financial leverage and holds the cost of capital as low as possible.
A corporate bond is a bond issued by a corporation in order to raise financing for a variety of reasons such as to ongoing operations, mergers & acquisitions, or to expand business. It is a longer-term debt instrument indicating that a corporation has borrowed a certain amount of money and promises to repay it in the future under specific terms. Corporate debt instruments with maturity shorter than one year are referred to as commercial paper.
A capital requirement is the amount of capital a bank or other financial institution has to have as required by its financial regulator. This is usually expressed as a capital adequacy ratio of equity as a percentage of risk-weighted assets. These requirements are put into place to ensure that these institutions do not take on excess leverage and risk becoming insolvent. Capital requirements govern the ratio of equity to debt, recorded on the liabilities and equity side of a firm's balance sheet. They should not be confused with reserve requirements, which govern the assets side of a bank's balance sheet—in particular, the proportion of its assets it must hold in cash or highly-liquid assets. Capital is a source of funds, not a use of funds.
Sukuk is the Arabic name for financial certificates, also commonly referred to as "sharia compliant" bonds. Sukuk are defined by the AAOIFI as "securities of equal denomination representing individual ownership interests in a portfolio of eligible existing or future assets." The Fiqh academy of the OIC legitimized the use of sukuk in February 1988.
Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital, which consists primarily of common stock and disclosed reserves, but may also include non-redeemable non-cumulative preferred stock. The Basel Committee also observed that banks have used innovative instruments over the years to generate Tier 1 capital; these are subject to stringent conditions and are limited to a maximum of 15% of total Tier 1 capital. This part of the Tier 1 capital will be phased out during the implementation of Basel III.
The following outline is provided as an overview of and topical guide to finance:
In finance, subordinated debt is debt which ranks after other debts if a company falls into liquidation or bankruptcy.
The Swiss Financial Market Supervisory Authority is the Swiss government body responsible for financial regulation. This includes the supervision of banks, insurance companies, stock exchanges and securities dealers, as well as other financial intermediaries in Switzerland. FINMA's name and acronym are usually expressed in English so as to avoid the semblance of favouring any one of Switzerland's linguistic regions.
Macroprudential regulation is the approach to financial regulation that aims to mitigate risk to the financial system as a whole. In the aftermath of the late-2000s financial crisis, there is a growing consensus among policymakers and economic researchers about the need to re-orient the regulatory framework towards a macroprudential perspective.
Corporate finance is the area of finance that deals with the sources of funding, and the capital structure of businesses, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value.
Mark Jeffrey Flannery is an American economist, since 2024 the Bank of America Eminent Scholar professor emeritus at the Warrington College of Business at the University of Florida. From 2000 to 2005, he was the Editor of the Journal of Money, Credit and Banking. From 2014 to 2016, Flannery was Director of the U.S. Securities and Exchange Commission's Division of Economic and Risk Analysis.
Kepler Cheuvreux is an independent European financial services company specializing in research, execution, advisory, and asset management services. Kepler Cheuvreux has 12 offices in Europe, 2 offices in the United States, and 600 employees worldwide.
Thomas P. Gottstein, Dr oec. is a former Swiss bank manager. He was a member of the Group Executive Board of Credit Suisse from October 2015 to July 2022. From February 2020 to July 2022, he was Chairman of the Executive Board of Credit Suisse.
On 19 March 2023, Swiss bank UBS Group AG agreed to buy Credit Suisse for CHF 3 billion in an all-stock deal brokered by the government of Switzerland and the Swiss Financial Market Supervisory Authority. The Swiss National Bank supported the deal by providing more than CHF 100 billion in liquidity to UBS following its takeover of Credit Suisse's operations, while the Swiss government provided a guarantee to UBS to cover losses of up to CHF 9 billion over the short term. Additionally, CHF 16 billion of Additional Tier 1 bonds were written down to zero.
Dario Item is a Swiss and Antiguan and Barbudan diplomat and lawyer. He is the Ambassador Extraordinary and Plenipotentiary of Antigua and Barbuda to Spain, Principality of Monaco, and the Principality of Liechtenstein. He is Antigua and Barbuda's Permanent Representative UNWTO. He is best known for his game changing efforts to boost investments in Antigua and Barbuda amounting to over 100 million, and for his investigations, which led to major revelations on Credit Suisse AT1 bonds considered by the Financial Times as "one of the most consequential European banking scoops of the year"
