One winner of Sunday’s European bank stress test: a risky type of bond that lenders have flocked to issue in recent years.
Prices of many so-called contingent capital bonds, or CoCos, rose Monday, and analysts said the generally positive stress-test results could pave the way for more supply.
CoCos pay coupons like conventional bonds, but if a bank’s key capital ratios sink, they can convert into common equity—which doesn’t pay interest and is first to be wiped out if a bank fails. That makes them riskier to hold than conventional bonds.Also making them like canaries in the coal mines, a market signal that a bank is weak or strong. HSIB has noted the enthusiasm for this form of bank self-regulation on the part of Columbia economist Charles Calomiris;
...the Columbia economist offers a suggestion to improve the banking system;Calomiris has said, in speeches, that the Federal Reserve has had the legal authority to do this since the 1999 Gramm, Leach, Bliley Act, but chose not to implement that reform. Now would be a good time to listen to Charlie.
I would establish a minimum uninsured debt requirement for large banks in the form of subordinated debt, known as contingent capital certificates, or "CoCos." The CoCos would automatically convert to equity based on predetermined market triggers, which would be very dilutive to pre-existing shareholders. One banker who understood my proposal for CoCo's said, "You are putting an electric fence behind me."The potential for dilution of stockholder equity being the key incentive for management to work to prevent that from happening.