Thursday, February 18, 2016

EuroCoCo, Guy

We again interrupt our blogging hiatus, for another update on banking regulation.

Tuesday, at the Brookings Institution, about 30 minutes into this discussion, retired Fed Board of Governor's member Donald Kohn tells Minneapolis Fed President Neel Kashkari, pretty much what Bentley University macroeconomist Scott Sumner concluded last November: That had contingent convertible bonds, with an explicitly defined trigger been in place years before 2008, the financial crisis may well have been averted.

Kohn's reasoning was that back then the conversion to equity of the long term bonds (CoCos) in the capital structure of stressed firms (such as Bear Stearns and Lehman Bros) would have protected the short term bond holders from runs: That's where the danger was. He then goes on to point to the CoCos in Europe (where such bonds are already in place), as an example. He believes that developments in the last few weeks show that markets believe that the threat of conversion from debt to equity is now affecting bond prices and is evidence that bank regulators are alert to possible stress in the banking system. That they will allow the stressed financial institutions to be automatically recapitalized. I.e., CoCos will work as advertised as canaries in the coal mine, and avert a repeat of the disaster of 2008-09.

Of course, European bank managers aren't happy that they're being disciplined by markets (and regulators):
...investors have indeed flipped out with concern about Cocos after the German lender Deutsche Bank was forced to reassure investors it could meet interest, or coupon, payments on its Coco bonds. 
The move has stoked fears that something is rotten at the heart of the European banking sector and led many to question why Cocos – considered a silver bullet solution – have melted like their chocolate breakfast cereal namesake in the face of market turmoil.

Which is what Charles Calomiris reported was their reaction when CoCos were authorized by the  1999 legislation known as Gramm, Leach Bliley:
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."
It's a feature...not a bug, guys.

Well, back to hiatusing.