Determinants of CoCo issuance: liquidity and risk incentives
| DOI | https://doi.org/10.1108/JFRC-09-2021-0080 |
| Published date | 17 March 2022 |
| Date | 17 March 2022 |
| Pages | 412-438 |
| Subject Matter | Accounting & finance,Financial risk/company failure,Financial compliance/regulation |
| Author | Bashar Abdallah,Francisco Rodríguez Fernandez |
Determinants of CoCo issuance:
liquidity and risk incentives
Bashar Abdallah
University of Granada, Granada, Spain, and
Francisco Rodríguez Fernandez
University of Granada and FUNCAS, Granada, Spain
Abstract
Purpose –This paper aims to study the impact of (regulatoryand nonregulatory) liquidity on contingent
convertible(CoCo) issuance and the relationship between CoCos and assetquality.
Design/methodology/approach –The analysis of this study comprises two stages. In the first stage,
the authors used a logit model to test whether banks with riskier assets as well as lower solvency and
(regulatory and nonregulatory)liquidity are more likely to issue CoCos. In the second stage, the authors used
univariate analysis and fixed effectsregression to measure the impact of Additional Tier 1 (AT1) CoCos on
the qualityof the issuer’sassets.
Findings –The study shows that regulatory liquidity ratiosare negatively related to CoCo issuance. This
study also finds that the likelihood to issueCoCo is higher when banks have lower regulatory capital or are
less risky. Assetquality is found to not change significantly afterthe issuance. All in all, these resultssuggest
that while solvency regulation is primarily regarded as the main motivation for CoCo issuance, liquidity
regulationalso matters.
Research limitations/implications –Despite the fact thatCoCos have been emerging as an alternative
way to help banks meet regulatorycapital requirements, the paper argues that the relation between liquidity
regulationand CoCos should be taken into account.
Originality/value –This study presents an empirical analysison the CoCos instrument, focusing on the
relationship betweenAT1 CoCos and liquidity regulation. Therefore,it serves to fill a gap in the literature on
the underlying forces behind CoCo issuance. Moreover, this study measures the impact of AT1 CoCos
issuanceon bank risk, particularlyon the quality of the issuer’s assets.
Keywords CoCos, Contingent capital, Liquidity, Risk incentives
Paper type Research paper
1. Introduction
Contingent convertible (CoCos) are regulatory hybrid securities that aim at increasing the
loss-absorbing capacity of banks. They convert into new equity or suffer a full or partial
write-down in principal upon a trigger event. According to Basel III rules, CoCos can be
classified as Tier 1 or Tier 2 capital instruments [1]. Unlike bailout instruments, CoCos are
designed to contingently convert before financial institutions go bankrupt. Additionally,
CoCos operate as a coupon paying bondif no trigger event applies. CoCos have been mainly
issued by European banks. The Lloyds Banking Group was the first one in 2009. Shortly
© Bashar Abdallah and Francisco Rodríguez Fernandez. Published by Emerald Publishing Limited.
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JFRC
30,4
412
Received30 September 2021
Revised13 January 2022
Accepted14 January 2022
Journalof Financial Regulation
andCompliance
Vol.30 No. 4, 2022
pp. 412-438
EmeraldPublishing Limited
1358-1988
DOI 10.1108/JFRC-09-2021-0080
The current issue and full text archive of this journal is available on Emerald Insight at:
https://www.emerald.com/insight/1358-1988.htm
after, they receivedincreased attention from Asian banks. However,American banks are not
allowed to use CoCos. From 2009 to 2019,banks issued more than $550bn in CoCos globally.
European banks allocated around e290bn, where write-down CoCos (full and partial)
represented 54%and conversion-to-equity CoCos 46% [2].
By converting CoCos into new equity at a predetermined conversion rate, issuers have
additional equity capital to shore up their loss absorption capacity. This rate can be set up
on the market share price when the loss absorption mechanism is activated or on a
predetermined price (typically the share price at the time of issuance)(Avdjiev et al.,2013).
As for the write-down mechanism, it could be partial or full based on the contract designand
provide additional equity by reducing the prespecified value from the issuance amount.
Overall, the likelihood of occurrenceof these mechanisms depends on the trigger definition.
CoCo triggers could be discretionary or bank-specific (mechanical trigger). A discretionary
trigger (point of nonviability) occurswhen the regulatory authorities realize that the issuers
will be prone to insolvency or they are delayed in applyinga prespecified trigger. Then, the
loss absorption mechanismseither convert the CoCos to equity or write them down partially
or fully. A mechanical trigger operates when regulatory capital ratio (CET1) falls below a
certain threshold, known as “book value trigger”or if the market value of the bank falls
below a certain threshold,known as “market value trigger”(Avdjiev et al.,2013).
There are different views on the underlying forces behind CoCo issuance and their
implications on the overall banking sector. It has been argued that they provide flexibility
for banks to meet the regulatory capital requirements or to use them as a tax shield
(Flannery, 2005,2014;Pazarbasioglu et al.,2011;Calomiris and Herring, 2013). CoCos,
compared to regular equity, are complexsecurities to design and carry some risk to issuers.
The conversion price of CoCos could be manipulated, particularly when the trigger is
potentially reached (Admati et al.,2013). In this paper, we examine two issues associated
with CoCo issuance in Europe. First, we investigatewhether (regulatory and nonregulatory)
liquidity is related to CoCo issuance. Second, we examine the impact of CoCo issuance on
bank asset quality. The analysisis restricted to Additional Tier 1 (AT1) CoCos since Tier 2
CoCos are considered as regular bonds with defined maturity date, and do not receive an
equity-like treatment by supervision. As far as we are aware, there is no empirical study on
how regulatory liquidity affects CoCo issuance (either AT1 or T2). Additionally, unlike
previous empirical studies that focus on the impact of CoCos issuanceon bank funding risk
by examining the effect of CoCo issue announcements on bank credit default swap (CDS)
spreads, we examinethe impact of AT1 CoCos on asset quality.
Our analysis relies on a sample of 413 banks across 16 European markets. Out of a total of
413 banks, 92 banks have issued CoCos from 2011 to 2018. There were 158 issuances of AT1
CoCos used in our analysis. Our findings reveal 112 out of 158 issuances with a write-down loss
absorption mechanism, either temporary or permanent and 46 issuances with a conversion-to-
equity loss absorption mechanism. As for the trigger level, we have 99 issuances with a trigger
level equal to 5.125% and 59 issuances with a trigger level above 5.125%. Our empirical
analysis comprises two stages. In the first stage, we use a logit model to examine whether
banks with riskier assets, and lower solvency and (regulatory and nonregulatory) liquidity are
more likely to issue CoCos. We compute the marginal effects at m eans then average the
marginaleffectstoassesseconomicimpact.Inthesecondstage,wemeasuretheimpactofAT1
CoCos on assets quality using univariate analysis and panel fixed effectsregression.
Our main findings suggest that banks with lower regulatory capital (Tier 1 and CET1)
ratios are more likely to issue CoCos. Although CoCos are not originally designed to deal with
liquidity problems, our results show that banks in Europe have not only used CoCos for
regulatory capital considerations but also to meet tighter liquidity requirements. We find that
Determinants
of CoCo
issuance
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