A proposal by Britain’s Barclays to use CoCo as a remuneration tool is being watched closely by peers.
Don’t confuse it with a new Swiss candy or a soft drink brand. CoCo is a bold, new concept which is being explored by banks in Europe as a revolutionary tool to revamp their compensation mechanism (read: bonus). The British financial giant, Barclays is reportedly looking to issue CoCos, subject to regulatory approval, to its senior employees in a bid to overhaul its compensation strategy that could help it navigate any crisis-like situation, such as the global financial crisis of 2008, better. Crisis-hit big European and US financial institutions (remember AIG) had recently come under scathing attack from the regulators and experts for issuing fat bonuses to their senior management even as they had to be bailed out by their respective governments. Now by using CoCo as a ‘bonus currency’ (as some experts call it), the issuers might hope to buy peace with critics. However, the utility of CoCos goes beyond as a mere compensation tool as several banks in Europe are looking to issue such bonds to recapitalize them to meet tougher Basel III and regulatory norms in their own nations.
CoCos or Contingent Convertible bonds are a kind of hybrid instruments. According to David Bishop, Ethan Zuofei Liu, Patrick Murray and Téa Solomonia of State University of New York, “Contingent Convertible bonds (CoCos) are debt instruments that must transform into shares of equity or are written off upon a triggering event.” The trigger event, they suggest, could be determined either by regulatory assessment or objective bank losses. So, the bonds become effectively worthless if the financial viability (a major trigger) becomes questionable. That means the employees have every incentive to make sure their institution’s remain financially strong. It also serves as an effective recapitalization tool if the issuer’s tier-I capital falls below a threshold or specified limit.
So far, two financial institutions which have issued CoCos include Lloyds Bank and another by Rabobank. In case of Lloyd Bank which issued these bonds in November 2009, the conversion is contingent upon the trigger event of Core Tier 1 leverage ratio falling below five per cent, while in case of Rabobank, in case trigger event happens it would lead to write-off of 25% of the principal amount.
“[They] are interesting as a pay device on two counts,” FT quoted a leading European banker as saying, who further added, “They (CoCos) give an employee downside and don’t incentivize strategies that would ramp the share price in the short term, as equity can. At the same time, they could count towards core capital.”
As regulators and bankers across the globe look for preemptive measures to prevent a repeat of the 2008 financial cataclysm, CoCos appear as a ray of hope. But will they deliver? “An inherent problem within banking finance is the risk of panic: when a bank needs to convert hybrid debt into equity, it sends a clear signal to investors that the bank is in trouble. These investors are then tempted to withdraw their investments, making the initial problem much worse. CoCo bonds are emerging as the most concrete new idea for solving these inherent problems,” comments peo.cambridge.org.
However, CoCos do suffer some drawbacks. A major concern about CoCo’s effectiveness is about the trigger event. According to Prof. Theo Vermaelen of the prestigious INSEAD, France, is that “how should the trigger be set?” “In the case of Lloyds the trigger is based on regulatory capital ratios, which are only computed once every quarter. Such a mechanism will not work in a situation where a bank capital structure deteriorates rapidly,” he writes in his article, “Message to Basel: Another way to avoid bank bailouts,” published in Wall Street Journal. “For example, Citibank had a Tier 1 capital ratio that was measured at 11.8 per cent in December 2008, at the height of the financial crisis. This means debt holders are not likely to get their money back, which makes the bonds very expensive, and reduces their attractiveness as an alternative to simply issuing equity.” He proposes a new framework, Call Option Enhanced Reverse Convertible or COREC in which the trigger is based on market values, and not "old" capital ratios and also, the design protects equity holders against dilution caused by manipulation and/or market panic.
Whatever, European banks, for now, it seems, are liking CoCos.
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