Use of CoCo bonds – hybrid securities issued by banks – do not protect taxpayers

Newswise — BLOOMINGTON, Ind. – A financial tool used in the bailout of global banking giant Credit Suisse Group, hybrid securities known as “CoCo” bonds, would not protect taxpayers. Their use should continue to be left to the private sector, instead of being treated as regulatory capital after bank failures in the United States, said a finance professor at the Indiana University Kelley School of Business.

The recent failures of Silicon Valley Bank and Signature Bank in the United States spilled over into Europe, where Credit Suisse Group was acquired by UBS Group AG, in a transaction brokered by the Swiss government.

The takeover surprised investors by wiping out 16 billion Swiss francs of AT1 CoCo bonds – or about $17.7 billion in U.S. dollars -- while paying 3 billion francs ($3.3 billion U.S.) to equity holders. Credit Suisse used contingent convertible bonds – popularly known as CoCo bonds or AT1 bonds, treating them as debt and equity simultaneously. It used the bonds as debt for cheaper funding, as equity to meet regulatory capital requirements and to arbitrage between bond market and banking regulation.

This wasn’t an available option in the United States, thanks to U.S. banking regulation, in which Zhenyu Wang, a banking scholar and the Edward E. Edwards Professor of Finance at the Indiana Kelley School of Business, helped to develop. As the government grapples with finding solutions for the struggling First Republic Bank, a pertinent question arises as to whether CoCo bonds could offer a viable solution for the wider U.S. banking industry.

As a vice president and the head of financial intermediation function at the Federal Reserve Bank of New York during the financial crisis of 2008-2009, he was directly involved in the bank bailout, the security design of the Troubled Assets Relief Program and the development of new capital requirements for banks.

He raised serious concerns about the design and use of CoCo bonds in banking regulation. The bonds are a unique hybrid security that combines the characteristics of debt and equity. They function as debt until they are either converted into equity or written down to lose value alongside or before equity.

While regulators and banks each can see merit in the use of CoCo bonds, their use in a crisis do not benefit taxpayers, Wang said in a new article published by the European Corporate Governance Institute, “Are CoCo bonds better than common equity as capital for financial stability?”

Instead, he questions whether the main purpose of CoCo bonds is to take advantage of the differential treatments in regulation, tax law, and bond markets.

“The main selling point by the proponents of CoCo bonds is that CoCo bonds help financial stability and protect taxpayers. However, the takeover of Credit Suisse by UBS put Swiss taxpayers at risk again 15 years after they had bailed out UBS,” Wang said, referring to the 109-billion-franc new credit and guarantee provided to UBS by the Swiss government. “A poll conducted a few days after the takeover announcement shows three quarters of Swiss people are unhappy about the takeover brokered by their government. The convincing logic in the selling point of CoCo bonds must be flawed.”

Banks can use CoCo bonds to exploit discrepancies among capital markets, tax policies, and banking regulations. If investors price them as debt, governments treat them as tax-deductible, and regulators count them as equity.

“CoCo bonds do not effectively protect taxpayers from bank risks, especially in light of the inactive Tier 1 ratio – the ratio of a bank's core equity capital to its total risk-weighted assets -- and slow regulators,” Wang added. “Although CoCo bonds may be more useful than non-convertible, non-written- down bonds for rescuing unviable banks, it remains uncertain whether they are more effective than common equity as capital for ensuring financial stability.”

No U.S. banks have issued any CoCo bonds. The Financial Stability Oversight Council reported to Congress in 2012 that U.S. regulators would leave CoCo bonds as a private sector innovation instead of using them as regulatory capital. In 2012, Wang left the Federal Reserve Bank of New York to come to Kelley.

Wang also recently presented the lecture, “CoCo Bonds: Are They Debt or Equity? Do They Help Financial Stability?,” as part of a lecture series presented online by Kelley’s Institute for Corporate Governance.