Of CoCos and Collapsing Bridges

September 8, 2017

This is a story in two parts, one fictional and one real.

 

A bridge collapsed in a faraway land. (Thankfully, this is the fictional part.) After months of investigation, shoddy construction materials were found to be responsible for the tragedy.

 

A new law was passed to avert future disasters. Shoddy materials, however, were not banned. Instead, the law required each bridge to be inspected every two years. A bridge found to be in bad condition was to be repaired swiftly.

 

If that sounds crazy, it is. But that is essentially the approach banking regulators in Europe have taken after the financial crisis of 2007-8.

 

The issue at hand has to do with “contingent convertible bonds,” or CoCos for short. The basic idea is that in normal times, CoCos are just debt – banks borrow money and pay interest on it. In a crisis, however, CoCos automatically convert to equity. CoCo investors take a hit, but the bank saves precious cash, and disaster is averted. Everything works like magic.

 

Or so the story goes. Turbulence that ensued when CoCos issued by Deutche Bank were close to conversion proved that reality may be less rosy.

 

But the problems run deeper. The right way to achieve financial stability is to fund banks with more equity. Instead of borrowing to the teeth, banks should simply put more of their own money on the line. No financial magic is required.

 

So why do we have CoCos? In normal times, CoCos are just debt, and so interest rate payments can be deducted to lower corporate taxes. For banks, issuing CoCos is cheaper than raising plain old equity.

 

Let that sink in. We are still dealing with the wreckage from the greatest financial crisis of the last eighty years. But instead of making our financial system safer, we have decided to continue using shoddy materials, lest we make banks a tiny bit less profitable.

 

If that sounds crazy, it is.

 

(Image credit: https://en.wikipedia.org/wiki/File:05-23-13_Skagit_Bridge_Collapse.jpg)

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