Contingent convertibles made a very modest entry in the financial landscape in December 2009 when the Lloyds banking group offered the holders of some of its hybrid debt the possibility to swap their bonds into a new bond which carried a possible conversion into shares. Early February 2011 Credit Suisse did it more spectacular. This bank managed to attract easily $2 bn in new capital using this brand new asset class. Where Lloyds was initially struggling, Credit Suisse succeeded: investors gave this new issue a warm welcome which resulted in a massive oversubscription [28].
A Contingent convertible (”CoCo”) is a debt instrument that automatically converts into equity or suffers a write down when the issuing bank gets into a state of a possible non-viability. This is a situation where the future of the bank is questioned by the depositors, bondholders and regulators. In order to quantify such a life threatening situation, the conversion or the write down is triggered by a particular pre-defined event. In this article, we will have a major focus on CoCos where a conversion in shares takes place. This automatic conversion makes this new product attractive from a regulatory point of view. The bank does not need to reach out to new investors in order to raise capital when it needs to reinforce its balance sheet.
The conversion of debt in equity takes place automatically. No shareholders meeting is required. The concept of contingent capital fits perfectly in the concept of a more stable banking system. CoCos can be added to the list of other measures such as living wills, centralized clearing counterparties, higher capital requirements, lower leverage, higher liquidity ratios and other incentives that saw daylight in the aftermath of the 2008 credit crunch.
CoCos are not just another category of innovative hybrid debt which was conceived on some isolated trading desk. The whole idea of standby contingent capital is relatively old. We have to go all the way back to the United States, prior to banking act of 1933. The banking system was build on a system of a double liability. From 1850 to 1933, the risk taking in banks was constrained through this double liability system. Under this system all bank shareholders would be legally required, in the event of distress, for a down payment equal to the initial par value of the shares [14]. An initial share holder with an initial investment of $100 would be confronted with a sudden extra down payment of another $100. This is the very first concept of an unfunded contingent capital commitment.
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Pricing Contingent Convertibles: A Derivatives Approach
