“Cocos,” as they are commonly known, act as debt but convert into equity when a bank looks like it is getting in trouble – usually when the share price falls below a set trigger level.
This is intended to shore up the bank’s position by increasing its loss-absorbing potential, but the report warned that shareholders and coco investors face different and competing sets of incentives.
These could lead to market manipulation and increased volatility, damaging the stability of the financial system as a whole, the Bank said.
“With a trigger metric based on a bank’s equity price, there would be a risk that investors may short-sell a bank’s equity to drive the equity price down,” said the report, written by Gareth Murphy, Mark Walsh and Matthew Willison.
That would trigger a conversion of the cocos despite no deterioration in the underlying value of the bank’s assets actually taking place, giving coco-holders a windfall gain.
Furthermore, “investors might interpret the fall as a signal about the solvency position of other banks. This could also raise the borrowing costs of other banks in wholesale markets,” damaging the system as a whole, the report warned.
Alternatively, incumbent shareholders could conspire to keep the share price artificially high, preventing cocos from converting and so stopping their shareholdings being diluted, it said.
When deciding on the structure and makeup of capital rules, “policymakers should consider the risk that it would be possible for holders of precautionary contingent capital to run before a conversion occurs,” the paper concluded.
Alternative types of coco with different trigger points were also discussed, some of which may reduce incentives to manipulate a bank’s share price. For example, those with a systemic trigger could convert debt to equity when the aggregate state of the banking system deteriorates, perhaps triggered by moves in a wider equity index. As a result, the hope is that cocos could act to shore up the position of the system as a whole, rather than undermine it.