Bank of England: Contingent convertible bonds won't make banks safer

The Telegraph reports that a study by the Bank of England shows that contingent convertible bonds won't make banks safer, but could make a bad situation even worse.

Regular readers know that your humble blogger doesn't think that much of a market will develop for contingent convertible bonds in the absence of ultra transparency.

If prospective buyers of the bonds do not have access on an on-going basis to a bank's current asset, liability and off-balance sheet exposure details, they have no way to assess the risk of the bank and the likelihood of the bonds converting to equity.  Therefore, they cannot properly value the bonds to buy them in either the primary or secondary market.

Bonds designed to protect banks in the event they get into financial difficulty could cause more problems than they solve, according to the Bank of England. 

So-called "contingent capital", more commonly knowns as CoCos, could create “wider systemic problems”, accordig to a report by the Bank, which warned that buyers of the bonds could deliberately undermine a bank’s share price to force the debt to convert into equity.... 

The Bank of England warned that buyers of the bonds could sell short a bank's shares to push their price down below the “conversion trigger”, or the pre-determined level at which the bond converts from debt into equity. 

To the extent that there is a buyer for these bonds, it is hedge funds.  These funds could engage in any number of trading strategies involving the bonds and the common stock.

Under the terms of a CoCo, an investor is sold a bond by a bank with the condition that should the lender’s core capital fall below a certain level the debt will transform into shares to provide the institution with an increased buffer to take new losses. 

However, the Bank of England said that while this was fine in theory, in practice buyers of the CoCos could “run” as soon as a bank showed any signs of getting into trouble to be replaced by investors who might have a vested interest in forcing the bonds to convert into shares. 

The reason for the buyers running is the lack of ultra transparency.  They have no way of evaluating the risk of the bank.

For their part, the hedge funds see the bonds and the bank's common stock as a trading opportunity.

“Policymakers should also consider the possibility that precautionary contingent capital instruments lead to wider systemic problems because investors have incentives to manipulate the conversion trigger to generate a conversion or bank equity holders or management have incentives to take actions (such as fire-selling assets) to try to avoid a conversion occurring,” said the Bank.