Could 'CoCos' be a short seller's dream?
Last week, Royal Bank of Canada issued $1-billion with of "non-viable contingent capital" bonds, known most enjoyably as CoCos. Ideally, CoCos encourage investors to monitor banks for excess leverage. However, as new research shows, if the conditions are right, CoCos may provide an incentive to cheat.
Back in the heady days of 2008, a big problem in financial markets was that banks had too much debt and not enough capital. Governments spent lots of money to keep banks afloat.
The Basel III banking rules have a solution to this problem. In order for non-common share instruments to count as loss absorbing or Tier 1 capital, those instruments have to either be written off or converted into equity when the bank reaches the point of non-viability. CoCos are debt that converts to equity when a bank gets into trouble and, therefore, can be counted as Tier 1 capital.
In essence, on the occurrence of a "triggering event" - which is almost always either a regulator telling the bank it is no longer viable (a "regulatory trigger") or based on some change in the bank's debt-to-equity ratio (an "accounting trigger") - CoCos will convert to equity. The stocks will be issued at either a fixed price or the market price of the bank's shares, thereby giving the distressed bank a jolt of capital to absorb losses. This is why CoCos are often called "bail-in" debt; bondholders recapitalize troubled banks so governments don't have to.
There are some nice incentives here. CoCo investors will lose their bonds' yield if they get converted into equity . Therefore, CoCo investors should have better incentives to monitor a bank's leverage and suppress volatility than existing shareholders.
But not always. Research by Jingya Li and Mark Reesor of the University of Western Ontario and Adam Metzler of the Wilfrid Laurier University shows that certain CoCo structures offer investors very different incentives. Where the conversion price of the CoCo is based on the market price of the institution's common stock and the CoCo uses an accounting trigger, investors have an incentive to short the underlying shares in order to depress the share price prior to conversion. When the price of the underlying shares rebounds - either because CoCo investors have closed their short positions or because the share price returns to reflect fundamental value - the CoCo investors will see a return on their newly converted shares.
Depending on how close to conversion CoCo investors open their short, Ms. Li calculates the return to short-selling at conversion to be between 3.7 per cent and 7.8 per cent.
In other words, there's an incentive for CoCo investors to drive down the price of an institution's stock as conversion approaches, making an already precarious time for the bank even more dangerous. At worst, this could lead a financial institution into a death spiral, where falling price begets falling investor confidence making it prohibitively expensive for a bank to raise further capital.
Ms. Li's research shows that not all structures offer equal shortselling incentives.
CoCos that use a trailing average with a price floor for the conversion price would decrease short selling incentives. The trailing average would increase the conversion price above the suppressed price, while the price floor would cap the amount of profit short sellers could make.
Second, a regulatory trigger is more difficult for investors to game. Under the accounting trigger, an investor only needs to predict when a bank's publicly available leverage ratio will cross the triggering threshold. Under the regulatory trigger, regulators can time the conversion to thwart short-sellers.
On the above measures, the RBC issuance grades out pretty well. It uses a regulatory trigger and has a price floor.Still, the best solution to this issue appears to be a regulatory one.
Ms. Li's paper offers evidence that accounting triggers should be more closely scrutinized or, perhaps, prohibited. The Office of the Superintendent of Financial Institutions should think about mandating both a trailing average price and a floor price to limit short-selling incentives.
Regulation is hard, especially with new securities. But CoCos are a good idea, and RBC has come up with a good structure. OSFI should modify its guidance to make sure that CoCos help prevent the next crisis, not cause it.