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Who or What has been Hobbling CoCos: Three Essentials for Making CoCos a Success

Journal 36: Global Finance and Regulation

George M. von Furstenberg

CoCos offer stabilization benefits from improved crisis management through efficient capital insurance that helps recapitalize a financial firm when needed. Even without regulatory mandates to issue them, they will have a market to the extent they lower the cost of capital to the firm. Despite their promise, there have been few going-concern CoCos issues to date. The outlook will remain bleak as long as complying with the capital requirements proposed by the Basel Committee on Banking Supervision (BCBS) and considered by the European Banking Authority (EBA) in effect relegates CoCos to the category of high-yield (speculative-grade or “junk”) bonds.

For CoCos to be able to compete in the capital market they must satisfy three conditions, which are not yet readily reconcilable. They must (1) qualify to fill some part of regulatory capital requirements, (2) be rated investment-grade debt by the major rating agency of CoCos, S&P, and (3) pay interest that is tax-deductible also in the United States. The procedure followed here is to work backwards from the characteristics of CoCos, which the U.S. Internal Revenue Service (IRS) may require to allow interest deductibility under the corporation income tax. The second task is to apply features that would allow those CoCos to be rated investment-grade by S&P when issued. The third and last step is to determine to what extent the resulting CoCos that qualify for tax deductibility of interest paid and an investment-grade rating would run afoul of what the BCBS and EBA would require to allow them to help meet capital requirements. If “qualifying” CoCos would be eligible to receive credit for some fraction of additional tier 1 (AT1) and tier 2 (T2) capital and become a usable component of the conservation and countercyclical buffers to be phased in from 2016 on, the question becomes how these “qualifying” CoCos differ from those that can receive an investment-grade rating and pay interest that is deductible for tax purposes. Regulators should not prevent these differences from being bridged by insisting on keeping CoCos under their thumb and requiring them to be equity-like right from the time of issue.