WHEN governments bailed out banks during the financial crisis, they tended to insist that shareholders suffer big losses. Most bondholders, however, got off scot-free. In theory, bondholders should have lost money too—but working out just how bankrupt the banks were, apportioning the losses and risking contagion among bondholders elsewhere seemed too risky to contemplate as the financial system was seizing up.
Regulators have since pushed banks to fund their activities with less debt and more loss-absorbing capital. The simplest form of capital is equity—the money raised by selling shares or retaining profits. But trimming dividends or increasing the number of shares reduces the value of the existing ones. So bankers and regulators dreamt up a new financial instrument that would act like debt, thus sparing shareholders dilution, unless capital was urgently needed. These instruments are called contingent convertible bonds, or “cocos”, also known as additional Tier-1 securities. In exchange for annual interest of around 6-7%, investors take on the risk that, if the going gets tough, the bank may suspend interest payments, convert the...Continue reading
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