## _sdn1101 - Executive Summary

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### Overview
- Contingent capital instruments are dated bonds with principal and scheduled coupon payments that can be automatically converted into equity (contingent-convertible bonds or CoCos) or written down when a predetermined trigger event occurs, enabling a fresh injection of capital into a distressed bank.
- Several regulators (Canada, Netherlands, United Kingdom, and the United States) have shown interest in adding contingent capital to their supervisory toolkits; Switzerland’s contingent capital proposal is expected to be adopted into law by early 2012.
- Contingent capital proposals are under discussion within the Basel Committee, the Financial Stability Board (FSB), and the European Union.

### Main conclusions and intended roles
- Contingent capital instruments could be considered as part of a comprehensive and consistent crisis-management framework; they are unlikely to be effective as stand-alone tools.
- Instruments should be implemented within a comprehensive framework including:
  - strengthened supervision;
  - an enhanced capital base;
  - revamped disclosure that better informs markets;
  - an effective resolution regime.
- Contingent capital should be viewed as a complement to, not a substitute for, equity.
- Policy objectives:
  - enable automatic conversion of debt into equity when market access is difficult; and
  - disincentivize excessive risk taking by financial institutions.
- Contingent capital instruments could be used to meet more stringent capital buffers, including additional loss-absorbing capital requirements for SIFIs; design of conversion triggers and conversion rates is crucial.

### Design considerations: triggers and conversion
- Triggers determine the probabilities of conversion or conversion risks; conversion aims to impose losses upon creditors who otherwise would be affected only by default.
- Trigger types:
  - Systemic triggers (system-wide conditions such as liquidity conditions, a market volatility index, or supervisory declaration of a systemic crisis):
    - May efficiently address systemic risks by increasing capital across the banking system simultaneously.
    - Forego market-discipline benefits since limited additional incentive exists for individual banks to improve risk management.
    - Rating and pricing would be complex given difficulty predicting systemic events and supervisory discretion.
  - Bank-specific triggers (a bank’s capital ratio, share price or CDS price, or an assessment of nonviability by the supervisor):
    - Market- or capital-ratio-based triggers are likely easier to rate and price than discretionary triggers.
    - Reported capital ratios align with regulatory frameworks but are lagging indicators and may not trigger conversion early enough.
    - Market-based triggers risk market manipulation; mitigations include using moving averages of market prices.
- Trigger level trade-offs:
  - High-level triggers (set well above distress thresholds) can prevent crisis by ensuring recapitalization well before serious difficulties and encourage market discipline.
  - Potential adverse effect: managers may deleverage before triggers, causing asset sales that could depress prices and transmit contagion ("fire sale" externality).

### Conversion design considerations
- Conversion rate determines burden sharing between shareholders and bondholders:
  - High dilution: ex ante shareholders lose most.
  - Little dilution: contingent debt holders lose most.
- Conversion design options (trade-offs noted):
  - Conversion into a predetermined number of shares based on par value divided by issuing bank’s share price at issuance — bondholders suffer losses as if shareholders; shareholder dilution limited to lower share prices.
  - Conversion into an ex post determined number of shares based on share price at time of conversion — holders receive notional amount in shares; ex ante shareholders suffer stronger dilution; risk of “infinite dilution” or “death spirals” when share prices fall close to zero; may be prone to market manipulation and could justify circuit breakers.
- Debt write-off features:
  - More suitable for cooperative and mutual banks that cannot issue shares.
  - Example cited: Rabobank Senior Contingent Notes (SCN) — original principal amount can be written off by 75 percent if the bank’s common equity ratio falls below 7 percent.

### Comparisons with existing instruments and Basel III interactions
- Differences vs existing hybrids:
  - Contingent capital are dated debt with contractual debt/equity conversion or write-down clauses; existing convertible hybrids are perpetual debt focusing on coupon deferral or maturity extension.
  - Contingent conversion is automatic upon activation of a predetermined trigger; existing hybrids’ conversion is largely at bank discretion unless regulatory ratios are breached.
- Contingent capital should be supplementary to common equity and should not compromise capital transparency or the enhanced capital structure under Basel III.
- Basel III changes cited in the source:
  - minimum common equity ratio raised from 2 percent to 7 percent (of which 2.5 percent is a conservation buffer).
  - elsewhere in the source, higher minimum capital requirements are summarized as: common equity from 2 percent to 4.5 percent; Tier 1 from 4 percent to 6 percent; overall capital ratio maintained at 8 percent. Additional capital buffers introduced.
- BCBS Point of Nonviability proposal (January 13, 2011):
  - All noncommon equity Tier 1 and all Tier 2 instruments must have a provision requiring them to be written off or converted into common equity upon trigger event (decision that firm would become nonviable without a debt write-off or public sector injection).
  - Conversion into common stock of issuing bank or parent (including any successor in resolution).
  - Proposal akin to a low-level trigger contingent capital instrument similar to a resolution tool; discretionary elements may affect pricing and marketability.
  - BCBS emphasizes contingent capital should not diminish need for reforming national insolvency and bank-resolution schemes.

### Potential benefits for market discipline and bank behavior
- Credible threat of losses from conversion and dilution could reduce risk taking by managers, shareholders, and bond holders.
- Bond holders required to bear part of future recapitalization costs would have enhanced incentives to exercise market discipline.
- Suggestion: bank manager bonuses could be paid in contingent convertible debt to reduce incentives for excessive risk taking.
- Theoretical model (Appendix I) findings:
  - Contingent convertible bonds reduce the bank’s incentives to take excessive risks by eliminating the bail-out or reducing the probability of default.
  - CoCos can promote market discipline and have effects equivalent to a risk-based, pre-funded bank resolution fund.

### Operational, marketability, and systemic-risk concerns
- Contingent capital instruments are largely untested and could have unintended consequences during high market volatility and uncertainty.
- Marketability is uncertain; sufficient investor demand is not guaranteed.
- Design features are key to avoid adding procyclicality and complexity to capital structures.
- Potential adverse effects:
  - Negative signaling as bank capital approaches conversion trigger.
  - Contagion risk and susceptibility to price manipulation.
  - Potential “death spirals” (very sharp and continuous declines in share prices); debt contracts could consider circuit breakers to mitigate this risk.
- Supervisory vigilance needed to monitor:
  - design and issuance of contingent capital instruments;
  - implied transfer of risks within the financial system;
  - potential build-up of systemic risks, including liquidity risks.

### Role in crisis prevention, going concern management, and orderly resolution (Box 1 schematic)
- Crisis prevention tools complementary to CoCos:
  - Better management incentives, higher capital buffers (e.g., Basel III), revamped disclosure, more intrusive supervision, and pre-emptive restructuring via recovery planning.
- Crisis management (going concern):
  - Revamped prevention lowers contagion by a distressed SIFI; central bank emergency liquidity assistance could be conditioned on equity solvency and proper collateral.
- Orderly resolution (gone concern):
  - Framework should provide a menu of resolution-transaction options including purchase of viable assets by existing institutions, temporary government-owned bridge institutions (necessary for SIFIs), and liquidation with deposit transfer/payout supported by depositor guarantee schemes (for smaller nonsystemic institutions).
- Trigger sequencing and objectives (examples cited):
  - High triggers example: Common equity ratio 7 percent of risk-weighted assets (Swiss proposal) — objective: recapitalization to stabilize; degree of stress: deteriorating financial situation (going concern).
  - Low triggers example: Common equity 5 percent of risk-weighted assets — objective: additional recapitalization to prevent receivership; degree of stress: threat of failure (going concern).
  - Point of nonviability triggers: compulsory restructuring to prevent insolvency (going/gone concern); subordinated and unsecured senior debt could be subject to debt-to-equity conversion; likely to require statutory powers.

### Pricing, investor demand, and market development
- Pricing/demand drivers: conversion triggers, types of conversion, conversion rates.
- For a given conversion rate, instruments with a low trigger should be cheaper than those with a high trigger.
- Investor preferences:
  - Conservative, traditional real-money investors prefer lower probability of conversion (lower triggers).
  - Dynamic/speculative investors more willing to consider high-level trigger CoCos.
- Figure summary (yields):
  - Indicative yields in the figure range from 6% and below to >12%, with investor categories including Fixed Income investors, Retail investors / Private Banking, SWF, HY Investors, Hedge Funds, Equity investors.
- Preconditions for a deeper market:
  - Obtain ratings.
  - Lift mandate restrictions preventing some investors from holding equity-like products.
  - Inclusion of CoCos in benchmark indices.
  - Historical parallel: European hybrid market took close to five years after inception in 1997 to reach critical mass.
- Tax and regulatory treatment:
  - Tax deductibility of interest lowers cost; two European banks issued tax-deductible contingent capital instruments with different regulatory capital status — Lloyds (lower Tier 2) and Rabobank (noncapital senior debt).
  - Lack of issuance possibly due to regulatory uncertainty.
  - Most existing hybrid securities will no longer qualify as regulatory capital under Basel III after January 2013 and will be phased out over time by 2023.
  - Under Basel III, Tier 1 capital ratio will incorporate up to 25 percent of “other qualifying” noncommon equity instruments, but based on stricter criteria.

### Market capacity and quantitative estimates
- Institutional market capacity indicators:
  - $260 billion (United States outstanding Tier 1 and Tier 2).
  - €580 billion (Europe outstanding Tier 1 and Tier 2).
  - $923 billion (European and U.S. bank equity markets combined).
- Illustrative SIFI issuance estimates:
  - For additional loss-absorbing capital of 2 percent of risk-weighted assets, 25 global SIFIs would need to issue $300 billion of CoCo bonds.
  - If those SIFIs use CoCos to meet the countercyclical buffer in bad times, they may need to issue another $400 billion.
  - If a sample of 25 global SIFIs were to issue CoCo bonds to cover up to 2.5 percent RWA for the countercyclical buffer, this would represent $392 billion.
  - If the SIFI additional loss-absorbing capital requirements were established at 2 percent of RWA, the same sample could use CoCo (or equity) to the extent of $314 billion.
- Phase-out implication:
  - Over $1 trillion of outstanding subordinated and hybrid debt will be phased out by 2022, implying banks may have to issue loss-absorbing instruments of this magnitude in coming years.
- Crowding and investor-composition risks:
  - Risk of “crowding out” if equity investors prefer CoCos to equity, potentially raising the cost of issuing common equity.
  - Sequencing recommendation: strong banks should issue first to build confidence; initial investors could include hedge funds, sovereign wealth funds, and high-yield or equity investors; over time, traditional credit investors, real money, asset managers, and insurers could provide depth.

### National initiatives and bail-in proposals
- Swiss contingent capital proposal (Swiss Commission of Experts, October 4, 2010):
  - Framework to be adopted into law by early 2012; raises total capital ratio to 19 percent: 10 percent in Common Equity Tier 1 (CET1) and 9 percent in contingent-convertible bonds (CoCos).
  - Breakdown: 3 percent with a “high level trigger” of 7 percent of CET1 to meet the enhanced “additional capital conservation buffer,” and 6 percent with a “low level trigger” of 5 percent of CT1 as a SIFI additional loss-absorbing capital requirements or “progressive component.”
  - Triggers contractually predefined and based on common equity ratios in line with Basel III.
  - Equity conversion prices would not be predefined and could be either set at time of conversion or at time of issuance; write-down could be an alternative.
  - Pre-conversion classification: dated subordinated debt with nondeferrable coupons (ex-lower Tier 2 debt).
  - Implementation timeframe: same timeframe as Basel III, by 2019; accumulation of capital overseen by FINMA and the SNB as part of capital planning.
- “Bail-in” proposals (statutory write-down/conversion powers):
  - Provide supervisors discretionary power to cancel, write-down, or convert existing claims of debt holders, or override pre-emption rights — enabling recapitalization in a few days rather than months.
  - Recapitalization via conversion of private debt into equity reduces moral hazard compared with bailouts and is better suited for larger shocks/tail risks because institutions maintain substantial unsecured debt eligible under “bail-in” schemes.
  - Challenges: legal and political opposition; require statutory powers to write down existing claims, override pre-emption rights, and change management; cross-border implementation challenges if home-country statutory power does not apply to debt booked in foreign jurisdictions or governed by foreign law.

### Models of bail-out, insurance funds, and CoCos (Appendix I)
- Basic model result:
  - For a given expected profit, the gross return increases when M decreases; bank’s incentive is to leverage as much as possible (increase default probability) to maximize return on equity.
- Bail-out effects:
  - Government bail-out transfers create incentive to maximize transfers via risk-taking; with expectation of bail-out and no interest-rate response, banks take maximum risk as long as probability of default > 0.
- Bail-out insurance fund:
  - Ex ante premium equal to expected bail-out transfer reduces incentives for excessive risk; riskier banks pay higher premiums.
- CoCo model:
  - Bank issues convertible debt Dc in addition to regular debt; three outcome regions for R determine default, conversion, or no conversion.
  - Interest rate is higher for convertible debt than for plain vanilla debt.
  - Result: the value of capital is maximized by the bank taking minimum risk; CoCos reduce incentives to take excessive risks by eliminating bail-out or reducing default probability.
- Trigger and conversion design trade-offs summarized in Appendix tables:
  - Bank-specific triggers: advantages (clearer incentives, targeted, easier pricing for financial indicators); disadvantages (lagging indicators, price/manipulation risks, false positives).
  - Systemic triggers: advantages (simultaneous recapitalization); disadvantages (lack of differentiation, possible high funding cost).
  - Dual triggers: mix benefits and drawbacks.
  - Conversion mechanisms (par, below par, trading-price-based, principal write-down, fixed-number-of-shares, capital-shortfall–based) each have trade-offs regarding valuation certainty, dilution risk, manipulation incentives, issuance costs, and effectiveness.

### Concluding observations and design recommendations
- Role and limits:
  - Contingent capital instruments should be part of a comprehensive crisis prevention and management framework, not standalone tools.
  - Not designed to deal with liquidity problems; conversion stops interest payments but does not generate additional liquidity and may, if perceived negatively, generate liquidity squeezes.
  - May require pre-committed liquidity support from central banks or consortia of private banks.
- Design priorities:
  - Conversion trigger and conversion rate are crucial; different objectives (prevention, resolution, market discipline) require different designs.
  - Triggers based on capital ratios of individual institutions are preferable—less prone to market manipulation and contagion; both shareholders and bondholders will have incentives to avoid letting capital fall near trigger point.
  - For crisis prevention, conversion triggers should be set high enough, relative to point of insolvency, to ensure conversion well ahead of distress.
  - For orderly resolution, conversion triggers may be set at low level close to insolvency to enlarge private sector burden sharing.
  - Ensure consistency, transparency, and standardization to avoid complex structures and support higher capital transparency.
  - Supervisors must monitor design and issuance, implied transfer of risks, and potential build-up of systemic risks, including liquidity risk.
- Uncertainty and vigilance:
  - Contingent capital instruments are untested; careful vigilance by supervisors is required to avoid adverse unintended consequences and to enhance market acceptance.

*Source: _sdn1101 - Executive Summary (and accompanying Box 1, Appendix I, Appendix Table 3)*

### Executive Summary ......................................................................................................

### _sdn1101 - Executive Summary

### Overview
- Contingent capital instruments are dated bonds with principal and scheduled coupon payments that can be automatically converted into equity (contingent-convertible bonds or CoCos) or written down when a predetermined trigger event occurs, enabling a fresh injection of capital into a distressed bank.
- Several regulators (Canada, Netherlands, United Kingdom, and the United States) have shown interest in adding contingent capital to their supervisory toolkits; Switzerland’s contingent capital proposal is expected to be adopted into law by early 2012.
- Contingent capital proposals are under discussion within the Basel Committee, the Financial Stability Board (FSB), and the European Union.

### Main conclusions and intended roles
- Contingent capital instruments could be considered as part of a comprehensive and consistent crisis-management framework; they are unlikely to be effective as stand-alone tools.
- These instruments should be implemented within a comprehensive framework including:
  - strengthened supervision;
  - an enhanced capital base;
  - revamped disclosure that better informs markets;
  - an effective resolution regime.
- Contingent capital should only be viewed as a complement to, not a substitute for, equity.
- Policies supporting contingent capital should be squarely geared toward reducing the risk and cost of systemic crises by:
  - enabling automatic conversion of debt into equity when market access is difficult; and
  - disincentivizing excessive risk taking by financial institutions.
- Contingent capital instruments could be used to meet more stringent capital buffers, including additional loss-absorbing capital requirements for SIFIs. The design of conversion triggers and conversion rates will be crucial to ensure effectiveness.

### Design considerations: triggers and conversion
- Triggers determine the probabilities of conversion or conversion risks; conversion aims to impose losses upon creditors who otherwise would be affected only by default.
- Types of triggers (Appendix II, Table 1):
  - Systemic triggers (system-wide conditions such as liquidity conditions, a market volatility index, or supervisory declaration of a systemic crisis):
    - May be efficient at addressing systemic risks by increasing capital across the banking system simultaneously.
    - Forego market-discipline benefits since limited additional incentive exists for individual banks to improve risk management.
    - Rating and pricing would be complex given difficulty predicting systemic events and supervisory discretion.
  - Bank-specific triggers (a bank’s capital ratio, share price or CDS price, or an assessment of nonviability by the supervisor):
    - Market- or capital-ratio-based triggers are likely easier to rate and price than discretionary triggers.
    - Reported capital ratios align with regulatory frameworks but are lagging indicators and may not trigger conversion early enough.
    - Market-based triggers risk market manipulation; mitigations include using moving averages of market prices.
- Trigger level:
  - High-level triggers (set at capital levels well above distress thresholds) can be useful for crisis prevention by ensuring recapitalization well before serious difficulties and by encouraging shareholders and bondholders to exercise market discipline.
  - Potential adverse effect: managers may prefer to deleverage before reaching triggers, causing asset sales that could depress prices and transmit contagion ("fire sale" externality).

### Comparisons with existing instruments and capital framework
- Contingent capital differs from existing hybrid instruments:
  - Contingent capital are dated debt with contractual debt/equity conversion or write-down clauses; existing convertible hybrids are perpetual debt focusing on coupon deferral or maturity extension.
  - Contingent conversion is automatic upon activation of a predetermined trigger; existing hybrids’ conversion is largely at bank discretion unless regulatory ratios are breached.
- Contingent capital should be supplementary to common equity and should not compromise capital transparency or the enhanced capital structure under Basel III.
- Basel III change cited: minimum common equity ratio raised from 2 percent to 7 percent (of which 2.5 percent is a conservation buffer).

### Potential benefits for market discipline and bank behavior
- Credible threat of losses from conversion and dilution could reduce risk taking by managers, shareholders, and bond holders.
- Bond holders required to bear part of future recapitalization costs would have enhanced incentives to exercise market discipline.
- Suggestion: bank manager bonuses could be paid in contingent convertible debt to reduce incentives for excessive risk taking.
- A simple two-period model (Appendix I) shows CoCos can promote market discipline and have effects equivalent to a risk-based, pre-funded bank resolution fund.

### Operational and marketability concerns
- Contingent capital instruments are largely untested and could have unintended consequences during high market volatility and uncertainty.
- Marketability is uncertain; sufficient investor demand is not guaranteed.
- Design features are key to avoid adding procyclicality and complexity to capital structures.
- Potential adverse effects include:
  - Negative signaling as bank capital approaches the conversion trigger.
  - Contagion risk and susceptibility to price manipulation.
  - Potential “death spirals” (very sharp and continuous declines in share prices); debt contracts could consider circuit breakers to mitigate this risk.
- Supervisory vigilance needed to monitor:
  - design and issuance of contingent capital instruments;
  - implied transfer of risks within the financial system;
  - potential build-up of systemic risks, including liquidity risks.

### Role in crisis prevention and resolution for SIFIs
- Contingent capital can help reduce the likelihood of SIFI failure and increase the possibility of private-sector burden sharing in failures, improving market discipline.
- Could be used to meet additional loss-absorbing capital requirements for SIFIs, but effectiveness depends on trigger and conversion-rate design.

### Final observations
- Contingent capital may be preferred by banks over equity because:
  - interest expense may be tax deductible (potentially cheaper);
  - prior to conversion it is nondilutive to existing shareholders and does not change corporate control;
  - it may be acceptable as Pillar 2 capital for supervisory stress tests.
- Lessons from the crisis and from pre-crisis hybrids must inform CoCo design to avoid repeating failures of hybrid instruments in absorbing losses.

*Source: _sdn1101 - Executive Summary*

### Box 1. A Schematic Exposition of Use of Contingent Capital Instruments

### Box 1. A Schematic Exposition of Use of Contingent Capital Instruments

### Crisis prevention, crisis management (going concern), and orderly resolution (gone concern)
- Crisis prevention tools:
  - Better management incentives to lower the risk appetite.
  - Higher capital buffers (e.g., Basel III) and additional loss-absorbing capital instruments that could include CoCos.
  - Revamped disclosure to inform markets of the true and fair view of the capital position of financial institutions.
  - More intrusive supervision—impose restrictions on dividends; mandate capital plans earlier.
  - Promote pre-emptive restructuring by virtue of effective resolution and recovery planning (e.g., sale of nonstrategic subsidiaries).
- Crisis management (going concern):
  - Revamped prevention lowers contagion by a distressed SIFI, allowing management and authorities to undertake progressively more aggressive restructuring measures to stave off insolvency as capital levels deteriorate.
  - Central bank emergency liquidity assistance could be made available under the conditions that equity solvency is sustained and borrowing is properly collateralized.
- Orderly resolution (gone concern):
  - A framework should provide a menu of resolution-transaction options, including:
    - A transaction for the purchase of viable assets and assumption of certain liabilities by an existing institution.
    - Temporary creation of government-owned bridge financial institution (both necessary for SIFIs).
    - Liquidation of assets with deposit transfer/payout supported by depositor guarantee schemes (available for smaller nonsystemic institutions).

### Triggers, objectives, stress levels, and instrument approaches
- Restructuring measures as capital declines—schematic distinctions:
  - Examples of high triggers:
    - Common equity ratio 7 percent of risk-weighted assets (Swiss proposal).
    - 7 percent above plus any countercyclical buffer requirements.
    - Objective: Recapitalization to stabilize the situation and build market confidence.
    - Degree of stress: Deteriorating financial situation (going concern).
    - Approach: High-trigger CoCos convert to equity via ex ante contractual agreement between issuers and investors.
  - Examples of low triggers:
    - Common equity 5 percent of risk-weighted assets, or ratio of equity to nonrisk-weighted assets.
    - Objective: Provide additional recapitalization to prevent receivership.
    - Degree of stress: Threat of failure (going concern).
    - Approach: Low-trigger CoCos convert to equity via ex ante contractual agreement between issuers and investors.
  - Point of nonviability or other resolution triggers:
    - Objective: Compulsory restructuring to prevent insolvency resolution.
    - Degree of stress: Threat of insolvency (going/gone concern).
    - Approach: In order of claim priority, subordinated debt and, ultimately, unsecured senior debt could be subject to debt-to-equity conversion. Contractual possible, but most likely would require statutory powers.

- Operational considerations and risks:
  - Instruments with low-level triggers can be useful for orderly resolution if the trigger is set at the point of nonviability to ensure private sector involvement (example cited: Lloyds Banking Group).
  - Market confidence could weaken as bank capital approaches conversion triggers, creating liquidity pressures—arguments for careful integration with emergency liquidity facilities and supervisory intervention.
  - Conversion rate determines burden sharing between shareholders and bondholders and affects monitoring incentives:
    - High dilution: ex ante shareholders lose most.
    - Little dilution: contingent debt holders lose most.
  - Conversion design options:
    - Conversion into a predetermined number of shares based on par value divided by issuing bank’s share price at issuance—bondholders suffer losses as if shareholders; shareholder dilution limited to lower share prices.
    - Conversion into an ex post determined number of shares based on par value divided by share price at time of conversion—holders receive notional amount in shares and would not suffer losses if they could sell shares, but ex ante shareholders suffer stronger dilution; risk of “infinite dilution” or “death spirals” when share prices fall close to zero; may be prone to market manipulation and could justify circuit breakers.

- Debt write-off features:
  - More suitable for cooperative and mutual banks that cannot issue shares.
  - Example: Rabobank Senior Contingent Notes (SCN) — original principal amount can be written off by 75 percent if the bank’s common equity ratio falls below 7 percent.
  - Large haircuts incentivize bondholder monitoring but increase instrument cost and likely limit issuance to strong banks.

### Pricing, investor demand, and market development
- Pricing and demand drivers:
  - Depend on conversion triggers, types of conversion, and conversion rates.
  - For a given conversion rate, instruments with a low trigger should be cheaper than those with a high trigger.
  - Investor preferences:
    - Conservative, traditional real-money investors prefer lower probability of conversion (lower triggers).
    - Dynamic/speculative investors more willing to consider high-level trigger CoCos (greater loss risk).
- Preconditions for a deeper contingent-capital market:
  - Obtain ratings.
  - Lift mandate restrictions that prevent some investors from holding equity-like products.
  - Obtain inclusion of CoCos in benchmark indices.
  - Historical parallel: European hybrid market took close to five years after inception in 1997 to reach critical mass.
- Tax and regulatory treatment:
  - Tax deductibility of interest lowers cost. Two European banks issued tax-deductible contingent capital instruments with different regulatory capital status—Lloyds (lower Tier 2) and Rabobank (noncapital senior debt).
  - Lack of further issuance possibly due to regulatory uncertainty.
  - Most existing hybrid securities will no longer qualify as regulatory capital under Basel III after January 2013 and will be phased out over time by 2023.
  - Under Basel III, Tier 1 capital ratio will incorporate up to 25 percent of “other qualifying” noncommon equity instruments, but based on stricter criteria.
- Potential investor pool and market capacity:
  - If contingent capital targets fixed-income investors, outstanding Tier 1 and Tier 2 debt markets indicate current institutional market capacity of about $260 billion for the United States and €580 billion for Europe.
  - European and U.S. equity markets for bank stocks, combined, amount to about $923 billion.
  - Risk of “crowding out” if equity investors prefer CoCos to equity, potentially raising the cost of issuing common equity.
- Sequencing recommendation:
  - Strong banks should issue first to build confidence; initial investor base could include hedge funds, sovereign wealth funds, and high-yield or equity investors; over time, traditional credit investors, real money, asset managers, and insurers could provide depth.

### Basel Committee Point of Nonviability proposal and national initiatives
- Basel Committee (January 13, 2011) proposal:
  - All noncommon equity Tier 1 and all Tier 2 instruments must have a provision requiring them to be written off or converted into common equity upon the trigger event.
  - Trigger event defined as earlier decision by the relevant authority that (i) the firm would become nonviable without a debt write-off; or (ii) the firm would become nonviable without a public sector injection of capital or equivalent support.
  - The relevant authority is where the capital is being given recognition for regulatory purpose.
  - In conversion, instruments must be converted into common stock of the issuing bank or of the parent company of the consolidated group, including any successor in resolution.
  - The proposal is akin to a low-level trigger contingent capital instrument similar to a resolution tool; discretionary elements may affect pricing and marketability.
  - BCBS emphasizes contingent capital should not diminish need for reforming national insolvency and bank-resolution schemes.
- Contingent capital as additional loss-absorbing buffer for SIFIs:
  - Calibration for SIFIs’ additional loss-absorbing capital still under discussion; may be defined as a Pillar 2 add-on.
  - Illustrative figures: for additional loss-absorbing capital requirements of 2 percent of risk-weighted assets, 25 global SIFIs would need to issue $300 billion of CoCo bonds. If those SIFIs use CoCos to meet the countercyclical buffer in bad times, they may need to issue another $400 billion.
- Swiss contingent capital proposal (Box 2):
  - Swiss Commission of Experts (released October 4, 2010) framework to be adopted into law by early 2012; raises total capital ratio to 19 percent: 10 percent in Common Equity Tier 1 (CET1) and 9 percent in contingent-convertible bonds (CoCos).
  - Breakdown: 3 percent with a “high level trigger” of 7 percent of CET1 to meet the enhanced “additional capital conservation buffer,” and 6 percent with a “low level trigger” of 5 percent of CT1 as a SIFI additional loss-absorbing capital requirements or “progressive component.”
  - Main features:
    - Triggers contractually predefined and based on common equity ratios in line with Basel III.
    - Equity conversion prices would not be predefined and could be either set at time of conversion or at time of issuance. Write-down could be an alternative.
    - Pre-conversion classification: dated subordinated debt with nondeferrable coupons (ex-lower Tier 2 debt).
  - Implementation timeframe: same timeframe as Basel III, by 2019; accumulation of capital overseen by FINMA and the SNB as part of capital planning.

### “Bail-in” proposals (Box 3)
- Nature and advantages:
  - “Bail-in” schemes represent a statutory approach to debt write-downs or debt-equity conversion, endowing regulators with statutory powers to cancel, write-down, or convert existing claims of debt holders, or override pre-emption rights.
  - Provide supervisors discretionary power to recapitalize an insolvent SIFI more quickly (a few days) than bankruptcy rules (a few months or longer).
  - Recapitalization via conversion of private debt into equity reduces moral hazard compared with bailouts.
  - Better suited than contingent capital for larger shocks/tail risks because institutions maintain substantial unsecured debt eligible under “bail-in” schemes.
- Challenges:
  - Tough legal challenges and strong political opposition; require clear and convincing legal procedures and statutory powers to write down existing claims, override pre-emption rights, and change management.
  - Upon trigger, creditors would be forced to give up full legal claims in exchange for overall value maximization and continued business operations, potentially interfering with laws guaranteeing property rights—necessitating legislative changes.
  - Cross-border implementation challenges: home-country statutory power may not apply to debt booked in foreign jurisdictions or governed by foreign law, reducing effectiveness unless states adopt laws recognizing foreign resolution authorities’ statutory power.

### Market capacity, regulatory interactions, and practical limits
- Existing market sizes:
  - Institutional market capacity indicators: $260 billion (United States outstanding Tier 1 and Tier 2), €580 billion (Europe outstanding Tier 1 and Tier 2), and $923 billion (European and U.S. bank equity markets combined).
- Regulatory and market constraints:
  - Barriers to CoCo market development include obtaining ratings, lifting mandate restrictions, and inclusion in benchmark indices.
  - Tax treatment and regulatory capital recognition are crucial; regulatory uncertainty has limited issuance.
  - Most existing hybrid securities will not qualify under Basel III after January 2013 and will be phased out by 2023.
  - Potential need to limit certain investors (e.g., leveraged financial institutions of systemic importance) from holding convertible instruments to avoid contagion from write-offs.
  - Regulators need to ensure post-conversion new equity holders are “fit and proper.”
  - Cross-holding limits for SIFIs’ holdings of CoCos unclear; Basel III’s more onerous liquidity requirements likely limit cross-holdings.

### Concluding remarks and design recommendations
- Role and limits:
  - Contingent capital instruments should be part of a comprehensive and consistent crisis prevention and management framework, not standalone tools.
  - Not designed to deal with liquidity problems; conversion stops interest payments but does not generate additional liquidity and may, if perceived negatively, generate liquidity squeezes.
  - May require pre-committed liquidity support from central banks or consortia of private banks.
- Design priorities and considerations:
  - Conversion trigger and conversion rate are crucial; different objectives (prevention, resolution, market discipline) require different designs.
  - Triggers based on capital ratios of individual institutions are preferable—less prone to market manipulation and contagion; both shareholders and bondholders will have incentives to avoid letting capital fall near trigger point.
  - For crisis prevention, conversion triggers should be set high enough, relative to point of insolvency, to ensure conversion well ahead of distress.
  - For orderly resolution, conversion triggers may be set at low level close to insolvency to enlarge private sector burden sharing.
  - Ensure consistency, transparency, and standardization to avoid complex structures and support higher capital transparency.
  - Supervisors must monitor:
    - The design and issuance of contingent capital instruments.
    - The implied transfer of risks within the financial system.
    - Potential build-up of systemic risks, including liquidity risk.
- Uncertainty and vigilance:
  - Contingent capital instruments are untested; careful vigilance by supervisors is required to avoid adverse unintended consequences and to enhance market acceptance.

*Source: _sdn1101 - Box 1. A Schematic Exposition of Use of Contingent Capital Instruments*

### APPENDIX I. MODELS OF BAIL-OUT AND BANK RISK TAKING

### APPENDIX I. MODELS OF BAIL-OUT AND BANK RISK TAKING

### A. The Basic Model
- Setup:
  - Bank starts at period 1 with cash capital M and investment I financed by outside equity (NP) and debt (D): P·N + M = I.
  - Period 2 repayment on debt is (1+r)D; risk-free rate assumed equal to zero.
  - Gross payoff on investment I is stochastic R.
  - Default and payoff cases:
    - If R < (1+r)D: bank defaults; creditors receive R; shareholders receive zero (default assumed costless initially).
    - If R > (1+r)D: debt is repaid and each share receives residual [R-(1+r)D]+.
- Equilibrium and returns:
  - Share value and expected value of shares determined by the distribution of R and the interest rate r set in equilibrium.
  - Gross return on the bank’s own capital M is 1 + (expected value of equity)/M (expressed in the source as ܸ ܯ = 1 + ܧ(ܴ) ܫ / ܯ).
- Key analytical result:
  - Result 1. For a given expected profit, the gross return increases when M decreases. Therefore, the bank’s incentive is to leverage as much as possible (thus increase default probability), so that potentially high profits from its investment will be spread over a common equity base.

### B. The Model with Government Bail-Out
- Bail-out mechanism and incentive:
  - If the government transfers T = (1+r)D – R when R < (1+r)D, the bank expects to receive T to prevent default; this creates an incentive to maximize T via risk-taking.
- Risk parameterization:
  - Assume cash M = 0. Let R = R* + σ ε, where σ ∈ [σl, σh] is risk and ε ∼ f(ε) on [εl, εh] with E(ε) = 0.
  - Default cost d introduced: upon default creditors receive R - d, shareholders nothing.
  - Default occurs when ε < - [R* - (1+r)D]/σ.
- Equilibrium conditions (interest rate and value expressions given by integrals over f(ε)):
  - Interest rate r and value of capital V are determined by integral expressions (as in the source).
- Results:
  - Result 2. To maximize its value, it is optimal for the bank to take the minimum risk because of default cost d.
  - If interest rate does not respond to risks because of an ex post bail-out guarantee that prevents default, then ∂V/∂σ > 0 (source expression: 0)(/])1([*... ), implying:
  - Result 3. With the expectation of bail-out, the bank will take maximum risk as long as the probability of default is greater than zero.

### C. The Model with a “Bail-Out” Insurance Fund
- Mechanism:
  - Government imposes an ex ante premium equal to the expected value of the bail-out transfer; the bank receives transfer T = [(1+r)D – R]+ in period 2 but the transfer goes to repay creditors.
  - Premium = E[T] = ∫_{ε_l}^{...} [(1+r)D - (R* + σ ε)]+ f(ε) dε (as in source expression).
- Effect on risk-taking:
  - A bank perceived as riskier (higher σ) pays a higher insurance premium.
  - Capital net of insurance premium V_net includes these premium deductions (integral expressions provided in source).
- Key result:
  - Result 4. A “bail-out” insurance fund reduces the incentives for banks to take excessive risk.

### D. A Model with Contingent Convertible Bonds (CoCos)
- Structure:
  - Bank issues convertible debt Dc in addition to regular debt D so that P·N + M + D + Dc = I.
  - Three outcome regions based on R:
    - i) R < (1+r)D: default; regular debt creditors receive R - d; shareholders and CoCo investors receive nothing.
    - ii) (1+r)D < R < (1+r)D + (1+rc)Dc: CoCos convert; CoCo investors receive share φ of total capital where φ = N'/(N+N').
    - iii) R > (1+r)D + (1+rc)Dc: no default and no CoCo conversion.
- Pricing and comparison:
  - Interest rates for convertible debt and plain vanilla debt determined by integral expressions over f(ε) (as in source).
  - One can show the interest rate is higher for convertible debt than for plain vanilla debt.
- Value and incentives:
  - Value of capital expressed as integrals incorporating Dc (source expression).
  - Result 5. The value of capital is maximized by the bank taking minimum risk. Contingent convertible bonds reduce the bank’s incentives to take excessive risks by eliminating the bail-out or reducing the probability of default.

### Policy-relevant summaries from the Appendix tables and later discussion
- Trigger design considerations for contingent capital (from Appendix Table 1):
  - Bank-specific triggers (financial soundness indicators, market indicators, supervisory discretion):
    - Advantages: clearer incentives, targeted, easy to price (for financial indicators), forward-looking (for market indicators), addresses lag of accounting measures (supervisory discretion).
    - Disadvantages: lagging indicators, price/manipulation risks, false positives, uncertainty and negative signaling from supervisory discretion.
    - Example: Lloyds exchange trigger set at “5% of published core Tier 1 capital to total RWA”.
  - Systemic triggers (pre-determined general conditions, supervisory declaration of systemic crisis):
    - Advantages: simultaneous recapitalization of system, automaticity (for pre-determined triggers).
    - Disadvantages: lack of differentiation among banks, potential mis-specification, reliance on supervisory judgment, possible high funding cost due to uncertainty.
  - Dual triggers (bank-specific + systemic):
    - Advantages: broad-based recapitalization with differentiation among banks.
    - Disadvantages: potential mixed signals and combining weaknesses of triggers.
- Conversion options for contingent capital (from Appendix Table 2):
  - Various conversion mechanisms (conversion at par value, below par, at/above/below trading price, principal write-down, fixed number of shares, conversion based on capital shortfall) have trade-offs:
    - Trade-offs address valuation certainty for holders, dilution risk for shareholders, incentives for market manipulation (e.g., short-selling), issuance costs, and effectiveness in creating capital buffers.
    - “No conversion but principal write-down” cited as most cost-efficient form (no dilution risk), but still vulnerable to market manipulation incentives.
- Comparison with hybrids and subordinated debt (Appendix III):
  - Hybrid instruments share debt and equity features and may be cheaper for issuers, but during the recent crisis they did not provide meaningful loss absorption because loss-absorbing clauses (coupon deferral, maturity extension) were at banks’ discretion and governments often avoided liquidation.
  - Responses during crisis included buybacks of bonds at heavy discounts, creating capital gains but imposing permanent losses on bondholders ahead of shareholders.
  - Regulatory tightening by BCBS:
    - Higher minimum capital requirements instituted: common equity from 2 percent to 4.5 percent; Tier 1 from 4 percent to 6 percent; overall capital ratio maintained at 8 percent. Additional capital buffers introduced.
    - All new Tier 1 and Tier 2 instruments must be loss-absorbing to be eligible as regulatory capital.
    - Most existing hybrid and subordinated instruments will not qualify as capital after January 1, 2013; other non-qualifying instruments phased out by 2022.
  - Tier 1, Tier 2, and contingent capital must entail equity conversion clauses or permanent write-offs under the new Basel III regime; the ordering of loss absorption (e.g., whether contingent capital conversion occurs before or after deferral/write-down of hybrids) requires regulatory clarification to facilitate pricing.

*Source: APPENDIX I. MODELS OF BAIL-OUT AND BANK RISK TAKING (from the supplied IMF content unit)*

### Appendix Table 3. Comparison of Characteristics of Contingent Capital and

### Appendix Table 3. Comparison of Characteristics of Contingent Capital and Basel III Tier 1 and Tier 2 Loss-Absorbing Instruments

### Key instrument characteristics (as reported in the table)
- Hybrid Tier 1 with Conversion or Write-Down
  - Rank: Tier 1
  - Maturity: Perpetual
  - Coupon deferability: Yes
  - Status of missed coupons: Noncumulative (cancelled)

- Tier 2 With Conversion or Write-Down
  - Rank: Tier 2
  - Maturity: Dated
  - Coupon deferability: No
  - Status of missed coupons: Not applicable

- High-Level Trigger Contingent Capital (>7%)
  - Rank: Possibly Tier 2 (pre-conversion)
  - Maturity: Dated
  - Coupon deferability: No
  - Status of missed coupons: Not applicable

- Low-Level Trigger Contingent Capital (5%)
  - Rank: Possibly Tier 2 (pre-conversion)
  - Maturity: Dated
  - Coupon deferability: No
  - Status of missed coupons: Not applicable

- Note: "Gone concern" refers to the point of nonviability. (Footnote 1/)

### Investor base, yields, and market implications (text and figure summary)
- Traditional investor base for hybrid Tier 1 and Tier 2 securities: fixed-income investors.
- Features of contingent capital (conversion into equity or permanent write-down) may deter traditional fixed-income investors; a new investor base may emerge for CoCos, starting with:
  - Hedge funds
  - High yield investors
  - Equity investors
- Figure 3 (Indicative Investors’ Yield Targets and Select Capital Instruments Yields in Europe) signals a possible shift in investor demand and required yields across instruments and investor types (yields shown on the figure range from 6% and below to >12%, with categories including Fixed Income investors, Retail investors / Private Banking, SWF, HY Investors, Hedge Funds, Equity investors).

### Quantitative estimates of potential CoCo market demand and stock replacement needs
- If a sample of 25 global SIFIs were to issue CoCo bonds to cover up to 2.5 percent RWA for the countercyclical buffer, this would represent $392 billion.
- If the SIFI additional loss-absorbing capital requirements were established at 2 percent of RWA, the same sample could use CoCo (or equity) to the extent of $314 billion.
- Over $1 trillion of outstanding subordinated and hybrid debt will be phased out by 2022, implying banks may have to issue loss-absorbing instruments of this magnitude in coming years.

### Observations and implications highlighted in the source text
- Contingent capital’s conversion or permanent write-down features may change the investor composition away from traditional fixed-income investors.
- Mapping investors’ yield targets against expected yields on future Basel III instruments highlights the potential for a gradual shift in the investor base toward investors targeting higher yields or equity-like payoffs.
- Standard & Poor’s (2010) noted contingent capital’s main use would be to replace the stock of disqualified capital instruments.

*Source: Appendix Table 3. Comparison of Characteristics of Contingent Capital and (from _sdn1101 - Appendix Table 3. Comparison of Characteristics of Contingent Capital and, IMF staff document).*

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