Overcooked Coco April 13, 2011 at 6:27 pm
Andy Haldane thinks that we should consider Cocos with market triggers as capital instruments for banks. Um. Dunno.
For me the issues are complex. First, whatever the Coco trigger is, it should be objective. There market will react badly to a trigger which is, in effect, whatever the supervisors want. That’s partly because as we have a longer period of calm the wisdom will develop that Cocos are never triggered; then, if they are, the shock will be enormous. So having an objective trigger – and one that is not too far from the money – is important.
Second, partial triggering is important. You do not want to be in a situation where the bank needs a bit more capital but not so much that the whole Coco needs to be triggered with the accompanying dilution for shareholders. IThe way to do that is to allow partial conversion.
Third, there is the hedging issue. Some folks will hedge Cocos by shorting equity against them. (And/or trading CDS.) The way to ensure that this hedging is not too disruptive, and is less likely to push the bank down, is to spread the gamma of the Coco around a range of strikes. This is a particular form of partial conversion where as the share price slides, more and more of the Coco converts. (Of course you need to adjust the current trigger for the dilution effect of earlier conversions.)
Fourth, false positives. Haldane is reasonably convincing that market based triggers do detect troubled firms. But do they detect trouble where none exists? My gut feeling is that part of the answer here is improved disclosure, but I’d want to see a thorough historical analysis of market based Coco conversions – and a behavioural analysis of how they would have been hedged – before truly embracing these instruments.
Update. See here for an interesting further discussion from VoxEU.