Bank of England official calls to simplify cocos

Bonds should be based on simple market triggers

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Contingent convertible bonds – dubbed “cocos” – should be based on simple market triggers rather than complex regulatory ratios, according to a top Bank of England official.

The call comes as banks looking to boost their capital are considering the bonds, which convert to equity when pre-set measures of financial strength are breached.

So far, the handful of deals issued have been based on regulatory capital ratios, which are each the product of hundreds of millions of separate calculations.

Instead, Andrew Haldane, director of financial stability at the Bank, has argued that cocos’ conversion could be based on one of three simple market-linked solvency tests that could be calculated by a “competent clerk and an envelope” rather than a “quant and a computer”.

“First, they are not reliant on myriad, mis-specified models,” said Mr Haldane. “Second, history suggests that, at least in the latest crisis, they would have given far timelier signals of impending stress.”

Mr Haldane suggested using either the ratio of a bank’s market capitalisation to its total assets; market capitalisation to total debt; or the ratio of the market value of its equity to its book value. The speech, released on Wednesday, offers one of the most detailed proposals on cocos to come from a top UK regulator.

While the speech is clearly Mr Haldane’s personal contribution to the debate, the proposal also offers clues on how the Bank, which will take over prudential regulation of banks in 2013, might approach the issue of cocos.

Banks have been exploring convertible debt as a way of heading off demands that they hold more equity against potential losses.

But global regulators, based in Basel, have not yet offered much detail on what kinds of cocos will be acceptable. Only Swiss regulators have moved forward unilaterally, calling for considerable billions of cocos on top of the regulatory capital minimums that have been agreed in Basel.

Last month Credit Suisse sold $2bn in cocos, attracting bids worth 11 times the amount sold. Rabobank, the Dutch mutual, and Lloyds Banking Group have also issued cocos.

Mr Haldane also addressed one of the strongest criticisms of market-based triggers – that short sellers would seek to drive the share price of a troubled bank down in order to trip the ratios and use the new shares to cover their positions.

He suggested that the conversion trigger be based on a 30-day average – making it harder and more expensive to move the share price – and that investors be prevented from using triggered cocos to cover their short positions.

The latter rule would be similar to existing regulations that prevent investors from using equity obtained in rights issues to cover short positions.

Lawyers and bankers, however, said that market-based triggers, while easier to calculate, may not prove to be any more reliable.

“Market-cap may be anything on any given day,” said Mark Glengarry, attorney at White & Case. “Is some of this equally open to arbitrage as regulatory capital?”

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