What are they?
Contingent convertible (CoCo) bonds are a new way for banks to raise capital. Traditionally, banks (like other businesses) had two sources of capital: debt (e.g. money from issuing bonds), which must be paid back to investors, and equity (e.g. money from issuing shares), which is permanent. In simple terms, this creates a conflict between the bank’s owners (who tend to prefer new finance to be raised from debt, to avoid having their own share of ownership reduced) and regulators (who expect banks to hold sufficient equity capital to cope with financial shocks). CoCo bonds are a kind of hybrid between debt and equity: they are issued as debt but convert automatically into equity when a bank gets into trouble.
Why are they in the news?
Regulators and bankers are keen to avoid a repeat of the recent financial crisis, when existing forms of hybrid finance were shown to have serious failings. An inherent problem within banking finance is the risk of panic: when a bank needs to convert hybrid debt into equity, it sends a clear signal to investors that the bank is in trouble. These investors are then tempted to withdraw their investments, making the initial problem much worse. CoCo bonds are emerging as the most concrete new idea for solving these inherent problems, but many issues remain to be solved, not least how to define the trigger that causes the bonds to convert automatically. The first CoCo bonds were issued by Lloyds Banking Group in November 2009.
How can I use it in class?
The first link below leads to an excellent short video explaining the concept of CoCo bonds (you will have to register for the FT site, but registration is free and easy), which would work as a good listening / vocabulary / discussion lesson. The video also introduces essential financial concepts. Before you watch, write key vocabulary items on the board (contingent, convertible, hybrid, capital cushion, equity, debt, leverage, return on equity, assets going bad, hybrid bonds, credit rating agencies, coupon payments, pain sharing, a gentlemen’s agreement, bailed out banks, a stand-off, to breach a pre-agreed level, core tier 1 capital, a ratio). Elicit from the class what each of the terms means, and draw a circle round any terms that the class cannot explain. Get students to predict the connection between the terms and what the video will say about each of them. Play the video, pausing after each key vocabulary item is mentioned to check students understand what is going on. Focus especially on the circled items. After the video, students work in pairs to reconstruct what was said in the video, using the vocabulary items on the board.
Where can I read about it?
- Contingent convertible bonds explained, Financial Times, 7th December 2009.
- How to make a bank raise equity, Financial Times, 7th February 2010.
- Base camp Basel: Regulators are trying to make banks better equipped against catastrophe, Economist, 21st January 2010.
- UK experiment raises prospect of new asset class, Financial Times, 5th November 2009.
- Cocos – contingent convertible bonds, This is Money, 3rd November 2009.
- Contingent convertible bonds (CoCo bonds), definition from Money Terms.