Exploring contingent convertible bond alternatives for African banks

Abstract

Background: A variant of the contingent convertible bond, first proposed in 2011, is investigated: the Call Option Enhanced Reverse Convertible (COERC). Although issued as a bond, it converts to new shareholder’s equity if a bank’s market share of capital falls below a pre-specified trigger point.

Aim: COERCs avoid the problems with market-based triggers (e.g. sell-offs and death spirals) due to panic and market manipulation. Banks that issue COERCs have less incentive to choose investments that may be subject to large losses and disincentive problems, associated with the replenishment of shareholder’s equity after market declines (also known as debt overhang) are also avoided.

Setting: Proposed amendments to the COERC structure are suggested for the African market.

Methods: The data used were simulated, stylised values for a standard COERC. No market parameters are required, such as equity or debt levels or market volatility. Details of the stylised example are provided in Table 4 and Table 5 in the ‘results and discussion’ section.

Results: Both examples of floating coupons for COERCS would aid in the objective of issuing a security that is countercyclical in nature, as banks would avoid having to pay coupons in times of distress.

Conclusion: In addition to the recommendations of the Basel frameworks, CoCos have been considered and proposed as an additional measure to promote counter cyclicality in terms of capital composition in banks.