Contingent capital, of one form or another, continues to be a hot topic in European financial markets. In January, Dutch mutual Rabobank announced plans to be the first to issue a hybrid bond that will comply with strict new global rules on which securities can count towards regulatory capital. The AAA rated bank is currently marketing a hybrid where investors can lose all their investment if the bank breaches pre-determined capital ratios.

This joins the ranks of only two other contingent capital issues so far (including an earlier one by Rabobank, and another from the UK's Lloyds Banking Group), neither the same as each other, and neither quite in the form envisaged for regulatory capital. 

While the Basel Committee and national regulators are still deliberating on how contingent capital – or Cocos – will work, last autumn, the Swiss National Bank put its weight behind the product when it decreed that systemically important Swiss banks (in other words, UBS and Credit Suisse) must hold 9% of their new capital ratio of 19% in the form of contingent convertible capital.

Swiss banks have until 2013 to raise this debt, but estimates suggest that Credit Suisse will have to raise about SFr36bn ($37.3bn) of Cocos, while UBS will have to raise approximately SFr27bn in the next two years. Research from Barclays suggests that the Coco market in Europe alone could be several hundred billion euros.

But it is still a fledgling market – and one that does not yet have a natural investor base. This is not least because these products do not sit neatly in either an equity or a bond portfolio, the typical structures for which mandates are awarded at the world's big institutional investment houses.

Then, in January, UK bank Barclays added another twist to the debate when it announced plans to pay a large portion of bonuses in the form of Cocos. Barclays' bonus plan is currently under review with the country's regulator, the Financial Services Authority, but many see the use of such instruments as a remuneration tool as a no-brainer.

Unlike share awards, which some argue prompt bankers to take big risks to keep their employer’s share price up, Cocos pay a fixed annual return, and only fall in value if an institution suffers heavy losses. Supporters argue that this better aligns bankers' interests with those of other stakeholders by encouraging recipients to pay more attention to a firm's overall risk profile instead of just their own division's profits.

According to many bankers at this year's meeting of the World Economic Forum in Davos, their own firms are discussing the notion of using Cocos as a remuneration tool for this very reason.

But it is unclear whether incentive structures can ever achieve the precision their advocates intend, or that such a close alignment of interests is achievable in practice. Senior executives at both Bear Stearns and Lehman Brothers were major holders of their own firms' equity and we can bet that they believed their interests were aligned with those of other shareholders. Neither Lehman Brothers’ or Bear Stearns’ downfall was a question of the wrong incentives, but a lack of understanding of the risks their businesses were undertaking.

Whether or not Cocos, or any other hybrid permutation, ultimately make an ideal bonus pool, bonus Cocos will not add up to a significant capital cushion for banks on conversion. Nor will bonuses create a market in these instruments.

Rumour has it that hedge funds – the nimble players that are often first into a market – are already readying Coco funds. We will have to see if mainstream institutional investors follow suit.


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