Riskiest Bank Debt Could Spark Market Turmoil, Bundesbank Says

(Bloomberg) -- Bonds that are supposed to make banks stronger may end up causing another crisis.

The 178.6 billion euros ($222 billion) of notes that are meant to absorb losses at European banks -- while keeping them a going concern -- have gone largely untested. Actually triggering these contingent convertible notes, or CoCos, could spook investors and destabilize other lenders, especially if their volume grows, according to Germany’s Bundesbank.

Investors had a taste of that in 2016, when some analysts questioned whether Deutsche Bank AG could make payments on its version of those bonds. It did, but a plunge in the notes made waves and caused the bank to lose revenue as worried clients took their business elsewhere.

Riskiest Bank Debt Could Spark Market Turmoil, Bundesbank Says

The bonds are designed to ensure lenders that are heading for trouble have a way to retain cash while they try to turn things around. The notes convert to equity or are written off when the lender’s capital ratio -- its capital as a percentage of assets weighted by risk -- falls to a preset level. Banks can also suspend the coupons on the bonds to retain funds.

The problem is that the bonds tend to have complex documentation, and a bank using them as intended could push investors to sell the bonds of other lenders and even cause a run on their deposits, the Bundesbank said in its monthly report for March.

“Some instruments are definitely over-engineered,” said Gildas Surry, a partner at Axiom Alternative Investments in London. “The degree of complexity is such that sometimes it could even be an impediment to resolution.”

Riskiest Bank Debt Could Spark Market Turmoil, Bundesbank Says

Here are some of the main variations between CoCo bonds:

  • Trigger levels for conversion or write-off vary between and within countries, and can even be different for banks and their groups
  • Loss absorbency mechanisms vary; some convert to equity, others are written down
  • Writedowns can be full or partial to cover the loss, and permanent or temporary, with the possibility of being written back up as the company recovers
  • Coupons might be skipped because of national accounting rules or because the European regulatory framework requires it

Regardless of the unintended consequences, the bonds may only absorb losses once a bank has entered a tailspin. European regulators should consider raising the minimum threshold for converting or wiping out the bonds -- currently set at 5.125 percent -- to make them easier to trigger, the Bundesbank said.

Supervisory authorities need to pay closer attention to this market and in the long-term regulators should focus more on common equity, a higher quality form of capital, the German central bank said.

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