Will ‘cocos’ make the banks go pop?

Wouldn’t it be great if the next time there is a global financial crisis, banks could call up extra capital as if by magic?

Since the economic meltdown of five years ago, regulators have been working on a bag of tricks to fix the industry.

But what if one of the main innovations designed to protect taxpayers is just an illusion? What if rather than save the banks, they could make the situation even worse?

Contingent convertible capital, known as coco bonds, have already become one of the most fashionable trades in the City with hedge funds and bankers.

Even though some have already nicknamed them “death spiral securities”.

So how are cocos meant to help the banks? Banks hold reserves of capital. This can be set against losses they make on loans as they build up.

The more capital they have, the safer the banks are.

Magic money?

Cocos start life as bonds, but in a crisis, Cocos become available as capital, which helps lenders absorb losses.

But critics think that when that happens, there could be problems.

When Lehman Brothers collapsed in 2008, it became dramatically clear that the foundations of some banks were terribly shaky. Some collapsed altogether.

If such a crisis were ever repeated in the future, cocos should spring into action to act an emergency buffer for the banks.

But shareholders and critics worry that the minute cocos are triggered, they give a signal to the market that a bank is in trouble. And that could trigger a run on the bank – similar to the ones that brought down Northern Rock.

Misplaced confidence?

Cocos could fail to offer enough protection if we had another financial crisis.

A leading voice in the City, Jessica Ground, from Schroders – one of the world’s biggest investors – told me there’s a risk investors could forget that these aren’t traditional bond-like investments.

“They think of them as being very safe… When you have systematic problems, regulators will get concerned about the signal of saying all of these banks have got to convert, all of these banks have got capital problems.

“They’re not going to want to cause a run on these banks and a drying up of liquidity, which was the real problem. They want to make sure that people remain confident, and I think they’ll be concerned about the idea of not triggering these cocos to maintain confidence if there’s a widespread crisis.”

A lot of people love cocos – even the regulators. But many in the City say the Bank of England is failing to factor in unpredictable market behaviour. A classic case, perhaps, of unintended consequences.

Some shareholders are sceptical – the trade in cocos is doubling in size every year, making a lot of people rich along the way.

Low returns

So why have most UK banks now issued them? Just this week, Lloyds closed a £5bn coco deal.

Ms Ground said: “I think the primary reason is that interest rates are so low so the returns that you’re getting on very safe assets like government bonds aren’t that attractive to a lot a of investors.

“They want more income and so they’re looking up the risk curve for different types of assets.”

There were warnings again this week that taxpayers could be on the hook for banks being rescued, and senior politicians want answers.

Among them Andrew Tyrie, the chair of the treasury select committee, who said: “Most people have concluded that cocos have something to offer in strengthening bank balance sheets in a crisis, but there’s always the risk that the structure of some cocos could have the opposite effect and that should be looked at carefully by the financial policy committee of the Bank of England.

“That’s what we’ve got them for – they’re a relatively new body put in to do exactly this kind of work – to identify what can help make our banks safer and what will make them riskier.”