Why Do Banks Issue Contingent Convertible Bonds?

Abstract

This study investigates why banks issue Contingent Convertible Bonds (CoCos). We find that a bank’s systemic risk level is a possible reason for CoCo issuance. Contrary to the pecking order theory, earnings management practices play a lesser role, and there is no evidence of banks becoming riskier after issuing CoCos. However, we find systemically riskier banks are more likely to issue CoCos. Thus, riskier banks may be utilising CoCo loss absorption mechanisms to partially internalise the costs of future loan losses. If banks are issuing such instruments without regulatory prompting, then an issuance may signal the need to provide greater oversight. Conversely, if such issuances do result from regulatory prompting, then banks may be engaging in risk management strategies, minimising their cost of equity issuance.

Keywords: Systemic risk, financial intermediation, capital structure, CoCos

JEL Classification: E58, G21, G32