Effectiveness of the Basel III Contingent Convertible Mechanism on Market Discipline

Abstract

As part of the Basel III capital reforms, a new Additional Tier 1 (AT1) capital is introduced with the intention to improve market discipline which are the contingent convertible capital instruments (Cocos) widely discussed in the literature. Eligible Cocos that included as Additional Tier 1 capital need to be issued with both a capital ratio trigger and a mandatory point of non- viability trigger. With Basel III capital reforms started to be implement in Australian banking system from 1 January 2013, which is 3 years ahead of Basel Committee’s phase-in deadline. We examines the extent to which a risk premium is embedded in the credit spreads of newly issued Basel III AT1 Cocos and whether there is an impact on the secondary market liquidity of Cocos. Our estimations suggest that (i) the Basel III AT1 Cocos realise a risk premium of around 20 basis points compared with hybrid securities issued under the Basel I and Basel II regimes; (ii) there is no evidence that the risk monitoring effects of Cocos get improved due to the contingent convertible mechanism with the implementation of Basel III capital reforms; (iii) the secondary market liquidity of Cocos gets improved since the implementation of the Basel III capital reforms.

Keywords: Cocos, Market discipline, Basel III capital reforms, Contingent convertible

JEL Classification: G21, G28