Contagion in the CoCos Market? A Case Study of Two Stress Events

Abstract

The post-crisis regulatory framework has fostered the development of the contingent convertible bonds (CoCos) market. These instruments permit banks to absorb losses as a going concern but their critics warn that they could have potentially destabilizing effects in stress situations. We analyse the dynamics of the European CoCos market during two stress episodes that occurred in 2016 and that were triggered by news of substantial unexpected losses faced by a European systemically important bank. Our econometric approach aims to disentangle the fundamental channel by which the contagion of such bank’s distress spreads to the rest of the market from a possible CoCo-specific contagion channel. We find evidence of significant CoCo-specific contagion in the two stress episodes, which could be the result of investors’ reassessment of the CoCos’ riskiness or of uncertainty about their supervisory treatment. Moreover, we find that the CoCo-specific contagion was weaker in the second stress event, suggesting that as investors learn about the specific features of these instruments and their supervisory treatment the CoCos market becomes more resilient.

Keywords: CoCos, Basel III, contagion

JEL Classification: G14, G21, G28