The “Sudden Death” Bank Bond

Danger in the Eurozone

Like from some avant garde video game, “sudden death” or “wipeout” bonds have surged. These are a type of contingent convertible bond (cocos) which either convert into equity when a bank’s capital ratio fallows below a pre-agreed trigger and bonds which are written off entirely after a trigger event.

These “Sudden Death” bonds are turning bank investors’ money into nothing, prompting criticism that they discriminate against investors. Nonetheless European banks, struggling with mounting regulation, are increasingly issuing them. In particular, Basel III regulation is forcing banks to hold more Tier One Capital, the safest portion of a bank’s capital comprising of common equity and retained earnings. Yet, in another demonstration of the perennial conflict between bankers and regulators, the bankers have innovated a loophole to bolster their Tier One Capital by using cocos. This way banks can push losses onto investors and at the same time provide fresh capital.

Despite the criticism, investors on the hunt for yield are buying up cocos and wealthy emerging market institutionals, able to leverage their investments, are using these products to boost their returns. From their perspective, cocos are at least yielding higher than other assets.

However in the USA, the prevalent restrictive definition of Tier one Capital has limited US banks from utilizing cocos to bolster their Tier One Capital. In the USA, only instruments considered debt for accounting purposes can be included in Tier One Capital, which effectively places cocos outside the realms of the definition. US regulators are worried about what they have coined the “slippery slope of increasingly diluted capital standards” if they let the definition widen.

Financial innovation seems to be galvanizing again. Let’s hope the American prudence continues to prevail for the longer-term rather than succumb to the desperation bred by desperation in Europe.