Document Type

Article

Publication Date

January 2012

Abstract

Bank-issued contingent-convertible capital instruments (known colloquially as "cocos ") are assumed to be a less costly substitute for common equity that will improve the stability of banks in a crisis situation. However, cocos are new and untested instruments. In a future financial crisis they are likely to incentivize behaviors and trading strategies (notably panic selling short selling, and the use of credit default swaps) that have the potential to harm confidence in banks. Without confidence, banks will have difficulty funding themselves and the likely consequences of bank difficulties (credit crunches and possible bailouts) will be felt by society at large. This should make regulators exceedingly wary of endorsing the use of cocos. Indeed, many of the supposed benefits of using cocos instead of ordinary common equity for regulatory capital purposes appear to be illusory: to best preserve systemic stability, regulatory capital requirements should therefore be satisfied with common equity rather than cocos.

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