How useful are contingent convertible instruments in preventing future banking crises?

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DECLARATION

I, (Your name), would like to declare that all contents included in this thesis/dissertation stand for my individual work without any aid, & this thesis/dissertation has not been submitted for any examination at academic as well as professional level previously. It is also representing my very own views & not essentially which are associated with university.

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Table of contents

ACKNOWLEDGEMENTii

DECLARATIONiii

CHAPTER 01: INTRODUCTION1

Background of the Study1

Problem Statement2

Aims and Objectives of the Study3

Research Questions3

Significance of the Study4

CHAPTER 02: LITERATURE REVIEW6

Convertibles as a Unique Asset Class6

Reasons of Issuing Convertibles6

Return and Risk of Convertibles7

Potential Explanations of Superior Performance7

COCO & European Banks8

CHAPTER 03: RESEARCH METHODOLOGY11

Research approach11

Research Design11

REFERENCES13

CHAPTER 01: INTRODUCTION

Background of the Study

CoCos have recently been issued by several investment banks. Banks have good reason to take a lot of leverage because they are lending businesses. Their equity investors expect a 20% return on their shares. But banks get to borrow only slightly more cheaply than the rate at which they lend to their customers. The difference between the rate at which the bank borrows and lends is called the "net interest margin" and may be as little as 1%. How can we turn a 1% margin into 20%? The answer is balance sheet leverage. By borrowing money banks can scale up their balance sheet and total loans and boost their profit without issuing more shares. However boosting leverage increases risk because if loans start to go bad this can quickly wipe out the total value of equity and lead to bankruptcy.

Market professionals explain the result within the context of portfolio theory: that convertibles cause a favourable shift in the efficient frontier (Calamos, 1998). Such explanations contradict the efficient market hypothesis, as a derivative can be represented as a portfolio of the underlying equity and the riskless asset. Accordingly, the academic literature is largely silent. Lummer and Riepe (1993) and Goldman Sachs (2001) identify three potential drivers of abnormal performance: under pricing at issuance, non-optimal call policies by firms that issue convertibles. This study analyzes how useful are contingent convertible instruments in preventing future banking crises.

Problem Statement

CoCos are bonds that pay a fairly high coupon, but they are bonds with a twist. If the leverage of a company grows too large the CoCos stop being debt and turn into equity. Some call this "programmed balance sheet de-leveraging" because once issued conversion of CoCos is beyond the control of the company or the bondholders. This means that at a stroke the cost of financing the company's debt drops because equity does not have to pay a dividend, whereas missing a bond coupon payment leads to bankruptcy. From the bondholders perspective they will stop receiving their large coupon and they will turn into shareholders rather than ...