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Bundesbank questions loss absorption capacity of CoCo bonds

The German central bank has expressed doubts about the viability of contingent convertible bonds as a loss-absorbing instrument for European banks and said regulatory incentives to issue those instruments are not justified given the complexity of CoCo bonds and potential risks for the wider market.

Contingent convertible bonds, or CoCos, which can qualify as either Tier 2 capital or the bank-specific Additional Tier 1 class, are meant to serve as a backstop when a bank runs into trouble, by converting into equity or being written down when capital levels fall below a certain threshold. Almost half, or 48%, of CoCos issued by EU banks carry a principal write-down feature, meaning they are entirely wiped out when the threshold is breached; the remainder typically convert into equity, Deutsche Bundesbank wrote in its monthly report for March.

AT1s represent about 80% of EU CoCos, and among their features is that they must be perpetual. CoCos qualifying as Tier 2 can be time-limited and do not have to carry a specific conversion threshold.

About 44% of CoCos issued in the EU since 2009 have a conversion trigger of 5.125%, equivalent to the standard 4.5% CET1 requirement for all banks under Basel III, plus the minimum 0.625% capital conservation buffer, the Bundesbank said. But the practical requirements of bank capitalization suggest that a 5.125% threshold is too low, it argued, and it is possible that regulators could decide that a bank is failing before the threshold is reached.

The central bank urged a review of CoCo requirements in the EU, suggesting an increase in the minimum conversion threshold as one potential measure. The bank also suggested that EU banks may be better off raising more core capital rather than issuing CoCo bonds.