Working Papers

Contingent Convertible Bonds (CoCos) allow banks to partly fulfill Tier 1 capital requirements. The instruments offer cheaper funding than equity (in terms of required returns) but don’t absorb losses before default with certainty. I investigate which banks use CoCos and document that the cheapest Tier 1-eligible CoCos, those with the lowest loss absorption abilities, are primarily issued by less-capitalized banks. While prior research suggests that CoCos are issued by relatively better-capitalized banks, I show that for the Tier 1-eligible subset, this applies only to more expensive instruments with stronger loss-absorption abilities. I further investigate whether CoCos are perceived as going-concern instruments, examining the reactions of CDS spreads on senior and junior debt following CoCo issuances. I find that market participants view issuances of the cheapest Tier 1-eligible CoCos as not reducing default risk, but rather fulfilling issuers’ regulatory requirements, sometimes at the expense of junior creditors. The results contribute to understanding banks’ capital structure choices and their implications for regulatory policy and financial stability.