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2014 – year of the CoCo (part 2 - supply)

by Justin McCarthy | Jan 21, 2014

Key points:

  1. CoCos are the new form of Tier 1 capital for banks, replacing the old-style step-up securities as Basel III regulation forces banks to increase capital
  2. The market is immature but is expected to grow exponentially and could be as large as €240bn
  3. Significant issuance in 2014 (and beyond) is expected to create attractive entry points in periods when supply outstrips demand

As we discussed last week, contingent convertible capital securities (or CoCos as they are more affectionately known) are the new form of hybrid regulatory capital security under Basel III, replacing the old-style step-up subordinated debt and Tier 1 securities. Please click here to read Part 1.

Like any market, the technical factors, predominately supply and demand, are of significant importance for investors. Moreover, the technical factors are often magnified in immature markets which are yet to find equilibrium.

This edition looks at the all important supply considerations and next week we will cover the demand aspects.


Regulatory developments have forced a change in the way banks can structure capital securities. As we wrote last week, the simple reality is that there are no more step-up securities being issued by banks. Further, those legacy issues that do exist are generally being called at first opportunity as they no longer count as capital on an individual security basis if they go past their call date.

It is estimated that circa €140bn of pre-Basel III Tier 1 capital securities (mainly step-up securities), remain on issue from European banks but will roll-off in coming years. This needs to be replaced by either equity or Additional Tier 1 (AT1) i.e. CoCo issues.

However, on top of simply replacing old-style Tier 1 securities, global regulations led by Basel III require significant increases in capital levels on a phased in basis to 2019.

It is expected the majority of that capital will likely come from share capital however, around 15-20% of a typical bank’s capital base is likely to be made up of AT1.

As a general rule, US-based banks have acted early to raise capital while those in Europe have lagged somewhat and need to raise hundreds of billions of dollars to meet the new Basel III requirements.

European banks have a strong incentive to use AT1 to meet the “Combined Buffer Requirement” due to the technical nature of what can and can’t be included in the calculation of capital under European Union regulation (specifically Article 141 of the Capital Requirements Directive or CRD IV). It is anticipated that many banks will issue the full 1.5% allowed of risk weighted assets (RWA) in AT1 and the vast majority of this in CoCos. European banks alone are forecast to reach around €16tn in RWA and if each was to issue 1.5% in the form of CoCos that would equate to €240bn.

Further, there is no cap on how much AT1 can be included in the overall Tier 1 ratio reported by banks and this is also expected to be the basis for the controversial leverage ratio to be implemented towards the end of the decade, meaning banks may issue in excess of 1.5% of RWA.

In a nutshell, European banks need to raise material amounts of capital between now and 2019 and a large part of this is expected to be in the form of CoCos.

Forecasts of the CoCo market size range from €120bn to €240bn. No matter which end of the range, it is a huge number and significant supply of the relatively new CoCo security is expected in coming years.

So far there has been around 27 CoCos issued from 11 different European banks with a total market size of circa €35bn. The largest issuers have been Barclays, Credit Suisse, UBS and Societe Generale.

The vast majority of issuance has been in USD, the reasons for which we will discuss next week when we assess demand factors. However, CoCos currently exist in USD, € and CHF, with trading margins (to call) ranging from +275bps to as much as +775bps.

Significant issuance in 2014 (and beyond) is expected to create attractive entry points in periods when supply outstrips demand.

Next week we will cover demand.