How does issuing contingent convertible bonds improve bank's solvency? A Value-at-Risk and Expected Shortfall approach

- The new contingent convertibles bonds (CoCos) are to make banks more resilient.
- CoCos convert into bank's common equity when bank approaches default.
- We used the VaR and Expected Shortfall concept for bank default risk modelling.
- We made a proof on what condition do CoCos improve issuer's solvency.
- The paper provides a guide for policy makers on how to reduce banks' default risk.

This paper examines how issuing an innovative financial instrument called contingent convertible bond (CoCo) may enhance bank's solvency in comparison to issuing a conventional bond. CoCos convert automatically into common equity or have a principal write-down when bank's regulatory capital fails to meet a predetermined level. They have been invented and put into legislation with an objective to absorb losses thus preventing institutions from bankruptcy. From the standpoint of an issuer CoCos bring about two counter effects regarding his solvency: on one hand they recapitalize a bank approaching insolvency on the other hand CoCos pay much higher coupon comparing to conventional bonds. In our model a bank has two funding alternatives: either to issue CoCos or conventional bonds. We measure issuer's default risk using the concept of Value-at-Risk (VaR) and Expected Shortfall (ES). We conclude that CoCos have the potential to strengthen the resilience of the issuer on the condition that the probability of conversion triggering is higher than the VaR's significance level. Our findings can be helpful to the policymakers and banks to better understand the impact of CoCos on issuer's solvency.