Coco bonds

Could contingent convertible bonds, or Cocos, stop a bank failing? Some regulators believe so. Cocos are just like normal bonds (IOUs) for as long as the bank holds enough capital to satisfy regulators it is solvent. However, should a bank’s safety fund fall too far, the Coco bonds would convert into shares. So say a bank has own funds (including shareholders’ equity) of £50m and risk-weighted assets (including £20m of Coco bonds) of £200m. Its capital ratio is (50/200) x 100% or 25%. But were the Coco bonds converted, this ratio becomes (70/180) x 100%, or 39%. Fine, but a sudden conversion of Cocos into equity at a troubled bank could start a fire sale of the bank’s shares. That would finish the bank off anyway.

• See Tim Bennett’s video tutorial: Bond basics.