What Went Wrong with CoCos? Rethinking Contingent Capital in Post-Crisis Banking

The ECB study finds that contingent convertible bonds have largely failed in their intended role as going-concern capital, increasing financial distress and regulatory uncertainty despite reducing outright default risk. While CoCos can outperform standard debt when equity issuance is constrained, they work better as debt substitutes than as equity replacements and impose significant costs on the public sector.

A study, produced within the European Central Bank’s Working Paper Series by Ricardo Correia and Francisco Javier Población García, examines contingent convertible bonds, or CoCos, a financial instrument promoted after the global financial crisis by institutions such as the ECB, the Eurosystem, and regulators operating under the Basel III framework designed by the Basel Committee on Banking Supervision. CoCos were introduced to help banks absorb losses during crises without relying on taxpayer-funded bailouts or issuing large amounts of new equity. The idea was simple: when a bank’s financial health deteriorates, CoCos would automatically convert from debt into equity, strengthening the bank’s capital position and preventing collapse.

How CoCos Actually Evolved

While the original concept was relatively straightforward, CoCos quickly became complex in practice. Most instruments classified as Additional Tier 1 (AT1) capital were designed with discretionary features, coupon suspension rights, and write-down mechanisms instead of clean conversion into equity. These features made CoCos difficult to value and hard for investors to understand. Crucially, real-world experience showed that CoCos often failed to convert early enough to prevent bank failure. The resolutions of Banco Popular in 2017 and Credit Suisse in 2023 demonstrated that AT1 CoCos absorbed losses only when banks were already beyond rescue, behaving more like failure-stage instruments than early stabilisers.

How the Authors Study CoCos

To assess whether CoCos deliver on their promises, the authors build a formal economic model of a bank financed by equity, corporate debt, and CoCo debt. Bank income and costs fluctuate over time, and shareholders are assumed to act purely in their own interest. If the bank becomes unprofitable, shareholders can abandon it. When this happens, the government steps in to keep the bank operating and protect depositors, absorbing losses if necessary. This setup allows the authors to compare how different financing choices affect shareholders, creditors, and the government.

A key feature of the model is the treatment of CoCo coupon suspension. Although suspending coupons does not immediately drain cash, the authors assume it sends a strong negative signal to markets, pushing the bank into financial distress. This reduces growth and increases costs, meaning that distress becomes more likely even if outright bankruptcy is delayed.

What the Results Show

The simulations produce a clear ranking. Equity financing performs best overall because it prevents both financial distress and default. However, when equity issuance is difficult or costly, CoCos perform better than standard debt. Even though CoCos increase the likelihood of distress due to coupon suspension, their ability to convert into equity lowers the probability of full default and raises total bank value compared to debt-only financing.

The benefits of CoCos are not shared evenly. Debt holders gain from CoCo issuance because CoCos absorb losses first, reducing default risk and lowering debt spreads. Shareholders prefer debt in good times because it maximises leverage without diluting ownership. If regulations prevent more debt, shareholders prefer CoCos, since they behave like debt until conversion. Equity issuance is chosen only when the bank is already close to failure.

For governments, CoCos are the least attractive option. While they reduce the chance of outright bankruptcy, they increase the frequency of financial distress. This reduces tax revenues and raises expected public costs. In good times, governments prefer equity because it delays abandonment; in bad times, they prefer debt because it avoids prolonged distress.

Why the Paper Is Critical of CoCos

Beyond the numerical results, the paper offers a broader warning about regulatory design. CoCos were promoted as a response to a crisis partly caused by overly complex financial products, yet they themselves became highly complex instruments. Their legal treatment is uncertain, their market behaviour confusing, and their role in crisis resolution unclear even to sophisticated investors. The authors argue that CoCos may have been useful during a period when banks urgently needed capital, but their design, especially in AT1 form, has serious flaws.

The study concludes that CoCos work better as substitutes for debt than as replacements for equity. Simpler instruments, such as Tier 2 CoCos or other convertible structures, may achieve similar goals with fewer risks and less confusion. In this sense, contingent convertible debt is presented not as a regulatory success story but as a cautionary example of how good intentions can produce overly complex and imperfect solutions.