Managing capital procyclicality in African banks using contingent convertible bonds

Abstract

In times of financial distress, banks struggle to source additional capital from reluctant private investors. Sovereign bailouts prevent disruptive insolvencies but distort bank incentives. Contingent convertible capital instruments (CoCos) – securities which possess a loss-absorbing mechanism in situations where the capital of the issuing bank reaches a level lower than a pre-defined level – offer a potential solution. Although gaining popularity in developed economies, CoCo issuance in Africa is still in its infancy, possibly due to pricing complexity and ambiguity about conversion triggers. In this thesis, the pricing of these instruments is investigated and the influence of local conditions (using data from three major African markets and an all-African index) on CoCo prices is explored. We find that the African milieu (high interest rates and equity volatility compared with developed markets) makes CoCos particularly attractive instruments for the simultaneous reduction of debt and enhancement of capital. If CoCo issuance becomes a viable bank recapitalisation tool in Africa, these details will be valuable to future investors and issuers. The procyclical nature of capital models under the Basel II accord has been widely criticised for exacerbating lending in economic expansions and restricting lending during economic contractions. These criticisms have led regulators to employ countercyclical measures in subsequent Basel accords. One of these measures, the Countercyclical Capital Buffer, has been proposed as an effective countercyclical measure in expansionary periods as a deterrent to excessive lending through increased bank capital requirements. The effectiveness of this measure during contractions, however, is less obvious. CoCos – which are bond-like until triggered by a deterioration of a prescribed capital metric, at which point they convert into a form of equity – are explored as a supplementary countercyclical capital measure for such periods. A variant of the CoCo, first proposed in 2011, is investigated: the Call Option Enhanced Reverse Convertible (COERC). Although issued as a bond, it converts to new shareholder's equity if a bank's market share of capital falls below a pre-specified trigger point. COERCs avoid the problems with market-based triggers (e.g. sell offs and death spirals) due to panic and market manipulation. Banks that issue COERCs have less incentive to choose investments which may be subject to large losses and disincentive problems associated with the replenishment of shareholder's equity after market declines (also known as debt overhang) are also avoided. Proposed amendments to the COERC structure are suggested for the African market.