Anything but Equity - On Banks’ Preference for Hybrid Debt

Contingent Convertible Bonds (CoCos) are a tool for banks to partly fulfil Tier 1 capital requirements. While these instruments are a cheaper source of funding than equity, only some banks have them on their balance sheets. I investigate why. I find that the cheapest Tier 1-eligible CoCos, the ones with the lowest loss absorption abilities, are issued by banks that prefer a higher leverage than other banks, potentially exceeding regulatory limits in some scenarios. After the issuance, these banks effectively achieve Tier 1 ratios on par with similar banks but remain to have higher systemic risk levels and more intense earnings management practices than peers. Tier 1-eligible CoCos with better loss absorption abilities are issued by larger banks and G-SIBs when facing
a higher fraction of impaired loans on their balance sheet. These banks utilize CoCos to offset risk weights and hedge against potential losses resulting from non-performing loans. The results shed light on banks’ capital structure choices and their implications for regulatory policy and financial stability