On write-down/ write-up loss absorbing instruments

Abstract

Purpose: The article deals with banks' vulnerability to insolvency. We discuss the impact of the CoCo write-down/write-up bonds issuance on the bank solvency. Such instruments absorb losses in two ways: 1) When a bank gets in trouble, the payment of interest is ceased, and 2) If the financial standing of the bank further deteriorates, its CoCo bonds are written down. Reversing it, when the bank solvency improves, the CoCos are gradually written up, and the payment of interest is restored. The investment in the CoCo bonds is risky. That is why they offer a greater interest rate than straight bonds. Hence there is a trade-off: loss absorption versus profitability. Design/Methodology /Approach: As a measure of insolvency, we consider the probability of the implementing resolution process, i.e., as it is called in actuarial sciences, the probability of ruin. Findings: We show that depending on the CoCo bonds' profitability, the additional issuance of the CoCos may reduce the probability of ruin. In this respect, we propose a theoretical explanation for the optimum share of CoCos in an institution's liabilities. Practical implications: Our findings may give the supervisory authorities a useful tool to determine the fair share of Additional Tier One (AT1) CoCos to fill the Pillar 2 bank capital layer. The model proves to be useful for setting the optimum size of Restricted Tier One (RT1) CoCos in the insurer's liabilities as well. Originality/value: The science lacks theoretical background for CoCos' optimal size in issuers' liabilities. Besides, we provide a new measure of bank insolvency. Contrary to the typical approach with a finite time horizon, we choose the default probability at any moment in the future as a measure of insolvency.