Reinforcing the Capital of a Bank with Two Tranches of Coco Bonds

Abstract

Following the 2008 crisis, Basel III has imposed higher banking capital requirements. To comply with this, banks will have to issue new equity and/or sell some of their assets, which will put pressure on financial markets. To ease such pressure, banks and regulators are wondering whether capital might be raised in other forms such as Contingent Convertible (CoCo) bonds, which are basically bonds that can be converted into equity when triggered by a specified event. This article examines the capital structure of a bank financed by equity, traditional bonds, and two tranches of debt-to-equity CoCo bonds. The Junior Tranche aims to prevent risk when the bank is still in good health, while the Senior Tranche aims to rescue the bank when it is already in crisis. The choice of triggers is decisive to ensure that the two tranches of CoCo bonds fulfil their missions of prevention and rescue.