European banks can raise Tier 1 capital by issuing CoCo bonds. In the banking sector, their use helps support a bank`s balance sheets by allowing it to convert its debt into shares when certain capital conditions arise. Conditional convertibles were created to help undercapitalized banks and prevent another financial crisis such as the 2007-2008 global financial crisis. Banks use conditional convertibles differently than corporate convertibles. Banks have their own parameters that justify converting the bond into shares. The triggering event for CoCos may be the value of the bank`s Tier 1 capital, the judgment of the regulator, or the value of the bank`s underlying shares. In addition, a single CoCo can have several triggering factors. Under the standards, a bank must hold enough capital or money to withstand a financial crisis and absorb unexpected losses from loans and investments. The Basel III framework tightened capital requirements by limiting the type of capital a bank can raise in its different levels and structures of capital. There is a significant difference between emergency convertible bonds issued by banks and ordinary or simple vanilla convertible bonds.
Convertible bonds have similar characteristics to bonds, pay a regular interest rate and have seniority in case the underlying company fails or fails to pay its debts. These debentures also allow the bondholder to convert the notes into common shares at a certain exercise price, which gives the bondholder a price increase. The strike price is a certain level of the share price that must be triggered for conversion. Investors can benefit from convertible bonds because the bonds can be converted into shares as the company`s share price rises. The conversion function allows investors to enjoy both the benefits of fixed-rate bonds and the potential for capital appreciation through higher stock prices. Banks absorb financial losses through CoCo bonds. Instead of converting bonds into common shares based solely on share price appreciation, CoCos investors agree to take equity in exchange for regular debt income when the bank`s capital ratio falls below regulatory standards. However, the share price could not go up, but down. .