In the Press…. Tail Risk

Robert Smith, FT, Friday, November 23, 2018:

Robert Smith describes very well how some reforms designed to protect the banking sector – at the core of the 2008-2009 crisis – may carry the seeds of the next crisis, this time maybe in the fund management industry. To protect the banking sector, some liquidity risks have been transfered to mutal funds which invest in potentially illiquid assets while offering generous redemptions rules. These  potentially illquid assets may be bonds issued by medium-size companies that may have stayed on banks’ balance sheets in the past. They may also be the “new breed of bank bonds that can be “bailed in” during the collapse of a financial institution, meaning that bondholders bear the burden of losses instead of taxpayers”. This new “breed of bank bonds” would probably be among the most illiquid asset classes when things go wrong. A key reason is that their value would depend a lot on how regulators act: as Lenders of Last Resort ready to help banks in a difficult situation or as Liquidators of Last Resort ruining existing shareholders over the week-end. It is impossible to price an asset when so much depends on the impossible to predict, and politically motivated, decisions of central banks and regulators. If things  go very wrong (for example in reaction to a deep recession), there will be no markets for the “bail-in” bonds, and maybe no market for banks’ shares as well (see our post on financial regulation).

In this context, Robert Smith is right to stress that Coco bonds may be among the most illiquid assets as in times of crisis they would be the first in the line among “bail-in” bonds. It is also clear that the difficulties in the Coco market would contribute to destabilize even more the main market for banks’ shares. The risk of conversion of Coco bonds would push holders of these bonds to protect themselves by taking a short position on the underlying equities they may receive (there are indeed always a lot of arbitrages going on between convertible securities and the underlying equities). The free fall of banks’ shares would make it very difficult to recapitlize banks the “normal” way (i.e. making a “road-show” to potential investors with the help of investment banks vanting the merits of this investment).