If the price of CoCos(contingent convertible bonds) decrease, and its yield increase dramatically. How will company's...

If the price of CoCos(contingent convertible bonds) decrease, and its yield increase dramatically. How will company's Tier 1 capital level changes? Increase or decrease? Would company's ROE ratio changes at the same time?

Expert Solution

A CoCo is a fixed income security that automatically converts into equity capital when a pre-arranged trigger is met. Issuances of CoCos in the United States are not expected due to unfavourable tax treatment. CoCos are viewed as equity rather than debt in the US, meaning that interest payments would not be tax deductible.

Capital consists of Common Equity Tier 1 capital and Additional Tier 1 capital. Common Equity Tier 1 capital is the highest quality component of a bank’s capital, which includes common shares and retained earnings. Under Basel III Common Equity Tier 1 must be at least 4.5 per cent. of risk weighted assets (up from 2 per cent. of risk weighted assets). Additional Tier 1 capital consists principally of instruments issued by the bank which must meet strict criteria (and are not included in Common Equity Tier 1 capital). Under Basel III the minimum total Tier 1 capital requirement will increase from 4 per cent. to 6 per cent. These new requirements will be phased from 1 January 2013 until 1 January 2015.

Therefore companies Tier1 capital level Increases.

ROE = Net Income / Shareholders Equity . Since the Capital level is increased ROE decreases.

jeff jeffy answered 1 year ago

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