European Central Bank working paper finds AT1 CoCos work better replacing debt than equity and raise financial distress risk

The European Central Bank published Working Paper No 3170 modelling Additional Tier 1 contingent convertible instruments (AT1 CoCos) alongside equity and corporate debt, and assessing whether CoCos are more effective as substitutes for equity or for vanilla debt. The paper’s simulations suggest CoCos create more value when they replace corporate debt, but reduce value when they replace common equity, while their coupon suspension feature is associated with a higher probability of financial distress even as conversion can make outright default less likely. In the model, shareholders can abandon an unprofitable bank and a welfare-maximising government steps in to keep it operating, with distress costs linked to coupon suspension and resolution-type outcomes. Across simulated scenarios, aggregate claim value is highest under equity financing because it prevents distress and default, while CoCos rank above standard debt on bank value because conversion to equity can limit default. The analysis also reports that CoCo issuance can benefit senior debt through subordination and recapitalisation effects, but is least favourable for the government given the tax treatment of CoCo coupons and increased incidence of distress; it also highlights incentive conflicts, with shareholders in good times preferring debt, then CoCos, and equity last. The paper underscores the complexity of AT1 CoCos and links it to regulatory uncertainty, arguing that simpler Tier 2 CoCos appear to have superior performance in the authors’ framework.