High stakes bet? I should CoCo

Lately, investing in banks has become as chancy as having a flutter on the Grand National horserace - hard to resist but a bit of a mug's game. False starts, steward inquiries and the financial district-equivalent of leaping 30 fences - all enlivened by thundering competition. And, if that's not heart-stopping enough, there's always the risk of becoming a casualty along the way.

But investors, like punters, still harbor the hope of backing an unlikely winner. The trade in contingent convertible bonds or "CoCos" -- a hybrid of debt and equity -- has become one of the more fashionable bits of riding gear in the City, as traders, hedge funds and banks all try to pull off a risky bet. But, while the returns can be high, so too can the carnage that CoCos cause.

KPMG's latest assessment of the British banking industry highlights the increasing difficulty of juggling regulators, government and investors while 80 percent of profits still going towards remediation costs.

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The CoCo market has doubled in size this year already, with some commentators expecting it to balloon to more than £200 billion ($332 billion) within 5 years. At this pace of growth, this particular financial innovation could become a problem for the industry, creating systemic risk and panic if they ever get called.

CoCos are sold as bonds that pay very lucrative interest rates. What makes them different to conventional debt is that if an issuer, such as a bank, has a shortage of capital, then CoCos transform into equity. Theoretically, this means that the bank has an emergency capital buffer that deflects problems.

London's financial district, known as the Square Mile.
Getty Images

But increasingly, people are concerned that the very act of calling a CoCo could create shock waves in the financial system, which since 2008 we have learned is incredibly interconnected.

Lloyds Bank closed a £5 billion CoCo deal last week, while Barclays has been an aggressive issuer of CoCos for the last two years. Barclays warned in an investor presentation that shares might not stabilize after the triggering of CoCos, creating unforeseen instability.

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Barclays said: "Capital Adequacy Trigger Event may be accompanied by a deterioration in the market price of the issuer's ordinary shares, which may be expected to continue after the occurrence of the Capital Adequacy Trigger Event."

What's even more worrying is no one knows exactly where U.K. regulators stands. Could they change capital rules, overrule bank decisions to convert CoCos, or demand they be converted when a bank is not ready? Already, City commentators complain that the usual conventions are being put aside to make room for CoCos, with banks retaining the right to suspend coupon payments or the entire CoCo, while still paying out equity dividends to keep investors and politicians happy.

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Creating 'bail-in' type debt rather that relying on taxpayers is progress from where we were 5 years ago. But regulators and banks shouldn't lose sight of the potential risks if the industry where ever to face the type of shock waves we saw in the financial crisis.

CoCos maybe ticking a lot of boxes right now, but a healthy skepticism about financial innovation could help us avoid falling at the last.