Financial Reporting for Contingent Convertibles in Banks: Liability or Equity?

Abstract: Economic development in the capital markets has led to the creation of financial instruments that have the characteristics of both equity and liability, so-called hybrid financial instruments. IASB is trying to create a new way of classifying this kind of instruments. Contingent Convertibles (CoCos), a hybrid financial instrument, have since 2009 become a popular way for banks to reach their capital requirements. This paper seeks to determine if CoCos are perceived by the market as equity or liability. Previous studies indicate that CoCos act to decrease the risk of banks when looking at the potential for bankruptcy and future solvency problems. Our sample consists of 40 listed banks from 2009 until 2015 in EU, including Norway and Switzerland, who follow IFRS. To understand whether CoCos share key characteristics with equity or liability two tests are carried out. The first test looks at the association between CoCos and bank’s common equity risk. The second test looks at the association between leverage and common equity risk when CoCos are calculated under two different accounting regimes, first, if CoCos were treated as a liability and then as if it were treated as equity This study did not find any significant relationships between risk and CoCos or leverage, and therefore it is not able to answer the question whether the market perceives CoCos to share key characteristics with equity or liability.