CoCos, or Contingent Convertible bonds, are hybrid securities that begin as interest-ber, but should specified triggering circumstances come to pass- say banks fall below their capital requirements- the bond converts to equity.

Q. We’re hearing this a lot with regard to the Spanish banking situation. Why?
A. Well, everyone agrees that that Spanish banks need a rescue, but there’s been a huge amount of debate about how that would happen. Looks like it will go through FROB, but still the question is: exactly what form will the rescue take? Many people would like it to be in the form of CoCos, contingent convertible bonds.

Q. Is this a new idea? What’s the point?
A. Fairly new idea, yes. There’s always been a huge amount of conflict between bank regulators and bank shareholders over how much leverage a bank should have and use. Obviously, the more leverage, the better the return on equity, which is great for shareholders. But, as we saw in the crisis, lots of leverage also makes the banks suseptible to shocks. So the point with the Spanish banks– and with banks around the world, really– is how the new money should come in: as equity, watering down the shareholders, or as bonds, adding to the leverage.

Q. And I guess CoCos somehow bridge this gap? They’re a compromise of some kind?
A. Yes, a hybrid security. They start off life as a bond and pay interest as usual. But if things go south for the bank, say its regulatory capital falls below a certain preset level, then the bond automatically converts into equity. It makes a lot of sense as a way to go about injecting capital into a troubled bank.

Q. But surely the idea of hybrid securities is not new? We’ve seen things like this before, haven’t we?
A. We have. There are all sorts of convertible instruments out there, and many banks have issued hybrid securities before, which walked the line so well that regulators called them “equity” while shareholders considered them “bonds”. But the problem with those was that there were no clear rules about exactly when and how they’d convert… the bank had discretion about that. That led to huge amounts of fighting during the crisis, as the banks wanted to convert to add equity, but the bondholders, who would’ve taken big baths, said: if you do that, we’ll never lend to you again. So the advantage here is you get the hybrid treatment, but the rules are clear; the conversion happens automatically.