the case for contingent convertible debt for sovereigns

Bank of England, Jan. 22, 2016.

The case for sovereign contingent debt

Stavros Zenios

University of Cyprus

Norwegian School of Economics

Senior Fellow, The Wharton School, USA

Joint work with Andrea Consiglio

University of Palermo


The devil is in the tails

Sovereign contingent debt: A proposal

www.voxeu.org


Sovereign contingent debt (S-CoCo)

A sovereign debt instrument, with (i) a built-in trigger to allow standstill of

payments(ii)activated when an indicator breaches

threshold(iii)invokes a precautionary credit line from the

IMF(iv)makes the triggered bond senior to

subsequently issued debt.


Outline

1. Debate on sovereign debt restructuring

2. Why S-CoCo3. S-CoCo designs 4. Risk management model with S-

CoCO5. Case study of Greece


Ongoing debate on sovereign debt restructuring


Some facts about sovereign debt

IMF 2013 mea culpa on Greece“Debt restructurings have often be too little and too late, failing to re-establish debt sustainability and market access in a durable way”

IMF Board 2013 Discuss legal and policy framework for sovereign debt restructuring

UN General Assembly 2014-2015 Negotiate legal framework for sovereign debt restructuring(124 in favor, 11 against, 41 abstain)Adopted draft resolution (136 in favor, 6 against and 41 abstained)



Data: Bank of Canada 2014.



Financial Stability Paper No. 27 – November 2013, Sovereign default and state-contingent debtMartin Brooke, Rhys Mendes, Alex Pienkowski and Eric Santor, Bank of England and Bank of Canada


Observations from the facts Sovereign debt restructuring is pervasiveAn equal opportunity malaiseSignificant amounts involved

Reminders of Hyman Minsky (1919—1996):

Debt is fragile


The issues in sovereign debt crises

To default or not to default?Eaton-Gersovitz (1981), Krugman (1988), Reinhart-Rogoff (2009), Sturzenegger-Zettelmeyer (2006),Benjamin-Wright (2009), De Grauwe (2012)

Is to forgive to forget? Bulow-Rogoff (1989), Arsanalp-Blaire (2005)Cruces-Trebesch (2013), B-W (above), Wright (2012)

Massive legal problems Krueger (2002), Gianviti et al. (2013), Buchheit et al. (2013),

Delays in resolving crisis destroys value


Why S-CoCo

From ex post to ex ante solutions


Why S-CoCo Contingent contracts

(Bazerman and Gillespie, HBR, 1999)Avoid biasesSharing risks

Neglected risks(Gennaioli, Schleifer, Vishny, J. Financial Economics, 2012)


Why S-CoCo Early proposals

Weber, Ulbrich, Wendor, Frankfurt Allgemeine Zeitung, 2011Barkbu, Eichengreen, Mody, J. of International Economics, 2012Brooke, Mendes, Pienkowski, Santor, Bank of England, 2013.

French Aid Agency 2009 Insurance and re-insurance Rated firms for capital management Service firms for liability insurance Michelin, Swiss Re, MBIA


Why S-CoCo Bank contingent capital

(Mark Flannery 2005) 2009-2013: $70bn 2014: $208bn, 187 instruments, 68

banks (Avdjeiv et al., BIS, 2015).


S-CoCo designs


S-CoCo designs: Trigger Accurate Timely Comprehensive in valuation of entity PredictableX Accounting data or institutional triggers


S-CoCo designs: Trigger 30-day average CDS spread > 300 to

400bp


S-CoCo designs: Trigger

Country TriggerSigned

Program Early

response

Greece 24 April 2010 5 Sept. 2010 4 months

Portugal 16 Nov. 2010 20 May 2011 6 months

Ireland 1 Oct. 2010 16 Dec. 2010 2,5 months

Spain 27 March 2012 Dec. 2012 9 months

Cyprus 11 July 2011 15 May 2013 21 months


S-CoCo designs: Incentives

Is there moral hazard?YES –Haldane and Scheibe, Bank of England 2004, othersNO –IMF 2007

Creditor vs Debtor moral hazard“Evidence on moral hazard is not definitive, it is likely that the risk of moral hazard increases as the expected size of official sector support packages rise”

(Brooke et al. Bank of England and Bank of Canada, 2013)

Standstill resolves creditor moral hazard



Debtor incentives:

- Why sovereigns pay?- Economic incentives:

Non-linear discounts on S-CoCoSeniority transfers rates to plain debt

- Political incentives:IMF precautionary lineVoted out like ousted Bank Board


S-CoCo designs: How long standstill


S-CoCo designs: False alarms and missed crises

Type I error Type II error


S-CoCo designs: Market manipulation and multiple equilibria

B-CoCo subject to multiple equilibria Sundaresan and Wang, J. of Finance, 2015Calomiris and Herring, J. App. Corp. Finance, 2013McDonald, J. Financial Stability, 2013 Prescott, Economic Quarterly, 2012

Market manipulation


S-CoCo designs: Pricing

Triggered by CDS spreadMean-reverting diffusion process with jumps and autocorrelationDonoghue et al., Intl. J. of Theoretical and Applied Finance, 2014.

Regime switching Bai-Perron, Econometrica, 1998

Cross validation K-fold approach for jump parameter (Tibshiriani)


1 2 3 4 5 6 7 8 9 10 11 12 130

20

40

60

80

100

120

1 2 3 4 5 6 7 8 9 10 11 12 130

20

40

60

80

100

120


Risk management for debt restructuring


Sovereign debt risk management

Risk management has not been part of analysis

“Need for development of criteria for “optimal” debt restructuring process”

(Wright 2012, Harvard Business Law Review)


Scenario dependent debt dynamics

Using Debt-to-GDP ratio



D is the term structure of debt r is the term structure of sovereign ratesGDP, NB can be state-dependentSF can be state-contingentTree integrates economic and financial risk factorsObjective and risk neutral probabilities(Consiglio, Carollo, Zenios, Quantitative Finance, in print)




At each terminal node:

Conservation of flow at each node:

xmj – nominal value of debt instrument j, issued at node m.



(Rockafellar and Uryasev 2000)

Conditional Debt-at-Risk

DEaR: Debt-at-Risk


Triggering the CoCo conversion

Difference of trigger variable from threshold


Risk management for debt restructuring with CoCo


Case study of Greece


Primary surplus 1.5% and improved country growth assuming fiscal multiplier 0.8


Interest rate concessions


Risk management for debt restructuring with CoCo


Conclusions and Challenges Ex ante treatment of uncertainty S-CoCo

Forestall default Reduce probability of default Market discipline debtors Solve creditor moral hazard Automatic stabilizers, countercyclical

fiscal Speedy crisis response Financial stability


Challenges

Safe asset for Banks CDS adjust to the issue of S-CoCo Develop solid investor base IMF involvement


References

Consiglio, A. and Zenios, S.A.Risk management optimization for sovereign debt restructuringJ. of Globalization and Development, special issue Stiglitz et al. (eds.)

Consiglio, A. and Zenios, S.A. Contingent convertible bonds for sovereign debt risk management http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2694973

Consiglio, Carollo and Zenios,A parsimonious model for generating arbitrage free scenario trees Quantitative Finance (in print)http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2362014

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2694973





the case for contingent convertible debt for sovereigns

Economy & Finance