As a component of financial-sector reform implemented in the wake of the global financial crisis, banks have been required to maintain various levels of capital, divided into tiers, which function as shock absorbers during times of economic distress. Common equity tier 1 capital is at the very top, followed by AT1 capital, which typically consists of hybrid bonds. Beneath this is tier 2 capital, which includes subordinated debt.

The use of CoCos and other loss-absorbing capital instruments helps to prevent government bailouts and increase banks' safety buffers. These bonds carry higher yields than comparable assets, reflecting the higher risk investors are taking. The mechanism of automatic loss absorption when the capital ratio falls below a specified threshold is a key feature of AT1 bonds, and one of the main risks is that bondholders can lose their investment entirely or end up with equity holdings in a weakened bank.

CoCos is an important tool. Effective for the bail-in mechanism, it can be utilized to enforce market discipline, such as being used as a bonus to bank management in the form of CoCos, with the rationale that it can reduce excessive risk-taking behavior. From the perspective of shareholders, the quantity of CoCos issued will affect the dilution of existing shareholders' equity. This creates an incentive for shareholders to request improvements in corporate governance and the enforcement of prudential regulations on banks.

However, the issuance of CoCos must also be carefully considered so as not to send a negative signal to the market. Thus, the effectiveness of the CoCos instrument is believed to rely on the existence of the CoCos market. If strong banks are the first to issue CoCos, investors can distinguish between strong and weak banks, thus enhancing confidence in the new instruments and promoting market stability.

Consequently, investors could progressively increase their exposure to riskier issuers, referred to as "second-tier" issuers. At first, hedge funds, sovereign-wealth funds and high-yield or equity investors may form the primary investor base, with traditional credit investors, asset managers and insurers gradually joining in to enhance market depth over time (IMF, 2011).

The banking regulatory framework in Indonesia has also implemented a bail-in mechanism, including the conversion of CoCos into equity under certain predefined conditions, typically when a bank reaches the point of non-viability (PONV). In the Financial Services Authority (OJK) Regulation regarding the Minimum Capital Requirement for Commercial Banks, additional tier 1 instruments include subordinated debt instruments that have the characteristics of capital, are subordinate in nature, have no maturity and have noncumulative perpetual interest payments.

OJK has the authority to establish conditions in which a bank is potentially at risk of nonviability and to order the conversion of additional core capital instruments into common shares or to carry out a write-down. The mandatory issuance documentation includes a clause stating additional core capital instruments may be converted into common shares or subject to write-down upon order from the OJK regulation.

The regulation also requires a clause in the mandatory issuance documentation stating additional core capital instruments may be converted into common shares or subject to write-down upon order from the OJK.

So far, there have not been any significant issuances of CoCos in Indonesia aimed at strengthening additional loss-absorbing capital instruments. However, the recent acquisition of Credit Suisse by UBS raised concern because the Swiss regulator FINMA declared the US$17 billion worth of Credit Suisse's AT1 contingent convertible bonds would be written off.

The Credit Suisse case is worth monitoring to learn lessons, particularly about how the court and financial regulators will balance investors' interests in their CoCos investments while ensuring the acquisition process is not disrupted and there is continuity in managing Credit Suisse's assets, liabilities and customer funds, which are presently being acquired by UBS.

In the case of Credit Suisse, the controversy surrounding the takeover centers on the issue of hierarchy. The question at hand is who should bear losses first in the event a bank faces financial difficulties. While AT1 bondholders are typically the first to anticipate losses, in the case of Credit Suisse, the shareholders will not be completely wiped out. Instead, they are expected to be compensated with UBS shares worth the equivalent of 0.76 Swiss franc per share. This compensation has caused concern among investors, as they assess whether the same could happen for their holdings of AT1 debt in other banks.

To calm the market, other European regulators have issued statements clarifying the situation. They have stated that owners of AT1 debt would only experience losses after shareholders were wiped out, unlike what happened at Credit Suisse.

The European Central Bank and the European Banking Authority have affirmed equity instruments would be the first to absorb losses, and only after their full use would AT1 debts be required to be written down. Meanwhile, the Bank of England has clarified AT1 bonds ranked before the highest tier of equity capital, but holders of such instruments should expect to be exposed to losses in resolution or insolvency in the order of their positions in this hierarchy.

The decision to write off AT1 bonds as part of the Credit Suisse-UBS deal has prompted investors to consider legal action. Indeed, the implementation of bail-in measures to address bank capitalization issues could encounter legal hurdles.

One challenge that may arise is legal opposition from minority shareholders, who could argue the conversion of CoCos into equity would dilute their ownership rights unfairly. Moreover, the legal and regulatory environment in some jurisdictions may not support government intervention in the financial sector, making legal challenges more likely to succeed. Consequently, financial authorities may need to work with governments to develop a clear and effective legal framework that supports the conversion of CoCos.

To minimize these risks, financial regulators should ensure the conversion process is transparent and fair, with clear guidelines that support financial stability. They should also justify the conversion to bondholders and shareholders, disclosing any potential losses that could result from such a move.

While the CoCos mechanism is intended to enhance banks' capitalization during times of financial stress, it could result in losses for investors holding these instruments. Therefore, it is crucial to provide adequate protection and disclosure of risks to potential investors before they invest in CoCos.

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The writer is a financial sector policy analyst, Fiscal Policy Agency, Finance Ministry. The views in this article are personal.

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