But it is possible that banks themselves might find such a capital structure in their own best interests. To see why, consider a standard model of optimal capital choice by a value-maximising firm. The firm faces a trade-off. Debt confers the benefits of tax deductibility, while equity offers the benefits of lower expected bankruptcy costs.15 The tradeoff between these two sets of benefits defines an optimal capital ratio for a firm to maximise its expected value (Chart 9).16 Now consider adding CoCos to the mix. They are, in effect, a hybrid of debt and equity whose payoffs depend on the state of nature. When nature is kind and times are good, they offer the upswing (tax-deductibility) benefits of debt. And when nature is cruel and times are bad, they offer the downswing (bankruptcy costs) benefits of equity. They are, in the  14  Commission of Experts for Limiting the Economic Risks Posed by Large Companies (2010). 15  Debt could also provide some incentive benefits in disciplining management (Jensen (1986)). 16  Leland (1994). BIS central bankers’ speeches  7  language of economists, a form of “contingent” contract when the contingency in question is crisis. As Chart 10 illustrates, the optimal fraction of CoCos in banks’ optimal debt structure is likely to be non-zero. In other words, a CDE capital structure might be a smart option for valuemaximising investors and managers, even without the need for regulatory intervention.

Chart 6: Market capitalisation to book-value of total assets 14.0% 12.0% 10.0% 8.0% 6.0% 'No crisis' banks 'Crisis' banks 5% threshold Lehman failure 15 Sep 08  4.0% 2.0%  Nov 08  May 08  Nov 07  May 07  Nov 06  May 06  Nov 05  May 05  Nov 04  May 04  Nov 03  May 03  Nov 02  May 02  0.0%  Sources: Capital IQ and Bank calculations (a) 30-day moving average of market capitalisation Other Footnotes as per chart 5  14  BIS central bankers’ speeches  Chart 7: Market capitalisation to book-value of debt 15.0% 12.5% 10.0% 7.5% 5.0% 'No crisis' banks 'Crisis' banks 5% threshold Lehman failure 15 Sep 08  2.5%  Nov 08  May 08  Nov 07  May 07  Nov 06  May 06  Nov 05  Nov 04  May 05  May 04  Nov 03  May 03  Nov 02  May 02  0.0%  Sources: Capital IQ and Bank calculations (a) 30-day moving average of market capitalisation Other Footnotes as per chart 5  Chart 8: Market capitalisation to book-value of equity 2.50 2.00 1.50 1.00  'No crisis' banks 'Crisis' banks 1.20 threshold Lehman failure 15 Sep 08  0.50  Nov 08  May 08  Nov 07  May 07  Nov 06  May 06  Nov 05  May 05  Nov 04  May 04  Nov 03  May 03  Nov 02  May 02  0.00  Sources: Capital IQ and Bank calculations (a) 30-day moving average of market capitalisation Other Footnotes as per chart 5  BIS central bankers’ speeches  15  Chart 9: Optimal capital structure – Debt and Equity  Optimal capital structure – D + E  Present value of costs  Expected costs of financial distress  Expected taxes  Optimal leverage ratio  Debt/Equity  Source: Bank of England  Chart 10: Optimal capital structure – Debt, Equity and Contingent Capital  Optimal capital structure – C + D + E  Present value  Expected taxes  Expected bankruptcy costs Taxes paid due to existing equity 0  Optimal portion of convertible debt  100%  Source: Bank of England  16  BIS central bankers’ speeches  Chart 11: Major UK banks’ Tier 1 capital ratio % 12  Including bonuses paid as cocos Including dividends paid as cocos  11  Actual Tier 1 capital ratio  10 9 8 7 6 2000 2001 2002 2003 2004 2005 2006 2007 Sources: Annual accounts and Bank calculations (a) Alliance and Leicester, Banco Santander, Barclays, Bradford & Bingley, HBOS, HSBC, Lloyds TSB, Nationwide, Northern Rock and RBS.