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CoCos: Incentive alignment, Diamond-style

It is one of the eternal unknowns of the bond market, a riddle wrapped inside a mystery inside an enigma: who is going to buy contingent capital notes?

Identifying a buyer base for these innovative instruments – which, so far, only two banks have issued – is the Holy Grail of the bank capital market for 2011.

But the answer might already have been found at Barclays and Credit Suisse. The UK’s third-biggest lender is now in talks with the Financial Services Authority over a proposal to pay the bonuses of 1,000 of its senior bankers in CoCos. Credit Suisse is also rumoured to be looking at doing the same; its chairman Hans-Ulrich Doerig saying last month that he would buy contingent convertible bonds for his own account "as the ultimate litmus test of their solidity". In 2008 Credit Suisse attracted the ire of some of its employees for paying bonuses in assets such as leveraged loans and CMBS.

Paying bonuses in CoCos is a win-win for the banks, freeing up cash for capital ratios and aligning the employees’ interests with those of the bank in an if-the-institution-goes-down, your-remuneration-goes -with-it embrace.

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