While millions of Europeans sun themselves on beaches in blissful ignorance, an unsettling problem has begun to rear its head. Turkey’s political and economic turmoil has laid regulatory weaknesses bare and has left some European investors to question the viability of the financial system’s ability to absorb new financial crises.

A good friend of mine – a Dutch entrepreneur with substantial capital invested in fixed income and equity markets – has been predicting that Coco’s will be the demise of the European Union and the Euro currency for months. “You know what will bring us all down? These things called Coco’s.” They sound cute, but they are shaping up to be anything but.

It all started 10 years ago, when the primary regulatory response to the financial crisis was additional capital requirements. More specifically, Basel III which stimulated European banks to begin issuing Contingent Convertible Bonds (Coco). What concerns my friend, professional investors, bankers and economists alike, is that the 178.6 billion euros of notes meant to absorb losses at European banks have gone largely untested.

It is correct to assume that the average European doesn’t know what a Coco is, let alone that they are – as economist Satyajit Das coins them – “deeply subordinated investments with uncertain income, complex conversion or bail-in provisions, and substantial capital risk.”

But even if the average European isn’t privy to what subordinated debt is, they need to wrap their head around the gravity of the matter: that these instruments which were used in Europe to prop up financial institutions after the 2008 financial crisis did not eliminate underlying risks from bad lending. They have instead simply transferred them from banks to investors.

According to Germany’s Bundesbank, actually triggering these Coco’s could destabilize other lenders, especially if their volume grows. Ironically, the first ‘taste’ of this came in 2016 from when some analysts questioned whether Deutsche Bank AG could make payments on its version of those bonds. Deutsche paid, but a plunge in the notes made waves and it caused the bank to lose considerable revenue.

Now, Turkey’s collapsing currency, rising bond yields and soaring debt loads could be the second, more severe ‘taste’ of a Coco ripple effect. The risk of contagion, or the transmission of financial problems from one nation to another, is omnipresent.

MSCI has developed a dedicated risk model which may help to “spot indications of a potential collapse, especially in a bull market” by picking up on early warning signs. I offered this to my friend as a piecemeal solution to his woes, but his strategy is altogether more drastic: he is moving his capital out of Europe, and into Asian stocks.

Written by Elizabeth K. James

Turkey/EU

Source: bne IntelliNews

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