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Bank stability and market discipline: The effect of contingent capital on risk taking and default probability

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  • Hilscher, Jens
  • Raviv, Alon

Abstract

This paper investigates the effects of financial institutions issuing contingent capital, a debt security that automatically converts into equity if assets fall below a predetermined threshold. We decompose bank liabilities into sets of barrier options and present closed-form solutions for their prices. We quantify the reduction in default probability associated with issuing contingent capital instead of subordinated debt. We then show that appropriate choice of contingent capital terms (in particular the conversion ratio) can virtually eliminate stockholders' incentives to risk-shift, a motivation that is present when bank liabilities instead include either subordinated debt or additional equity. Importantly, risk-taking incentives continue to be weak during times of financial distress. Our findings imply that contingent capital may be an effective tool for stabilizing financial institutions.

Suggested Citation

  • Hilscher, Jens & Raviv, Alon, 2014. "Bank stability and market discipline: The effect of contingent capital on risk taking and default probability," Journal of Corporate Finance, Elsevier, vol. 29(C), pages 542-560.
    • Handle: RePEc:eee:corfin:v:29:y:2014:i:c:p:542-560
    DOI: 10.1016/j.jcorpfin.2014.03.009
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    More about this item

    Keywords

    Contingent capital; Executive compensation; Risk taking; Banking regulation; Bank default probability; Financial crisis;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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