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Contingent convertibles. Solving or seeding the next banking crisis?

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  • Koziol, Christian
  • Lawrenz, Jochen
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    Abstract

    A recent proposal to enhance banking stability recommends the use of contingent convertibles (CoCos). Since these hybrid securities are mandatorily converted into equity when banks are in need of a recapitalization, they are credited for reducing banks’ likelihood of financial distress. In this paper, we show within a continuous-time framework that this allegedly beneficial impact hinges critically on the assumption of complete contracts. If contracts are incomplete in the sense that manager–owners enjoy discretion over the risk of the investment program, our analysis shows that CoCo bonds always distort risk taking incentives. Our main contribution is to demonstrate that there exist conditions under which CoCo bond financing increases investors’ wealth, but also increases the bank’s probability of financial distress, so that the banking system as a whole will be destabilized. Thus, individually rational decisions can have systemically undesirable outcomes. Further results indicate that CoCos should be used only in conjunction with devices to control risk shifting incentives.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Banking & Finance.

    Volume (Year): 36 (2012)
    Issue (Month): 1 ()
    Pages: 90-104

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    Handle: RePEc:eee:jbfina:v:36:y:2012:i:1:p:90-104

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    Web page: http://www.elsevier.com/locate/jbf

    Related research

    Keywords: Contingent capital certificates; Reverse convertibles; Restructuring mechanisms; Regulatory hybrid security;

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    Cited by:
    1. Barucci, Emilio & Del Viva, Luca, 2012. "Countercyclical contingent capital," Journal of Banking & Finance, Elsevier, Elsevier, vol. 36(6), pages 1688-1709.
    2. Nataliya Klimenko, 2013. "Tailoring Bank Capital Regulation for Tail Risk," AMSE Working Papers 1310, Aix-Marseille School of Economics, Marseille, France, revised Feb 2013.
    3. Thomas Conlon & John Cotter, 2014. "Anatomy of a Bail-In," Papers 1403.7628, arXiv.org.
    4. Thomas Conlon & John Cotter, 2014. "Anatomy of a Bail-In," Working Papers, Geary Institute, University College Dublin 201405, Geary Institute, University College Dublin.
    5. Nataliya Klimenko, 2013. "Tailoring Bank Capital Regulation for Tail Risk," Working Papers halshs-00796490, HAL.
    6. Fernando Díaz & Gabriel Ramírez & Kenneth Daniels, 2013. "Corporate Bond Clawbacks as Contingent Capital," Working Papers, Facultad de Economía y Empresa, Universidad Diego Portales 44, Facultad de Economía y Empresa, Universidad Diego Portales.
    7. Dutordoir, Marie & Lewis, Craig & Seward, James & Veld, Chris, 2014. "What we do and do not know about convertible bond financing," Journal of Corporate Finance, Elsevier, Elsevier, vol. 24(C), pages 3-20.

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