Understanding Contingent Capital

Contingent capital (CC) is a bond that automatically converts into common stock when equity capital is impaired. This paper analyzes the determinants of the interest rate at which CC is issued and discusses the impacts of CC issuance on other financial markets. The paper shows that Japanese banks are likely to offer high interest rates to CC investors, reflecting the economic and balance-sheet conditions of individual banks in Japan. The paper suggests that in order to draw much advantage from CC, regulators should avoid placing excess restrictions on the design of CC. By doing so, regulators can encourage banks to look for the ways to lower the interest rate of CC, some of which are illustrated in the paper. A minimum set of regulations, however, must be imposed on the design and issuing conditions of CC; otherwise, CC may disrupt the functioning of financial markets. In addition, the likelihood of bank failure is not necessarily reduced by replacing subordinated bonds with CC. Furthermore, the optimal combination of CC and subordinated bonds is extremely sensitive to economic conditions, such as the expected growth rate. All these issues are relevant when considering whether or not to allow banks to issue CC.