Bank stability and market discipline: The effect of contingent capital on risk taking and default probability
AbstractThis 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 analyze a tractable form of contingent convertible bonds ("coco") and provide a closed-form solution for the price. We quantify the reduction in default probability associated with contingent capital as compared to subordinated debt. We then show that appropriate choice of contingent capital parameters (conversion ratio and threshold) can virtually eliminate stockholders' incentives to risk-shift, a motivation that is present when bank liabilities instead include either only equity or subordinated debt. 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.
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Bibliographic InfoPaper provided by Brandeis University, Department of Economics and International Businesss School in its series Working Papers with number 53.
Length: 51 pages
Date of creation: Sep 2012
Date of revision:
Contingent capital; Executive compensation; Risk taking; Banking regulation; Bank default probability; Financial crisis;
Find related papers by 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
This paper has been announced in the following NEP Reports:
- NEP-ALL-2012-10-13 (All new papers)
- NEP-BAN-2012-10-13 (Banking)
- NEP-CBA-2012-10-13 (Central Banking)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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