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

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Author Info

  • Jens Hilscher

    ()
    (International Business School, Brandeis University)

  • Alon Raviv

    ()
    (International Business School, Brandeis University)

Abstract

This paper investigates the e¤ects of ?nancial 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 op- tions and present closed-form solutions for their prices. We quantify the reduction in default probability associated with issuing contingent capital instead of subor- dinated 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 ei- ther subordinated debt or additional equity. Importantly, risk-taking incentives continue to be weak during times of ?nancial distress. Our ?ndings imply that contingent capital may be an e¤ective tool for stabilizing ?nancial institutions.

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File URL: http://www.brandeis.edu/departments/economics/RePEc/brd/doc/Brandeis_WP53R.pdf
File Function: Revised version, 2014
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File URL: http://www.brandeis.edu/departments/economics/RePEc/brd/doc/Brandeis_WP53.pdf
File Function: First version, 2012
Download Restriction: no

Bibliographic Info

Paper provided by Brandeis University, Department of Economics and International Businesss School in its series Working Papers with number 53.

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Length: 51 pages
Date of creation: Sep 2012
Date of revision: Jan 2014
Handle: RePEc:brd:wpaper:53

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Postal: MS032, P.O. Box 9110, Waltham, MA 02454-9110
Web page: http://www.brandeis.edu/departments/economics/
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Related research

Keywords: contingent capital; executive compensation; risk taking; banking regulation; bank default probability; ?financial crisis;

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References

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  1. Anat R. Admati & Peter M. DeMarzo & Martin F. Hellwig & Paul Pfleiderer, 2010. "Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive," Working Paper Series of the Max Planck Institute for Research on Collective Goods 2010_42, Max Planck Institute for Research on Collective Goods.
  2. Edward S. Prescott, 2012. "Contingent capital: the trigger problem," Economic Quarterly, Federal Reserve Bank of Richmond, issue 1Q, pages 33-50.
  3. repec:fip:fedreq:y:2012:i:1q:p:33-50:n:vol.98no.1 is not listed on IDEAS
  4. Ericsson, Jan & Reneby, Joel, 1995. "A Framework for Valuing Corporate Securities," Working Paper Series in Economics and Finance 89, Stockholm School of Economics, revised Oct 1998.
  5. Ing-Haw Cheng & Harrison Hong & Jose Scheinkman, 2010. "Yesterday’s Heroes: Compensation and Creative Risk-Taking," NBER Chapters, in: Market Institutions and Financial Market Risk National Bureau of Economic Research, Inc.
  6. Hamid Mehran & Joshua Rosenberg, 2007. "The effect of employee stock options on bank investment choice, borrowing, and capital," Staff Reports 305, Federal Reserve Bank of New York.
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Cited by:
  1. Stig Helberg & Snorre Lindset, 2013. "Bank Debt Regulations Implications for Bank Capital and Bond Risk," Working Paper Series 14813, Department of Economics, Norwegian University of Science and Technology.

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