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CoCo Design, Risk Shifting and Financial Fragility

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  • van Wijnbergen, Sweder
  • Chan, Stephanie

Abstract

Contingent convertible capital (CoCo) is a debt instrument that converts to equity or is written off if the issuing bank fails to meet a distress threshold. The conversion increases the issuer's loss-absorption capacity, but results in wealth transfers between CoCo holders and shareholders, which may change risk-shifting incentives to shareholders. Higher risk increases the probability of CoCo conversion, while lowering the wealth transfer. We show that for Principal-Write-Down (PWD) CoCos, the net effect is to always increase risk-shifting incentives, while for equity-converting CoCos, it depends on the extent of dilution after conversion. We integrate the analysis in a game-theoretic optimal capital regulation framework and show that use of PWD or insufficiently dilutive CE CoCos requires higher capital requirements for given asset structure to offset the rising risk-shifting incentives these instruments give rise to.

Suggested Citation

  • van Wijnbergen, Sweder & Chan, Stephanie, 2016. "CoCo Design, Risk Shifting and Financial Fragility," CEPR Discussion Papers 11099, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:11099
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    References listed on IDEAS

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    Cited by:

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    3. Avdjiev, Stefan & Bogdanova, Bilyana & Bolton, Patrick & Jiang, Wei & Kartasheva, Anastasia, 2020. "CoCo issuance and bank fragility," Journal of Financial Economics, Elsevier, vol. 138(3), pages 593-613.
    4. Martynova, Natalya & Perotti, Enrico, 2018. "Convertible bonds and bank risk-taking," Journal of Financial Intermediation, Elsevier, vol. 35(PB), pages 61-80.

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    More about this item

    Keywords

    Capital requirements; Contingent convertible capital; Risk shifting incentives; Systemic risk;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • 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
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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