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Convertible Bonds and Bank Risk-Taking

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  • Natalya Martynova

    (University of Amsterdam)

  • Enrico Perotti

    (University of Amsterdam)

Abstract

We study the effect of going-concern contingent capital on bank risk choice. The possibility of debt for equity conversion forces deleveraging in highly levered states, when risk incentives are worse. The additional equity reduces endogenous risk shifting by diluting returns in high states. An optimally designed trigger and convertible debt amount trades off this risk reduction against its debt dilution effect. Interestingly, contingent capital may be less risky in equilibrium than traditional debt, as its lower priority is compensated by reduced endogenous risk. Its effectiveness in risk reduction depends critically on the informativeness of the trigger. Adopting a noisy market trigger produces excess conversion (type II error), while an accounting trigger converts too infrequently (type I error) because of regulatory forbearance.

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Bibliographic Info

Paper provided by Tinbergen Institute in its series Tinbergen Institute Discussion Papers with number 12-106/IV/DSF41.

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Date of creation: 09 Oct 2012
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Handle: RePEc:dgr:uvatin:20120106

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Web page: http://www.tinbergen.nl

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Keywords: Risk shifting; Financial Leverage; Contingent Capital;

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  1. Green, Richard C., 1984. "Investment incentives, debt, and warrants," Journal of Financial Economics, Elsevier, Elsevier, vol. 13(1), pages 115-136, March.
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