Coco Design, Risk Shifting Incentives and Capital Regulation

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 insuffciently dilutive CE CoCos requires higher capital requirements for given asset structure to offset the rising risk-shifting incentives these instruments give rise to.