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Bank Stability and Market Discipline: Debt-for-Equity Swap versus Subordinated Notes

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Author Info

  • Alon Raviv

    (The Hebrew University Business School)

Abstract

Several studies have recommended reliance on subordinated debt as a tool for monitoring banks by investors and for enhancing depositors’ protection. However, subordinated debenture increases the level of leverage and thus the probability of costly failure. We propose a novel financial instrument, ‘Debt-for-Equity Swap’ contract (DES), that pays to its holder a fixed income unless the value of the bank’s assets falls below a predetermined threshold. In such an event, the debt obligation is automatically converted to the bank’s common equities. By using a contingent claims valuation approach we present closed-form solutions for the valuation of liabilities, the cost of deposit insurance and the value of bankruptcy costs of a bank that includes DES or alternatively subordinated debt in its capital structure. We compare and evaluate quantitatively the effects of DES contract versus subordinated debt on bank stability, depositor protection, incentives for risk taking, the ability to provide market discipline and the value of bankruptcy costs. The implications of the paper highlight the fact that the DES contract has salient advantages over subordinated debt as an efficient tool for enhancing market stability and bank efficiency, since it reduces the value of bankruptcy costs. The advantage of the DES over subordinated debt as a provider of depositors’ protection depends on the level of mandatory intervention, assets value and volatility as well as on the ratio of bankruptcy costs. The model illustrates the pros and cons of each of the two capital instruments as a tool for enhancing market discipline. While the value of subordinated debt increases with the value of assets, its disadvantage as a monitoring tool derives from its low sensitivity to changes in assets volatility when the level of regulatory intervention is relatively high in terms of capital adequacy and the rate of bankruptcy costs is relatively low. The DES contract is beneficial as a tool for monitoring due to its negative sensitivity to increase in assets risk. However, when the conversion ratio is relatively high its price might increase as the leverage ratio increases.

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File URL: http://128.118.178.162/eps/fin/papers/0408/0408003.pdf
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Bibliographic Info

Paper provided by EconWPA in its series Finance with number 0408003.

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Length: 59 pages
Date of creation: 13 Aug 2004
Date of revision:
Handle: RePEc:wpa:wuwpfi:0408003

Note: Type of Document - pdf; pages: 59
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Web page: http://128.118.178.162

Related research

Keywords: bank; financial stability; market discipline; deposit insurance; options pricing; subordinated debt; Debt for Equity Swap.;

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References

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  1. Black, Fischer & Cox, John C, 1976. "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions," Journal of Finance, American Finance Association, vol. 31(2), pages 351-67, May.
  2. DeYoung, Robert, et al, 2001. "The Information Content of Bank Exam Ratings and Subordinated Debt Prices," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(4), pages 900-925, November.
  3. Avery, Robert B & Belton, Terrence M & Goldberg, Michael A, 1988. "Market Discipline in Regulating Bank Risk: New Evidence from the Capital Markets," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 20(4), pages 597-610, November.
  4. Franklin Allen & Richard Herring, 2001. "Banking Regulation versus Securities Market Regulation," Center for Financial Institutions Working Papers 01-29, Wharton School Center for Financial Institutions, University of Pennsylvania.
  5. Acharya, Viral V & Huang, Jing-Zhi & Subrahmanyam, Marti G. & Sundaram, Rangarajan K, 2002. "When Does Strategic Debt Service Matter?," CEPR Discussion Papers 3566, C.E.P.R. Discussion Papers.
  6. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  7. Jan Ericsson & Joel Reneby, 1998. "A framework for valuing corporate securities," Applied Mathematical Finance, Taylor & Francis Journals, vol. 5(3-4), pages 143-163.
  8. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
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Cited by:
  1. Edward S. Prescott, 2011. "Contingent capital: the trigger problem," Working Paper 11-07, Federal Reserve Bank of Richmond.
  2. Hans Gersbach, 2013. "Preventing Banking Crises--with Private Insurance?," CESifo Economic Studies, CESifo, vol. 59(4), pages 609-627, December.
  3. Dwight Jaffee & Alexei Tchistyi & Boris Albul, 2013. "Contingent Convertible Bonds and Capital Structure Decisions," 2013 Meeting Papers 682, Society for Economic Dynamics.
  4. von Furstenberg, George M., 2011. "Contingent capital to strengthen the private safety net for financial institutions: Cocos to the rescue?," Discussion Paper Series 2: Banking and Financial Studies 2011,01, Deutsche Bundesbank, Research Centre.
  5. repec:fip:fedreq:y:2012:i:1q:p:33-50:n:vol.98no.1 is not listed on IDEAS
  6. Barucci, Emilio & Del Viva, Luca, 2012. "Countercyclical contingent capital," Journal of Banking & Finance, Elsevier, vol. 36(6), pages 1688-1709.
  7. Christian Wolff & Theo Vermaelen & George Pennacchi, 2010. "Contingent Capital: The Case for COERCs," LSF Research Working Paper Series 10-08, Luxembourg School of Finance, University of Luxembourg.
  8. Pennacchi, George G. & Vermaelen, Theo & Wolff, Christian C, 2010. "Contingent Capital: The Case for COERCs," CEPR Discussion Papers 8028, C.E.P.R. Discussion Papers.

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