Bank Stability and Market Discipline: Debt-for-Equity Swap versus Subordinated Notes
AbstractSeveral 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.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by EconWPA in its series Finance with number 0408003.
Length: 59 pages
Date of creation: 13 Aug 2004
Date of revision:
Note: Type of Document - pdf; pages: 59
Contact details of provider:
Web page: http://22.214.171.124
bank; financial stability; market discipline; deposit insurance; options pricing; subordinated debt; Debt for Equity Swap.;
Find related papers by JEL classification:
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- 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
- G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation
- E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
This paper has been announced in the following NEP Reports:
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- 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.
- Douglas W. Diamond & Philip H. Dybvig, 2000.
"Bank runs, deposit insurance, and liquidity,"
Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
- 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.
- 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.
- Viral Acharya & Jing-zhi Huang & Marti Subrahmanyam & Rangarajan Sundaram, 2006.
"When does Strategic Debt-service Matter?,"
Springer, vol. 29(2), pages 363-378, October.
- 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.
- 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.
- 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.
- Edward S. Prescott, 2012.
"Contingent capital: the trigger problem,"
Federal Reserve Bank of Richmond, issue 1Q, pages 33-50.
- 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.
- Barucci, Emilio & Del Viva, Luca, 2012. "Countercyclical contingent capital," Journal of Banking & Finance, Elsevier, vol. 36(6), pages 1688-1709.
- Dwight Jaffee & Alexei Tchistyi & Boris Albul, 2013. "Contingent Convertible Bonds and Capital Structure Decisions," 2013 Meeting Papers 682, Society for Economic Dynamics.
- 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.
- Hans Gersbach, 2013. "Preventing Banking Crises--with Private Insurance?," CESifo Economic Studies, CESifo, vol. 59(4), pages 609-627, December.
- repec:fip:fedreq:y:2012:i:1q:p:33-50:n:vol.98no.1 is not listed on IDEAS
- 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.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (EconWPA).
If references are entirely missing, you can add them using this form.