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How do capital structure and economic regime affect fair prices of bank’s equity and liabilities?

Author

Listed:
  • Donatien Hainaut

    (ESC Rennes Business School and CREST)

  • Yang Shen

    (York University)

  • Yan Zeng

    (Sun Yat-sen University)

Abstract

This paper considers the capital structure of a bank in a continuous-time regime-switching economy. The modeling framework takes into account various categories of instruments, including equity, contingent convertible debts, straight debts, deposits and deposits insurance. Whereas previous researches concentrate on the determination of the capital structure that maximizes shareholders’ equity, this work focuses on the fair pricing of liabilities that ensures no cross-subsidization among stakeholders. This is discussed in a case study where the bank’s EBIT is modeled by a four-regime process and is fitted to real market data. A numerical analysis reveals that convertible debts can significantly reduce the cost of deposits insurance and straight debts as well as probabilities of bankruptcy. Although it is found that the risk of dilution for shareholders is important, paradoxically, a high conversion rate for the contingent convertible debt, compensated by a low interest cost before conversion, can delay this dilution. Finally, we find that in case of change of economic regime, there exists an optimal capital structure from the shareholder’s perspective.

Suggested Citation

  • Donatien Hainaut & Yang Shen & Yan Zeng, 2018. "How do capital structure and economic regime affect fair prices of bank’s equity and liabilities?," Annals of Operations Research, Springer, vol. 262(2), pages 519-545, March.
    • Handle: RePEc:spr:annopr:v:262:y:2018:i:2:d:10.1007_s10479-016-2210-8
    DOI: 10.1007/s10479-016-2210-8
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    3. Philippe Oster, 2020. "Contingent Convertible bond literature review: making everything and nothing possible?," Journal of Banking Regulation, Palgrave Macmillan, vol. 21(4), pages 343-381, December.

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    More about this item

    Keywords

    Contingent convertibles; Regime-switching; Wiener–Hopf factorization; Hitting time;
    All these keywords.

    JEL classification:

    • J26 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Retirement; Retirement Policies
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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