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Bank stability and market discipline: The effect of contingent capital on risk taking and default probability

  • Jens Hilscher

    ()

    (International Business School, Brandeis University)

  • Alon Raviv

    ()

    (International Business School, Brandeis University)

This paper investigates the e¤ects of ?nancial institutions issuing contingent capital, a debt security that automatically converts into equity if assets fall below a predetermined threshold. We decompose bank liabilities into sets of barrier op- tions and present closed-form solutions for their prices. We quantify the reduction in default probability associated with issuing contingent capital instead of subor- dinated debt. We then show that appropriate choice of contingent capital terms (in particular the conversion ratio) can virtually eliminate stockholders?incentives to risk-shift, a motivation that is present when bank liabilities instead include ei- ther subordinated debt or additional equity. Importantly, risk-taking incentives continue to be weak during times of ?nancial distress. Our ?ndings imply that contingent capital may be an e¤ective tool for stabilizing ?nancial institutions.

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File URL: http://www.brandeis.edu/departments/economics/RePEc/brd/doc/Brandeis_WP53R.pdf
File Function: Revised version, 2014
Download Restriction: no

File URL: http://www.brandeis.edu/departments/economics/RePEc/brd/doc/Brandeis_WP53.pdf
File Function: First version, 2012
Download Restriction: no

Paper provided by Brandeis University, Department of Economics and International Businesss School in its series Working Papers with number 53.

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Length: 51 pages
Date of creation: Sep 2012
Date of revision: Jan 2014
Handle: RePEc:brd:wpaper:53
Contact details of provider: Postal: MS032, P.O. Box 9110, Waltham, MA 02454-9110
Web page: http://www.brandeis.edu/departments/economics/

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  1. Jan Ericsson & Joel Reneby, 1998. "A framework for valuing corporate securities," Applied Mathematical Finance, Taylor & Francis Journals, vol. 5(3-4), pages 143-163.
  2. Umut Cetin & R. Jarrow & P. Protter & Y. Yildirim, 2004. "Modeling credit risk with partial information," LSE Research Online Documents on Economics 2840, London School of Economics and Political Science, LSE Library.
  3. repec:fip:fedreq:y:2012:i:1q:p:33-50:n:vol.98no.1 is not listed on IDEAS
  4. Ing-Haw Cheng & Harrison Hong & Jose A. Scheinkman, 2010. "Yesterday's Heroes: Compensation and Creative Risk-Taking," NBER Working Papers 16176, National Bureau of Economic Research, Inc.
  5. Hamid Mehran & Joshua Rosenberg, 2007. "The effect of employee stock options on bank investment choice, borrowing, and capital," Staff Reports 305, Federal Reserve Bank of New York.
  6. Edward S. Prescott, 2011. "Contingent capital: the trigger problem," Working Paper 11-07, Federal Reserve Bank of Richmond.
  7. Admati, Anat R. & DeMarzo, Peter M. & Hellwig, Martin F. & Pfleiderer, Paul, 2010. "Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity Is Not Expensive," Research Papers 2065, Stanford University, Graduate School of Business.
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