Bank stability and market discipline: The effect of contingent capital on risk taking and default probability
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.
|Date of creation:||Sep 2012|
|Date of revision:||Jan 2014|
|Contact details of provider:|| Postal: MS032, P.O. Box 9110, Waltham, MA 02454-9110|
Web page: http://www.brandeis.edu/departments/economics/
More information through EDIRC
References listed on IDEAS
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.:
- Edward Simpson Prescott, 2012.
"Contingent capital: the trigger problem,"
Federal Reserve Bank of Richmond, issue 1Q, pages 33-50.
- Anat R. Admati & Peter M. DeMarzo & Martin F. Hellwig & Paul Pfleiderer, 2010.
"Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive,"
Working Paper Series of the Max Planck Institute for Research on Collective Goods
2010_42, Max Planck Institute for Research on Collective Goods.
- 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.
- repec:fip:fedreq:y:2012:i:1q:p:33-50:n:vol.98no.1 is not listed on IDEAS
- 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.
- Ing-Haw Cheng & Harrison Hong & Jose Scheinkman, 2010.
"Yesterday's Heroes: Compensation and Creative Risk-Taking,"
in: Market Institutions and Financial Market Risk
National Bureau of Economic Research, Inc.
- 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.
- Hamid Mehran & Joshua V. Rosenberg, 2007. "The effect of employee stock options on bank investment choice, borrowing, and capital," Staff Reports 305, Federal Reserve Bank of New York.
- Ericsson, Jan & Reneby, Joel, 1995.
"A Framework for Valuing Corporate Securities,"
SSE/EFI Working Paper Series in Economics and Finance
89, Stockholm School of Economics, revised Oct 1998.
When requesting a correction, please mention this item's handle: RePEc:brd:wpaper:53. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Leslie Yancich)
If references are entirely missing, you can add them using this form.