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

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  • Jens Hilscher

    (International Business School, Brandeis University)

  • Alon Raviv

    (International Business School, Brandeis University)

Abstract

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.

Suggested Citation

  • Jens Hilscher & Alon Raviv, 2012. "Bank stability and market discipline: The effect of contingent capital on risk taking and default probability," Working Papers 53, Brandeis University, Department of Economics and International Business School, revised Jan 2014.
    • Handle: RePEc:brd:wpaper:53
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    File URL: http://www.brandeis.edu/economics/RePEc/brd/doc/Brandeis_WP53R.pdf
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    File URL: http://www.brandeis.edu/economics/RePEc/brd/doc/Brandeis_WP53.pdf
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    More about this item

    Keywords

    contingent capital; executive compensation; risk taking; banking regulation; bank default probability; ?financial crisis;
    All these keywords.

    JEL classification:

    • 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
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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