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

Listed author(s):
  • 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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