CoCo Design, Risk Shifting Incentives and Financial Fragility

Contingent convertible capital (CoCo) is a debt instrument that converts to equity or is written off if the issuing bank fails to meet a distress threshold. The conversion increases the issuer’s loss-absorption capacity, but results in wealth transfers between CoCo holders and shareholders, which in turn gives rise to risk-shifting incentives to shareholders. Using the framework of call options, this paper finds that the risk-shifting incentives arising from issuing CoCos relative to subordinated debt have two opposite effects: higher risk increases the probability of CoCo conversion, while lowering the benefit of the wealth transfer relative to the same amount of subordinated debt. For writedown CoCos, the risk-shifting incentive is always positive, while for equity-converting CoCos, it depends on the dilutive power of the CoCo. While recent regulation has deemed CoCos suitable for increasing loss absorption capacity, our results show that some CoCos are potentially riskier than issuing subordinated debt in their place. To sidestep these consequences, their use by banks must be tempered by increasing capital requirements, and as such, they should not be treated as true substitutes for equity.