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CoCo Design, Risk Shifting Incentives and Financial Fragility

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  • Chan, Stephanie
  • Wijnbergen, Sweder

Abstract

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.

Suggested Citation

  • Chan, Stephanie & Wijnbergen, Sweder, 2017. "CoCo Design, Risk Shifting Incentives and Financial Fragility," ECMI Papers 12166, Centre for European Policy Studies.
  • Handle: RePEc:eps:ecmiwp:12166
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    File URL: https://www.ceps.eu/publications/coco-design-risk-shifting-incentives-and-financial-fragility
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    1. Suresh Sundaresan & Zhenyu Wang, 2015. "On the Design of Contingent Capital with a Market Trigger," Journal of Finance, American Finance Association, vol. 70(2), pages 881-920, April.
    2. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    3. Hilscher, Jens & Raviv, Alon, 2014. "Bank stability and market discipline: The effect of contingent capital on risk taking and default probability," Journal of Corporate Finance, Elsevier, vol. 29(C), pages 542-560.
    4. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    5. Charles W. Calomiris & Richard J. Herring, 2013. "How to Design a Contingent Convertible Debt Requirement That Helps Solve Our Too-Big-to-Fail Problem," Journal of Applied Corporate Finance, Morgan Stanley, vol. 25(2), pages 39-62, June.
    6. Amadou N Sy & Jorge A Chan-Lau, 2006. "Distance-to-Default in Banking; A Bridge Too Far?," IMF Working Papers 06/215, International Monetary Fund.
    7. Anil K. Kashyap & Jeremy C. Stein, 2004. "Cyclical implications of the Basel II capital standards," Economic Perspectives, Federal Reserve Bank of Chicago, vol. 28(Q I), pages 18-31.
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    Cited by:

    1. Goncharenko, Roman & Ongena, Steven & Rauf, Asad, 2018. "The Agency of CoCos: Why Contingent Convertible Bonds Aren't for Everyone," CEPR Discussion Papers 13344, C.E.P.R. Discussion Papers.
    2. Ioana Neamtu, 2020. "Multiple buffer CoCos and their impact on financial stability," Tinbergen Institute Discussion Papers 20-010/IV, Tinbergen Institute.
    3. Goncharenko, Roman & Ongena, Steven & Rauf, Asad, 2017. "The agency of CoCo: Why do banks issue contingent convertible bonds?," CFS Working Paper Series 586, Center for Financial Studies (CFS).

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