Contingent capital to strengthen the private safety net for financial institutions: Cocos to the rescue?
This study examines the promise of reducing expected resolution costs of financial institutions through either voluntary or mandated addition of contingently convertible debt securities to their long-term financing mix. I model the stochastic process by which an initially very well capitalized banking firm may come to violate its minimum capital maintenance requirement. Conversion of cocos then provides a second chance because the firm's initial capitalization is restored. Although regulatory insolvency remains a distant threat, the expected reductions in the cost of bankruptcy and hence the cost of capital are such that cocos may win a place in the liability structure of financial institutions without the need for mandates.
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