Contingent Capital with a Dual Price Trigger
Robert L. McDonald
Northwestern University - Kellogg School of Management
February 15, 2010
This paper proposes a form of contingent capital for financial institutions that converts from debt to equity if two conditions are met: the firm's stock price is at or below a trigger value and the value of a financial institutions index is also at or below a trigger value. This structure protects financial firms during a crisis, when all are performing badly, but during normal times permits a bank performing badly to go bankrupt. I discuss a number of issues associated with the design of a contingent capital claim, including susceptibility to manipulation and whether conversion should be for a fixed dollar amount of shares or a fixed number of shares; the susceptibility of different contingent capital schemes to different kinds of errors (under and over-capitalization); and the losses likely to be incurred by shareholders upon the imposition of a requirement for contingent capital. I also present some illustrative pricing examples.
Number of Pages in PDF File: 37
Keywords: Contingent capital, bank regulation, capital
JEL Classification: G21, G28
Date posted: February 17, 2010 ; Last revised: April 12, 2011
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