Does Contingent Capital Induce Excessive Risk-Taking and Prevent an Efficient Recapitalization of Banks?

Abstract:     
In this paper we analyze the effect of the conversion price of CoCo-Bonds on equity holders' incentives. First, we show in an option-pricing context that CoCo- Bonds can magnify both the asset substitution and the debt overhang problem if the conversion price implies a wealth transfer from CoCo-Bond holders to equity holders at conversion. Second, we present a clinical study of the CoCo-Bonds issued so far by Lloyds, Rabobank and Credit Suisse. We show that i) these contracts are designed in a way that a wealth transfer from CoCo-Bond holders to equity holders takes place at conversion and ii) this contract design is reflected in traded prices of CoCo-Bonds. In particular, CoCo-Bonds are short in volatility with a magnitude four times larger than what can be observed for straight bonds. We conclude that the CoCo-Bonds issued so far have perverse incentives on risk-taking which are magnified close to the trigger point.

Number of Pages in PDF File: 44

Keywords: Contingent capital, banking regulation, risk-taking incentives, asset substitution, debt overhang, credit crunch

JEL Classification: G20, G21, G28

working papers series