Does Contingent Capital Induce Excessive Risk-Taking and Prevent an Efficient Recapitalization of Banks?
Humboldt Universität zu Berlin; New York University (NYU)
Technische Universität München (TUM)
August 22, 2012
Systemic Risk, Basel III, Financial Stability and Regulation 2011
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 magnified 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, G28working papers series
Date posted: November 17, 2010 ; Last revised: August 23, 2012
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