Corporate Bond Clawbacks as Contingent Capital for Banks

Abstract

In this paper, we propose a clawback-type security as an alternative source of contingent capital, which we call COCLA for contingent clawback bonds. We develop a simple model in which a COCLA is used to manage the “debt overhang problem” that banks may encounter during a financial crisis. We solve the model numerically, setting its parameters close to the situation that was prevalent for the average North American large bank at the end of 2007. Our theoretical setting allows us to compare the equilibrium outcomes when the bank uses straight debt and COCLA debt. We obtain that, in the context of an economy in which there exists private benefits of control and significant costs of financial distress, a COCLA is the preferred instrument of the bank manager and equity holders.The bank manager maximizes their expected utility by choosing the supply of loans, the level of effort, and the amount of junior debt. We show that a bank manager will exercise the clawback provision (and convert a fraction of the junior debt into equity) in order to raise the bank's capital adequacy ratio above the regulator’s minimum requirement. The voluntary exercise of the clawback provision results from the trade off the manager faces between the private benefits of control, via maximization of her expected utility and the expected costs of financial distress imposed on her upon bankruptcy or liquidation. Thus, one novel result is that a COCLA bond does not suffer from the trigger problem. Another novelty of the proposed model, as compared to the recent developments in the CoCos literature, is that the supply of loans and the amount of debt chosen by the bank manager, and consequently the future cash flows of the bank, are endogenized.The calibration of the model is based upon several parameter values such as the fraction of the loans that default, the probability of full repayment of the loans, the salary of the manager, the fraction of deposits withdrawn, the private benefits of control, the cost of effort, the cost of violating the capital asset ratio and the fixed cost of financial distress. Further, the bank manager chooses her level of costly effort in screening the quality of the loans and thus reducing the probability of loan default which increases the value of the assets and eventually reduces the chances of a potential conversion (exercising the COCLA). From a practical point of view, we show that the clawback conversion rate that maximizes the manager's expected utility and level of effort exercised as well as the supply of loans the banks offers is around 25-26%, a level that also results in the lowest variability of capital ratios.As presented later, COCLAs design is based on a popular corporate bond with a clawback (IPOC) that has as conversion rate a range between 30 and 35% (See Daniels et al. (2013)). In the model, the costs of financial distress are in a sense dynamic as captured by the presence of two components: a fixed element dependent on the bank's manager initial equity position and a variable component reflected as a fraction of the manager's future bank ownership. Also, the managers faces regulatory cost oversight if the bank does not meet the regulatory capital requirements which creates incentives for the manager to take actions to avoid falling below the required capital ratios. Other features of the model are early conversion at par for a fraction of the debt issue and the exercise of the clawback option results in reduction of financial distress, which is a fairly standard characteristic of models that explain the convertibility of hybrid debt. Thus, our model is very flexible and representative of today's bank conditions and environment faced by bank managers.

Keywords: Contingent Capital, Systemic Risk, Basel Capital Requirements, Bank Regulation

JEL Classification: G21, G32