Contingent Capital with a Dual Price Trigger

37 Pages Posted: 17 Feb 2010 Last revised: 12 Apr 2011

Date Written: February 15, 2010

Abstract

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.

Keywords: Contingent capital, bank regulation, capital

JEL Classification: G21, G28

Suggested Citation

McDonald, Robert L., Contingent Capital with a Dual Price Trigger (February 15, 2010). Available at SSRN: https://ssrn.com/abstract=1553430 or http://dx.doi.org/10.2139/ssrn.1553430

Robert L. McDonald (Contact Author)

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States
847-491-8344 (Phone)
847-491-5719 (Fax)

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