23 Pages Posted: 6 Aug 2010 Last revised: 28 Aug 2010
Date Written: August 2, 2010
Regulators have embraced the idea of pre-arranging bank recapitalizations through (funded or unfunded) contingent capital issuance. Contingent capital is intended to be triggered when a bank is headed toward failure in order to provide an automatic equity injection that keeps the bank out of distress. This note discusses counterparty risk, effectiveness, moral hazard, contagion and systemic risk, as well as death-spiral issues arising from the hedging strategies of the investors. We pay attention to important design issues with respect to the trigger and conversion ratio and comment on their pricing from an equity and credit derivative perspective.
Keywords: Contingent Capital, Moral Hazard, Financial Regulation
JEL Classification: G12, G13, G21, G28, G32
Suggested Citation: Suggested Citation