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Does Contingent Capital Induce Excessive Risk-Taking?

55 Pages Posted: 17 Nov 2010 Last revised: 11 Feb 2015

Tobias Berg

Frankfurt School of Finance & Management

Christoph Kaserer

Technische Universität München (TUM)

Date Written: January 10, 2015

Abstract

In this paper, we analyze the e ffect of the conversion price of CoCo bonds on equity holders' incentives. First, we use an option-pricing context to show that CoCo bonds can magnify equity holders' incentives to increase the riskiness of assets and decrease incentives to raise new equity in a crisis in cases in which conversion transfers wealth from CoCo bond holders to equity holders. Second, we present a clinical study of the CoCo bonds issued so far. We show that i) almost all existing CoCo bonds are designed in a way that implies a wealth transfer from CoCo bond holders to equity holders at conversion and ii) this contractual design is reflected in traded prices of CoCo bonds. In particular, CoCo bonds are short volatility with a magnitude five times greater than that which can be observed for straight bonds. These results are robust and economically signifi cant. We conclude that the CoCo bonds issued so far can create perverse incentives for banks' equity holders.

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

JEL Classification: G20, G21, G28

Suggested Citation

Berg, Tobias and Kaserer, Christoph, Does Contingent Capital Induce Excessive Risk-Taking? (January 10, 2015). Journal of Financial Intermediation, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1709341 or http://dx.doi.org/10.2139/ssrn.1709341

Tobias Berg (Contact Author)

Frankfurt School of Finance & Management ( email )

Sonnemannstraße 9-11
Frankfurt am Main, 60314
Germany

Christoph Kaserer

Technische Universität München (TUM) ( email )

Arcisstr. 21
Munich, D-80290
Germany
+49 89 289 25489 (Phone)
+49 89 289 25488 (Fax)

HOME PAGE: http://www.cefs.de

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