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Contingent Capital: The Case for COERCs

49 Pages Posted: 16 Mar 2011  

George Pennacchi

University of Illinois

Theo Vermaelen

INSEAD - Finance

Christian C. P. Wolff

University of Luxembourg - Luxembourg School of Finance; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 3 versions of this paper

Date Written: March 10, 2011

Abstract

In this paper we propose a new security, the Call Option Enhanced Reverse Convertible (COERC). The security is a form of contingent capital, i.e. a bond that converts to equity when the market value of equity or capital falls below a certain trigger. The conversion price is set significantly below the trigger price and, at the same time, equity holders have the option to buy back the shares from the bondholders at the conversion price. Compared to other forms of contingent capital proposed in the literature, the COERC is less risky in a world where bank assets can experience sudden, large declines in value. Moreover, the structure eliminates concerns of an equity price “death spiral” as a result of manipulation or panic. A bank that issues COERCs also has a smaller incentive to choose investments that are subject to large losses. Furthermore, COERCs reduce the problem of “debt overhang,” the disincentive to replenish shareholders’ equity following a decline.

Keywords: Convertible bonds, bank capital, death spiral, debt overhang

JEL Classification: G20, G32

Suggested Citation

Pennacchi, George and Vermaelen, Theo and Wolff, Christian C. P., Contingent Capital: The Case for COERCs (March 10, 2011). Available at SSRN: https://ssrn.com/abstract=1785380 or http://dx.doi.org/10.2139/ssrn.1785380

George G. Pennacchi

University of Illinois ( email )

4041 BIF, Box 25
515 East Gregory Drive
Champaign, IL 61820
United States
217-244-0952 (Phone)

HOME PAGE: http://www.business.illinois.edu/gpennacc/

Theo Vermaelen

INSEAD - Finance ( email )

Boulevard de Constance
F-77305 Fontainebleau Cedex
France
33 1 60 72 42 63 (Phone)
33 1 60 72 40 45 (Fax)

Christian C. P. Wolff (Contact Author)

University of Luxembourg - Luxembourg School of Finance ( email )

4, rue Albert Borschette
Luxembourg, 1246
Luxembourg

HOME PAGE: http://www.lsf.lu

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

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