What's the Contingency? A Proposal for Bank Contingent Capital Triggered by Systemic Risk

17 Pages Posted: 22 Jun 2014

See all articles by Linda Allen

Linda Allen

City University of New York, Baruch College - Zicklin School of Business - Department of Economics and Finance

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Date Written: June 20, 2014

Abstract

Contingent capital can automatically recapitalize the banking system during financial crises if the trigger mechanism is properly designed. We propose a dual trigger mechanism that is a function of: (1) aggregate systemic risk in the banking system, measured using CATFIN, and (2) individual bank contribution to overall risk in the banking system, measured using CoVaR. Contingent capital is modeled as a callable put option with the call option’s exercise price determined by the likelihood of systemic crisis (the difference between CATFIN and the early warning threshold forecasting macroeconomic declines) and the impact of individual bank distress on system stability (ΔCoVaR).

Keywords: contingent capital, callable put option, dual trigger exercise price, systemic risk

JEL Classification: G21, E58

Suggested Citation

Allen, Linda, What's the Contingency? A Proposal for Bank Contingent Capital Triggered by Systemic Risk (June 20, 2014). Available at SSRN: https://ssrn.com/abstract=2457187 or http://dx.doi.org/10.2139/ssrn.2457187

Linda Allen (Contact Author)

City University of New York, Baruch College - Zicklin School of Business - Department of Economics and Finance ( email )

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