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

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