Cocos, Contagion and Systemic Risk

Tinbergen Institute Discussion Paper 14-110/VI/DSF 79

55 Pages Posted: 22 Aug 2014 Last revised: 7 Oct 2014

See all articles by Stephanie Chan

Stephanie Chan

Xiamen University; University of Amsterdam - Faculty of Economics and Business (FEB); Tinbergen Institute

Sweder van Wijnbergen

Universiteit van Amsterdam; Tinbergen Institute; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Date Written: September 30, 2014

Abstract

CoCo’s (contingent convertible capital) are designed to convert from debt to equity when banks need it most. Using a Diamond-Dybvig model cast in a global games framework, we show that while the CoCo conversion of the issuing bank may bring the bank back into compliance with capital requirements, it will nevertheless raise the probability of the bank being run, because conversion is a negative signal to depositors about asset quality. Moreover, conversion imposes a negative externality on other banks in the system in the likely case of correlated asset returns, so bank runs elsewhere in the banking system become more probable too and systemic risk will actually go up after conversion. CoCo’s thus lead to a direct conflict between micro- and macroprudential objectives. We also highlight that ex ante incentives to raise capital to stave off conversion depend critically on CoCo design. In many currently popular CoCo designs, wealth transfers after conversion actually flow from debt holders to equity holders, destroying the latter’s incentives to provide additional capital in times of stress. Finally the link between CoCo conversion and systemic risk highlights the tradeoffs that a regulator faces in deciding to convert CoCo’s, providing a possible explanation of regulatory forbearance.

Keywords: Contingent Convertible Capital, Contagion, Systemic Risk, Bank Runs, Global Games

JEL Classification: G01, G21, G32

Suggested Citation

Chan, Stephanie and van Wijnbergen, Sweder, Cocos, Contagion and Systemic Risk (September 30, 2014). Tinbergen Institute Discussion Paper 14-110/VI/DSF 79. Available at SSRN: https://ssrn.com/abstract=2484449 or http://dx.doi.org/10.2139/ssrn.2484449

Stephanie Chan (Contact Author)

Xiamen University ( email )

Xiamen, Fujian 361005
China

University of Amsterdam - Faculty of Economics and Business (FEB) ( email )

Roetersstraat 11
Amsterdam, 1018 WB
Netherlands

Tinbergen Institute ( email )

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

Sweder Van Wijnbergen

Universiteit van Amsterdam ( email )

Roetersstraat 11
Amsterdam, 1018 WB
Netherlands
+31 20 525 4011 / 4203 (Phone)
+31-35-624 91 82 (Fax)

Tinbergen Institute

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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