Convertible Bonds and Bank Risk-Taking

Abstract

We study how contingent capital that converts in equity ahead of default affects bank risk-shifting. Going concern conversion restores equity value in highly levered states, thus reducing heightened risk incentives. In contrast, conversion at default for traditional bail-inable debt has no effect on endogenous risk. The main beneficial effect comes from reduced leverage at conversion. In contrast to traditional convertible debt, equity dilution under going concern conversion has the opposite effect. The negative effect of dilution is tempered by any value transfer at conversion. We find that CoCo capital may be less risky than bail-inable debt when lower priority is compensated by lower endogenous risk, which is beneficial as a lower bond yield improves incentives. The risk reduction effect of CoCo debt depends critically on the informativeness of the trigger, but is always inferior to pure equity.

Keywords: Banks, Contingent Capital, Risk-shifting, Financial Leverage

JEL Classification: G13, G21, G28