What's the Contingency? A Proposal for Bank Contingent Capital Triggered by Systemic Risk
43 Pages Posted: 11 Nov 2015 Last revised: 26 May 2016
Date Written: May 2016
Contingent capital (coco) automatically recapitalizes the banking system during financial crises if the trigger mechanism is properly designed. We propose a dual trigger mechanism based on: (1) aggregate systemic risk in the banking system, measured using CATFIN, and (2) the individual bank’s contribution to overall systemic risk, measured using delta CoVaR. The dual trigger is highly correlated with system-wide insolvency risk and prices systemic risk. We set different triggers for banks, insurance companies and broker-dealers. Using the 99% cut-off, systemic coco issued by Lehman and Bear Stearns would have been triggered in November 2007, months prior to their actual demise.
Keywords: contingent capital, callable put option, dual trigger exercise price, systemic risk
JEL Classification: G21, E58
Suggested Citation: Suggested Citation