Cocos, Contagion and Systemic Risk

45 Pages Posted: 1 Dec 2015

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: November 2015

Abstract

Cocos (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. Cocos 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 cocos, providing a possible explanation of regulatory forbearance.

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

JEL Classification: G01, G21, G32

Suggested Citation

Chan, Stephanie and van Wijnbergen, Sweder, Cocos, Contagion and Systemic Risk (November 2015). CEPR Discussion Paper No. DP10960. Available at SSRN: https://ssrn.com/abstract=2697593

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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