Coco Design, Risk Shifting and Financial Fragility

44 Pages Posted: 17 Feb 2016 Last revised: 11 Dec 2017

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)

Multiple version iconThere are 2 versions of this paper

Date Written: February 2016

Abstract

Contingent convertible capital (CoCo) is a debt instrument that converts to equity or is written off if the issuing bank fails to meet a distress threshold. The conversion increases the issuer's loss-absorption capacity, but results in wealth transfers between CoCo holders and shareholders, which may change risk-shifting incentives to shareholders. Higher risk increases the probability of CoCo conversion, while lowering the wealth transfer. We show that for Principal-Write-Down (PWD) CoCos, the net effect is to always increase risk-shifting incentives, while for equity-converting CoCos, it depends on the extent of dilution after conversion. We integrate the analysis in a game-theoretic optimal capital regulation framework and show that use of PWD or insufficiently dilutive CE CoCos requires higher capital requirements for given asset structure to offset the rising risk-shifting incentives these instruments give rise to.

Keywords: capital requirements, contingent convertible capital, risk shifting incentives, systemic risk

JEL Classification: G01, G13, G21, G28, G32

Suggested Citation

Chan, Stephanie and van Wijnbergen, Sweder, Coco Design, Risk Shifting and Financial Fragility (February 2016). CEPR Discussion Paper No. DP11099. Available at SSRN: https://ssrn.com/abstract=2733072

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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