The Implications of Reverse Convertible Bonds for Bank Runs and Risk Shifting

Abstract

We describe a new type of bank liability, reverse convertible bonds, that help prevent bank runs that lead to bank failures (ex-post), and inefficient risk-taking (ex-ante). These bonds are short-term debt that automatically convert into equity following a missed debt repayment. They can be designed to eliminate strategic complementarities among bank creditors that give rise to bank runs, thus allowing a bank to fully play its maturity transformation role and avoid bankruptcy. Since bank shareholders are then residual claimants in all states of the world, they do not engage in risk shifting. We discuss similarities and differences with contingent capital.

Keywords: banking regulation, contingent capital, financial regulation, financial stability, reverse convertible bonds

JEL Classification: G21, G28