No Pain, No Gain? Effecting Market Discipline Via 'Reverse Convertible Debentures'

32 Pages Posted: 26 Feb 2003

See all articles by Mark J. Flannery

Mark J. Flannery

University of Florida - Department of Finance, Insurance and Real Estate

Date Written: November 2002

Abstract

The deadweight costs of financial distress limit many firms' incentive to include a lot of (tax-advantaged) debt in their capital structures. It is therefore puzzling that firms do not make advance arrangements to re-capitalize themselves if large losses occur. Financial distress may be particularly important for large banking firms, which national supervisors are reluctant to let fail. The supervisors' inclination to support large financial firms when they become troubled mitigates the ex ante incentives of market investors to discipline these firms. This paper proposes a new financial instrument that forestalls financial distress without distorting bank shareholders' risk-taking incentives. "Reverse convertible debentures" (RCD) would automatically convert to common equity if a bank's market capital ratio falls below some stated value. RCD provide a transparent mechanism for un-levering a firm if the need arises. Unlike conventional convertible bonds, RCD convert at the stock's current market price, which forces shareholders to bear the full cost of their risk-taking decisions. Surprisingly, RCD investors are exposed to very limited credit risk under plausible conditions.

Suggested Citation

Flannery, Mark Jeffrey, No Pain, No Gain? Effecting Market Discipline Via 'Reverse Convertible Debentures' (November 2002). Available at SSRN: https://ssrn.com/abstract=352762 or http://dx.doi.org/10.2139/ssrn.352762

Mark Jeffrey Flannery (Contact Author)

University of Florida - Department of Finance, Insurance and Real Estate ( email )

P.O. Box 117168
Gainesville, FL 32611
United States
352-392-3184 (Phone)
352-392-0103 (Fax)

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