Risk-taking and Uncertainty: Do Contingent Convertible (CoCo) Bonds Increase the Risk Appetite of Banks?

Abstract

We assess the impact of contingent convertible (CoCo) bonds and the wealth transfers they imply conditional on conversion on the risk-taking behaviour of the issuing bank. We also test for regulatory arbitrage: do banks try to maintain risk-taking incentives by issuing CoCo bonds, when regulators reduce them through higher capitalisation ratios? While we test for, and reject sample selection bias, we show that CoCo bonds issuance has a strong positive effect on risk-taking behaviour, and so do conversion parameters that reduce dilution of existing shareholders upon conversion. Higher economic volatility amplifies the impact of CoCo bonds on risk-taking.

Keywords: Contingent convertible bonds, risk-taking, bank capital structure, selection bias

JEL Classification: G01, G11, G21, G32