CoCo Futures as a Macroprudential and Microprudential Policy Tool

Abstract

We investigate implications of banks using contingent-convertible (CoCo) futures contracts to hedge financial-sector risk. As a microprudential policy tool, the bail-in feature of CoCo futures allows value-maximizing banks to dramatically reduce default probabilities in spite of choosing significantly higher leverage ratios, while unintentionally generating aggregate bank default rates that are minuscule across all states of nature. As a macroprudential policy tool for reducing negative externalities associated with an underfunded banking system, futures contracts are superior to, and indeed supplant, other proposed policy tools because they allow for the costless transfer of bank capital from "normal" states of nature where its marginal benefit is low to "crisis" states where it is high, in turn eliminating both systemic risk and the need for bailouts.

Keywords: Bank, financial crises, risk management, bailout, too-big-to-fail

JEL Classification: G01, G21, G28, G32