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Bank Stability and Market Discipline: The Effect of Contingent Capital on Risk Taking and Default Probability

45 Pages Posted: 13 Aug 2004 Last revised: 26 Mar 2014

Jens Hilscher

University of California, Davis

Alon Raviv

Bar-Ilan University - Graduate School of Business Administration

Date Written: January 2, 2014

Abstract

This paper investigates the effects of financial institutions issuing contingent capital, a debt security that automatically converts into equity if assets fall below a predetermined threshold. We decompose bank liabilities into sets of barrier options and present closed-form solutions for their prices. We quantify the reduction in default probability associated with issuing contingent capital instead of subordinated debt. We then show that appropriate choice of contingent capital terms (in particular the conversion ratio) can virtually eliminate stockholders' incentives to risk-shift, a motivation that is present when bank liabilities instead include either subordinated debt or additional equity. Importantly, risk-taking incentives continue to be weak during times of financial distress. Our findings imply that contingent capital may be an effective tool for stabilizing financial institutions.

Keywords: contingent capital, executive compensation, risk taking, banking regulation, bank default probability, financial crisis

JEL Classification: G13, G21, G28, E58

Suggested Citation

Hilscher, Jens and Raviv, Alon, Bank Stability and Market Discipline: The Effect of Contingent Capital on Risk Taking and Default Probability (January 2, 2014). Available at SSRN: https://ssrn.com/abstract=575862 or http://dx.doi.org/10.2139/ssrn.575862

Jens Hilscher

University of California, Davis ( email )

One Shields Avenue
Davis, CA 95616
United States

Alon Raviv (Contact Author)

Bar-Ilan University - Graduate School of Business Administration ( email )

The Graduate School of Business Administration
Ana and Max Web st
Ramat Gan
Israel

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