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
Date Written: January 2, 2014
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: Suggested Citation