Contingent Convertible Bonds and Capital Structure Decisions

Albul, Boris; Jaffee, Dwight M.; Tchistyi, Alexei

doi:10.2139/ssrn.2772612

Cited by 104 publications

(66 citation statements)

References 18 publications

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“…First proposed by Flannery (2002), the idea of contingent capital has since been advocated by several authors (Duffie (2010) and Squam Lake Working Group on Financial Regulation (2009)). Several papers derive valuation formulae for contingent capital instruments and discuss key design issues (Pennacchi, Vermaelen, and Wolff (2012), Glasserman and Nouri (2012a), Albul, Jaffee, and Tchistyi (2010), Sundaresan and Wang (2010), Posner (2010), Pennacchi (2011)). Sundaresan and Wang (2010) show that in cases in which conversion is triggered by market values falling below a certain threshold, CoCo bonds generally do not lead to a unique equilibrium for equity and CoCo bond prices.…”

Section: Model Of Default Second We Empirically Analyze the Incentimentioning

confidence: 99%

Does contingent capital induce excessive risk-taking?

Berg

Kaserer

2015

Journal of Financial Intermediation

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In this paper, we analyze the effect of the conversion price of CoCo bonds on equity holders' incentives. First, we use an option-pricing context to show that CoCo bonds can magnify equity holders' incentives to increase the riskiness of assets and decrease incentives to raise new equity in a crisis in cases in which conversion transfers wealth from CoCo bond holders to equity holders. Second, we present a clinical study of the CoCo bonds issued so far. We show that i) almost all existing CoCo bonds are designed in a way that implies a wealth transfer from CoCo bond holders to equity holders at conversion and ii) this contractual design is reflected in traded prices of CoCo bonds. In particular, CoCo bonds are short volatility with a magnitude five times greater than that which can be observed for straight bonds. These results are robust and economically significant. We conclude that the CoCo bonds issued so far can create perverse incentives for banks' equity holders.

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Section: Model Of Default Second We Empirically Analyze the Incentimentioning

confidence: 99%

Does contingent capital induce excessive risk-taking?

Berg

Kaserer

2015

Journal of Financial Intermediation

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“…Replacing debt with CoCos reduces the probability of default via the deleveraging which takes when the loss absorption mechanism is activated (Albul, Jaffee, and Tchistyi (2013), Pennacchi (2011), and McDonald (2013). But the risk shifting incentives induced by CoCos may result in upward pressure on probability of default (Koziol and Lawrenz (2012), Hilscher and Raviv (2014), Berg and Kaserer (2015), Chan and van Wijnbergen (2017), Goncharenko (2017)).…”

Section: Introductionmentioning

confidence: 99%

The Agency of CoCo: Why Do Banks Issue Contingent Convertible Bonds?

2017

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Why do banks issue contingent convertible debt? To answer this question we study comprehensive data covering all issues by publicly traded banks in Europe of contingent convertible bonds (CoCos) that count as additional tier 1 capital (AT1). We find that banks with lower asset volatility are more likely to issue AT1 CoCos than their riskier counterparts, but that CDS spreads do not react following issue announcements. Our estimates therefore suggest that agency costs play a crucial role in banks' ability to successfully issue CoCos. The agency costs may be higher for CoCos than for equity explaining why we observe riskier or lowly capitalized banks to issue equity rather than CoCos.JEL-Classification: G01, G12, G24

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“…Kaserer (2014); Chen et al (2013); Hilscher and Raviv (2014) use this framework to assess risk-shifting incentives and the probability of default, Albul et al (2013) use them to determine the impact on a bank's market value. Zeng (2014) takes it a step further by combining both risk decisions of the bank and the op-timal capital structure when CoCos are in the mix.…”

Section: Risk Shifting Incentives and Coco Designmentioning

confidence: 99%

Coco Design, Risk Shifting and Financial Fragility

Chan

Wijnbergen

2016

SSRN Journal

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Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may AbstractWe highlight the ex ante risk-shifting incentives faced by a bank's shareholders/managers when CoCos (contingent convertible capital) are part of the capital structure. The risk shifting incentive arises from the wealth transfers that the shareholders will receive upon the CoCo's conversion under CoCo designs widely used in practice. Specifically we show that for principal writedown and nondilutive equity-converting CoCos, shareholders/managers have an incentive to take on more risk to make conversion more likely because of those wealth transfers. As a consequence, wide spread use of CoCos will increase systemic fragility. We show that such improperly designed CoCos should not be allowed to fill in loss absorption capacity requirements unless accompanied by higher required equity ratios to mitigate the increased risk taking incentives they lead to. Sufficiently dilutive CoCos do not lead to undesired risk taking behavior.JEL classification: G01, G13, G21, G28, G32 Nontechnical SummaryCoCos are instruments that start out as debt and then either convert to equity or are written off upon the occurrence of a trigger event. This makes them very attractive to regulators as they avoid a costly bailout by providing loss absorption capacity. However, the design of CoCos may cause bank shareholders to choose actions now that necessitates the loss absorption capacity in the future. Prior to conversion, there is no discernible difference between CoCos and ordinary subordinated debt. However, after conversion, the payoffs to CoCo holders and shareholders are altered drastically, leading to potential wealth transfers from CoCo holders and shareholders. If the shareholders are better off after conversion, then they will choose actions that make conversion more likely. However, these actions have to be decided upon and implemented before anything else occurs. Therefore we examine the expected value of residual equity and determine which action maximizes it.In our setup, the action is a decision about the riskiness of the assets that the bank invests in. Our base case uses subordinated debt in the capital structure, and our analysis involves replacing the subordinated debt with the same amount of CoCos. The expected value of residual equity with CoCos can be expressed as the value of residual equity with subordinated debt, plus an expected wealth transfer. With this formulation, we can very easily say whether the CoCo indu...

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Contingent Convertible Bonds and Capital Structure Decisions

Cited by 104 publications

References 18 publications

Does contingent capital induce excessive risk-taking?

Does contingent capital induce excessive risk-taking?

The Agency of CoCo: Why Do Banks Issue Contingent Convertible Bonds?

Coco Design, Risk Shifting and Financial Fragility

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