Bank stability and market discipline: The effect of contingent capital on risk taking and default probability

Jens Hilscher and Alon Raviv

No 53, Working Papers from Brandeis University, Department of Economics and International Business School

Abstract: This paper investigates the e¤ects of ?nancial 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 op- tions and present closed-form solutions for their prices. We quantify the reduction in default probability associated with issuing contingent capital instead of subor- dinated 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 ei- ther subordinated debt or additional equity. Importantly, risk-taking incentives continue to be weak during times of ?nancial distress. Our ?ndings imply that contingent capital may be an e¤ective tool for stabilizing ?nancial institutions.

Keywords: contingent capital; executive compensation; risk taking; banking regulation; bank default probability; ?financial crisis (search for similar items in EconPapers)
JEL-codes: E58 G13 G21 G28 (search for similar items in EconPapers)
Pages: 51 pages
Date: 2012-09, Revised 2014-01
New Economics Papers: this item is included in nep-ban and nep-cba
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (81)

Downloads: (external link)
http://www.brandeis.edu/economics/RePEc/brd/doc/Brandeis_WP53R.pdf Revised version, 2014 (application/pdf)
http://www.brandeis.edu/economics/RePEc/brd/doc/Brandeis_WP53.pdf First version, 2012 (application/pdf)

Related works:
Journal Article: Bank stability and market discipline: The effect of contingent capital on risk taking and default probability (2014)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:brd:wpaper:53

Access Statistics for this paper

More papers in Working Papers from Brandeis University, Department of Economics and International Business School Contact information at EDIRC.
Bibliographic data for series maintained by Andrea Luna ().