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

Jens Hilscher and Alon Raviv

Journal of Corporate Finance, 2014, vol. 29, issue C, 542-560

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 (search for similar items in EconPapers)
JEL-codes: E58 G13 G21 G28 (search for similar items in EconPapers)
Date: 2014
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (80)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:corfin:v:29:y:2014:i:c:p:542-560

DOI: 10.1016/j.jcorpfin.2014.03.009

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