 Contingent convertibles. Solving or seeding the next banking crisis?Christian Koziol and Jochen Lawrenz Journal of Banking & Finance, 2012, vol. 36, issue 1, 90-104 Abstract: A recent proposal to enhance banking stability recommends the use of contingent convertibles (CoCos). Since these hybrid securities are mandatorily converted into equity when banks are in need of a recapitalization, they are credited for reducing banks’ likelihood of financial distress. In this paper, we show within a continuous-time framework that this allegedly beneficial impact hinges critically on the assumption of complete contracts. If contracts are incomplete in the sense that manager–owners enjoy discretion over the risk of the investment program, our analysis shows that CoCo bonds always distort risk taking incentives. Our main contribution is to demonstrate that there exist conditions under which CoCo bond financing increases investors’ wealth, but also increases the bank’s probability of financial distress, so that the banking system as a whole will be destabilized. Thus, individually rational decisions can have systemically undesirable outcomes. Further results indicate that CoCos should be used only in conjunction with devices to control risk shifting incentives. Keywords: Contingent capital certificates; Reverse convertibles; Restructuring mechanisms; Regulatory hybrid security (search for similar items in EconPapers) Downloads: (external link) Related works: Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text Persistent link: https://EconPapers.repec.org/RePEc:eee:jbfina:v:36:y:2012:i:1:p:90-104 DOI: 10.1016/j.jbankfin.2011.06.009 Access Statistics for this article Journal of Banking & Finance is currently edited by Ike Mathur More articles in Journal of Banking & Finance from Elsevier |
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