Optimal Capital Structure and Risk Management Policies of Banks That Use CoCo Futures to Hedge Financial-Sector Risk*

Robert S Goldstein and Fan Yang

Review of Finance, 2024, vol. 28, issue 1, 235-270

Abstract: We investigate the joint optimal risk management and capital structure decisions of banks when they use contingent-convertible (CoCo) futures contracts to hedge financial-sector risk. In spite of banks choosing significantly higher leverage ratios, their default probabilities drop appreciably while their equity values increase, allowing banks to compete more favorably with the shadow-banking system. Banks’ value-maximizing decision to hedge financial-sector risk unintentionally leads to an economy with extremely low aggregate bank default rates across all future states of nature. Thus, CoCo futures offer a powerful microprudential and macroprudential policy tool. That banks choose not to hedge financial-sector risk in practice is consistent with managers internalizing bank bailouts.

Keywords: Bank; Financial crises; Risk management; Bailout; Too-big-to-fail (search for similar items in EconPapers)
JEL-codes: G2 G21 G28 G32 (search for similar items in EconPapers)
Date: 2024
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