Optimal Volatility, Covenants and Cost of Capital Under Basel III Bail-in

Kenjiro Hori and Jorge Martin Ceron
Additional contact information
Jorge Martin Ceron: Department of Economics, Mathematics & Statistics, Birkbeck

No 1502, Birkbeck Working Papers in Economics and Finance from Birkbeck, Department of Economics, Mathematics & Statistics

Abstract: This paper investigates three consequences of the new financial regulation: the agency costs, the monitoring costs and the effect on banksÂ’ cost of capital. For the first, the shareholdersÂ’ behaviour is analysed as a trade-off between the value of the bank and its volatility by using an indifference curve model of the bankÂ’s choice of optimal risk. While the first-best optimal risk maximises the value of the bank, the shareholders select suboptimally high risks under bail-in structures. This leads to both the wealth transfer and the value destruction agency costs. For the second, as a result of these consequences of the DAPR (Deviation from the Absolute Priority Rule) the bondholders are forced to closely monitor the bank behaviour. Requiring higher rate of return for higher risk, reflecting the costs of monitoring, is shown to alleviate the agency problems. Different types of covenants are proposed as an efficient way of implementing this solution. For the third, the impact of the new bail-in structure and the monitoring costs on the WACC of 16 largest European banks is estimated, and is shown to increase the cost of capital by between 75% and 110%.

Keywords: Indifference curves; CoCo; Bail-in; Covenants; WACC. (search for similar items in EconPapers)
JEL-codes: D82 G21 G28 G32 (search for similar items in EconPapers)
Date: 2015-03
New Economics Papers: this item is included in nep-ban and nep-cba
References: Add references at CitEc
Citations: View citations in EconPapers (1)

Downloads: (external link)
https://eprints.bbk.ac.uk/id/eprint/15277 First version, 2015 (application/pdf)

Related works:
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:bbk:bbkefp:1502

Ordering information: This working paper can be ordered from

Access Statistics for this paper

More papers in Birkbeck Working Papers in Economics and Finance from Birkbeck, Department of Economics, Mathematics & Statistics Malet Street, London WC1E 7HX, UK.
Bibliographic data for series maintained by ( this e-mail address is bad, please contact ).