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 School of Business and Economics

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 (87)

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Related works:
Journal Article: Bank stability and market discipline: The effect of contingent capital on risk taking and default probability (2014)
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