CoCo Design, Risk Shifting and Financial Fragility

Sweder van Wijnbergen and Stephanie Chan

No 11099, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: Contingent convertible capital (CoCo) is a debt instrument that converts to equity or is written off if the issuing bank fails to meet a distress threshold. The conversion increases the issuer's loss-absorption capacity, but results in wealth transfers between CoCo holders and shareholders, which may change risk-shifting incentives to shareholders. Higher risk increases the probability of CoCo conversion, while lowering the wealth transfer. We show that for Principal-Write-Down (PWD) CoCos, the net effect is to always increase risk-shifting incentives, while for equity-converting CoCos, it depends on the extent of dilution after conversion. We integrate the analysis in a game-theoretic optimal capital regulation framework and show that use of PWD or insufficiently dilutive CE CoCos requires higher capital requirements for given asset structure to offset the rising risk-shifting incentives these instruments give rise to.

Keywords: Capital requirements; Contingent convertible capital; Risk shifting incentives; Systemic risk (search for similar items in EconPapers)
JEL-codes: G01 G13 G21 G28 G32 (search for similar items in EconPapers)
Date: 2016-02
New Economics Papers: this item is included in nep-ban, nep-cfn and nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (8)

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