Optimal Design of Contingent Capital

Lionel Melin () and Ahyan Panjwani
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Lionel Melin: https://www.edhec.edu/en/research-and-faculty/faculty/professors-and-researchers/lionel-melin
Ahyan Panjwani: https://www.federalreserve.gov/econres/ahyan-panjwani.htm

No 2024-051, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

Abstract: This paper proposes a parsimonious framework for designing contingent capital contracts (CoCos). CoCos designed this way (i) are either optimal or incentive compatible for equity holders, (ii) implement a unique equilibrium, and (iii) result in an optimal capital structure for the firm. We consider CoCos with equity conversion and write-down modalities. Equity conversion CoCos are optimal; write-down CoCos are incentive-compatible. Both types of CoCos can be implemented by exogenously specifying a capital ratio rule that triggers conversion and, hence, qualify as additional tier 1 (AT1) capital. A policymaker can use a normative criterion, e.g., capital ratio after conversion, to determine the desired capital ratio rule ex-ante. Given the policymaker's choice of the capital ratio rule, our model pins down the CoCo that respects (i), (ii), and (iii). We show that including such a CoCo in the firm's capital structure increases its optimal levered value while making it more resilient to bankruptcy. Lastly, CoCos in this framework are time-consistent. This characteristic alleviates the risk of renegotiation by stakeholders and removes the uncertainty of a discretionary trigger: precisely what spooked markets during the run on Credit Suisse in March 2023.

Keywords: Contingent convertible debt; Bail-in debt; Capital structure; Capital requirements; Bank regulation; Bank capital (search for similar items in EconPapers)
JEL-codes: G12 G13 G23 G32 (search for similar items in EconPapers)
Pages: 44 p.
Date: 2024-07-11
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedgfe:2024-51

DOI: 10.17016/FEDS.2024.051

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