Working Paper: CEPR ID: DP11099
Authors: Stephanie Chan; Sweder van Wijnbergen
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
JEL Codes: G01; G13; G21; G28; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| CoCo design (PWD) (O36) | risk-shifting incentives (D82) |
| higher risk (D81) | probability of CoCo conversion (C10) |
| higher risk (D81) | wealth transfer (H87) |
| CoCo design (CE) (O36) | risk-shifting incentives (D82) |
| dilution after conversion (significant) (Y10) | risk-shifting incentives (D82) |
| CoCos (C10) | capital requirements (G32) |
| CoCo design (O36) | risk-taking behavior (D91) |
| risk-taking behavior (D91) | capital requirements (G32) |