Working Paper: CEPR ID: DP13344
Authors: Roman Goncharenko; Steven Ongena; Asad Rauf
Abstract: Most regulators grant contingent convertible bonds (CoCos) the status of equity. The theory, however, suggests that these securities can distort incentives via inducing debt overhang and risk shifting. In this paper, we therefore theoretically model how the degree of this distortion varies with bank risk. Our model predicts that riskier banks face higher debt overhang from CoCos. Next, analyzing a comprehensive database of CoCo issuance in Europe, we empirically test the predictions of our model. We find that banks with lower risk are more likely to issue CoCos than their riskier counterparts. Since in the current regulatory framework of Basel III banks are expected to raise equity prior to CoCo conversion, future debt overhang makes CoCos an expensive source of capital. Thus, riskier banks will opt for equity issuance over CoCos.
Keywords: CoCos; Contingent Convertible Bonds; Bank Capital Structure; Debt Overhang; Basel III
JEL Codes: G01
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| riskier banks (G21) | lower likelihood of issuing CoCos (G33) |
| increase in asset volatility (G19) | lower likelihood of issuing CoCos (G33) |
| riskier banks (G21) | higher debt overhang from CoCos (F65) |
| higher debt overhang from CoCos (F65) | discouragement of riskier banks to issue CoCos (G33) |