Citation

Discussion Paper Details

Please find the details for DP10960 in an easy to copy and paste format below:

Full Details   |   Bibliographic Reference

Full Details

Title: Cocos, Contagion and Systemic Risk

Author(s): Stephanie Chan and Sweder van Wijnbergen

Publication Date: November 2015

Keyword(s): Bank Runs, Contagion, Contingent Convertible Capital, Global games and Systemic Risk

Programme Area(s): Financial Economics

Abstract: Abstract Cocos (contingent convertible capital) are designed to convert from debt to equity when banks need it most. Using a Diamond-Dybvig model cast in a global games framework, we show that while the coco conversion of the issuing bank may bring the bank back into compliance with capital requirements, it will nevertheless raise the probability of the bank being run, because conversion is a negative signal to depositors about asset quality. Moreover, conversion imposes a negative externality on other banks in the system in the likely case of correlated asset returns, so bank runs elsewhere in the banking system become more probable too and systemic risk will actually go up after conversion. Cocos thus lead to a direct conflict between micro- and macroprudential objectives. We also highlight that ex ante incentives to raise capital to stave off conversion depend critically on coco design. In many currently popular coco designs, wealth transfers after conversion actually flow from debt holders to equity holders, destroying the latter's incentives to provide additional capital in times of stress. Finally the link between coco conversion and systemic risk highlights the tradeoffs that a regulator faces in deciding to convert cocos, providing a possible explanation of regulatory forbearance.

For full details and related downloads, please visit: https://cepr.org/active/publications/discussion_papers/dp.php?dpno=10960

Bibliographic Reference

Chan, S and van Wijnbergen, S. 2015. 'Cocos, Contagion and Systemic Risk'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=10960