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Title: CoCo Design, Risk Shifting and Financial Fragility

Author(s): Stephanie Chan and Sweder van Wijnbergen

Publication Date: February 2016

Keyword(s): capital requirements, contingent convertible capital, risk shifting incentives and systemic risk

Programme Area(s): Financial Economics

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.

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Bibliographic Reference

Chan, S and van Wijnbergen, S. 2016. 'CoCo Design, Risk Shifting and Financial Fragility'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=11099