DP11099 CoCo Design, Risk Shifting and Financial Fragility
Author(s): | Stephanie Chan, Sweder van Wijnbergen |
Publication Date: | February 2016 |
Date Revised: | December 2017 |
Keyword(s): | capital requirements, contingent convertible capital, risk shifting incentives, systemic risk |
JEL(s): | G01, G13, G21, G28, G32 |
Programme Areas: | Financial Economics |
Link to this Page: | cepr.org/active/publications/discussion_papers/dp.php?dpno=11099 |
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.