DP13344 The Agency of CoCos: Why Contingent Convertible Bonds Aren't for Everyone

Author(s): Roman Goncharenko, Steven Ongena, Asad Rauf
Publication Date: November 2018
Keyword(s): Bank Capital Structure, Basel III, CoCos, Contingent Convertible Bonds, Debt overhang
JEL(s): G01
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13344

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.