DP8028 Contingent Capital: The Case for COERCs

Author(s): George G. Pennacchi, Theo Vermaelen, Christian C Wolff
Publication Date: September 2010
Keyword(s): Banks, Financial crisis, Financial stability, Security design
JEL(s): G01, G20
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8028

In this paper we propose a new security, the Call Option Enhanced Reverse Convertible (COERC). The security is a form of contingent capital, i.e. a bond that converts into equity when the market value of equity relative to debt falls below a certain trigger. The conversion price is set significantly below the trigger price and, at the same time, equity holders have the option to buy back the shares from the bondholders at the conversion price. Compared to other forms of contingent capital proposed in the literature, the COERC is less risky in a world where bank assets can experience sudden jumps. Moreover, the structure eliminates concerns about putting the company in a ?death spiral? as a result of manipulation or panic. A bank that issues COERCs also has a smaller incentive to choose investments that are subject to large losses.