Coco Design, Risk Shifting and Financial Fragility

Abstract

Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may AbstractWe highlight the ex ante risk-shifting incentives faced by a bank's shareholders/managers when CoCos (contingent convertible capital) are part of the capital structure. The risk shifting incentive arises from the wealth transfers that the shareholders will receive upon the CoCo's conversion under CoCo designs widely used in practice. Specifically we show that for principal writedown and nondilutive equity-converting CoCos, shareholders/managers have an incentive to take on more risk to make conversion more likely because of those wealth transfers. As a consequence, wide spread use of CoCos will increase systemic fragility. We show that such improperly designed CoCos should not be allowed to fill in loss absorption capacity requirements unless accompanied by higher required equity ratios to mitigate the increased risk taking incentives they lead to. Sufficiently dilutive CoCos do not lead to undesired risk taking behavior.JEL classification: G01, G13, G21, G28, G32 Nontechnical SummaryCoCos are instruments that start out as debt and then either convert to equity or are written off upon the occurrence of a trigger event. This makes them very attractive to regulators as they avoid a costly bailout by providing loss absorption capacity. However, the design of CoCos may cause bank shareholders to choose actions now that necessitates the loss absorption capacity in the future. Prior to conversion, there is no discernible difference between CoCos and ordinary subordinated debt. However, after conversion, the payoffs to CoCo holders and shareholders are altered drastically, leading to potential wealth transfers from CoCo holders and shareholders. If the shareholders are better off after conversion, then they will choose actions that make conversion more likely. However, these actions have to be decided upon and implemented before anything else occurs. Therefore we examine the expected value of residual equity and determine which action maximizes it.In our setup, the action is a decision about the riskiness of the assets that the bank invests in. Our base case uses subordinated debt in the capital structure, and our analysis involves replacing the subordinated debt with the same amount of CoCos. The expected value of residual equity with CoCos can be expressed as the value of residual equity with subordinated debt, plus an expected wealth transfer. With this formulation, we can very easily say whether the CoCo indu...

The Agency of CoCo: Why Do Banks Issue Contingent Convertible Bonds?

“…But the risk shifting incentives induced by CoCos may result in upward pressure on probability of default (Koziol and Lawrenz (2012), Hilscher and Raviv (2014), Berg and Kaserer (2015), Chan and van Wijnbergen (2017), Goncharenko (2017)). …”

Accounting Noise and the Pricing of Cocos

“…The lines for different leverage converge to the same point on the vertical axis as ∆ → 0; for a PWD CoCo, leverage has no impact on the price since both the CoCo and equity are junior to debt. This result does depend on the assumption that the variance of the asset value process is exogenously chosen; if it would be endogenously chosen, higher leverage would lead to more risk taking and a higher variance, which would have an impact on the value of the CoCo even if it has a PWD structure (this point is made in Chan and van Wijnbergen (2016;revised November 2017)). 6.4 Capital structure, CoCos and Risk Taking Incentives…”

Contingent Convertible Bonds with Floating Coupon Payments: Fixing the Equilibrium Problem

“…Despite this, 60 percent of the recently issued CoCos is of the principal write down (PWD) type, where instead of being converted to equity, CoCos are written down with a pre-defined percentage. In Chan and van Wijnbergen (2015) and Chan and van Wijnbergen (2016) it is argued that this feature is highly undesirable, as it could increase the systemic risk and give equity holders an incentive to increase the risk taken instead of decreasing it. Despite this, the opposite effect can occur as well, as described in Martinova and Perotti (2015), where it is shown that under certain assumptions the risk-taking incentive is higher with CE as compared to PWD Cocos.…”

“…This design resolves the multiple equilibria or no equilibrium problem, from now on referred to as the multiple equilibria problem (see Sundaresan and Wang (2015)). This design could, furthermore, reduce the potential increasing risk-taking incentives addressed in Berg and Kaserer (2015) and Chan and van Wijnbergen (2016) and the problems with pricing Co-Cos due to the hybrid structure as in Wilkens and Bethke (2014). The lack of a unique equilibrium price for the CoCos and equity could cause high volatility in these prices and lead to discomfort among investors.…”