Contingent Convertible Obligations and Financial Stability

Abstract

This paper investigates whether a financial system can be made more stable if financial institutions share risk by exchanging contingent convertible (CoCo) debt obligations. The question is framed in a financial network model of debt and equity interlinkages with the addition of a variant of the CoCo that converts continuously when a bank's equity-debt ratio drops to a trigger level. The main theoretical result is a complete characterization of the clearing problem for the interbank debt and equity at the maturity of the obligations. We then consider a simple setting in which introducing contingent convertible bonds improves financial stability, as well as specific networks for which contingent convertible bonds do not provide uniformly improved system performance. To return to the main question, we examine the EU financial network at the time of the 2011 EBA stress test to do comparative statics to study the implications of CoCo debt on financial stability. It is found that by replacing all unsecured interbank debt by standardized CoCo interbank debt securities, systemic risk in the EU will decrease and bank shareholder value will increase.

Contingent Capital with Stock Price Triggers in Interbank Networks

“…A number of very recent papers study network effects of CoCos with accounting-based triggers, building on the single-bank model of Glasserman and Nouri (2012) (rather than Glasserman and Nouri, 2016). Of these recent contributions, Feinstein and Hurd (2020) is closest in spirit to our paper, proving existence of equilibrium in a model with accountingbased triggers but allowing, e.g., for CoCos with different maturities. Gupta et al (2020) show both in simulations and empirically that CoCos are an effective instrument for mitigating systemic risk.…”