Contingent Capital: The Case for COERCs

49 Pages Posted: 16 Mar 2011

See all articles by George Pennacchi

George Pennacchi

University of Illinois

Theo Vermaelen

INSEAD - Finance; European Corporate Governance Institute (ECGI)

Christian C. P. Wolff

University of Luxembourg; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 3 versions of this paper

Date Written: March 10, 2011

Abstract

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 to equity when the market value of equity or capital 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, large declines in value. Moreover, the structure eliminates concerns of an equity price “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. Furthermore, COERCs reduce the problem of “debt overhang,” the disincentive to replenish shareholders’ equity following a decline.

Keywords: Convertible bonds, bank capital, death spiral, debt overhang

JEL Classification: G20, G32

Suggested Citation

Pennacchi, George G. and Vermaelen, Theo and Wolff, Christian C. P., Contingent Capital: The Case for COERCs (March 10, 2011). Available at SSRN: https://ssrn.com/abstract=1785380 or http://dx.doi.org/10.2139/ssrn.1785380

George G. Pennacchi

University of Illinois ( email )

4041 BIF, Box 25
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HOME PAGE: http://https://giesbusiness.illinois.edu/profile/george-pennacchi

Theo Vermaelen

INSEAD - Finance ( email )

Boulevard de Constance
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France
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33 1 60 72 40 45 (Fax)

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
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1000 Brussels
Belgium

Christian C. P. Wolff (Contact Author)

University of Luxembourg ( email )

6, rue Richard Coudenhove-Kalergi
Kirchberg Campus
Luxembourg, South 1359
Luxembourg

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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