Convertible Bonds and Bank Risk-Taking

43 Pages Posted: 16 Nov 2012

See all articles by Natalya Martynova

Natalya Martynova

De Nederlandsche Bank - Research Department

Enrico C. Perotti

University of Amsterdam - Finance Group; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 3 versions of this paper

Date Written: September 15, 2012

Abstract

We study the effect of going-concern contingent capital on bank risk choice. The possibility of debt for equity conversion forces deleveraging in highly levered states, when risk incentives are worse. The additional equity reduces endogenous risk shifting by diluting returns in high states. An optimally designed trigger and convertible debt amount trades off this risk reduction against its debt dilution effect. Interestingly, contingent capital may be less risky in equilibrium than traditional debt, as its lower priority is compensated by reduced endogenous risk. Its effectiveness in risk reduction depends critically on the informativeness of the trigger. Adopting a noisy market trigger produces excess conversion (type II error), while an accounting trigger converts too infrequently (type I error) because of regulatory forbearance.

Keywords: Risk shifting, Financial Leverage, Contingent Capital

JEL Classification: G13, G21, G28

Suggested Citation

Martynova, Natalya and Perotti, Enrico C., Convertible Bonds and Bank Risk-Taking (September 15, 2012). Available at SSRN: https://ssrn.com/abstract=2176191 or http://dx.doi.org/10.2139/ssrn.2176191

Natalya Martynova (Contact Author)

De Nederlandsche Bank - Research Department ( email )

P.O. Box 98
1000 AB Amsterdam
Netherlands

Enrico C. Perotti

University of Amsterdam - Finance Group ( email )

Plantage Muidergracht 12
Amsterdam, 1018 TV
Netherlands
+31 20 525 4159 (Phone)
+31 20 525 5285 (Fax)

HOME PAGE: http://www.fee.uva.nl/fm/people/pero.htm

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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