CoCo Design, Risk Shifting Incentives and Capital Regulation

Tinbergen Institute Discussion Paper 16-007/VI

43 Pages Posted: 2 Feb 2016 Last revised: 9 Dec 2017

See all articles by Stephanie Chan

Stephanie Chan

De La Salle University - School of Economics

Sweder van Wijnbergen

Universiteit van Amsterdam; Tinbergen Institute; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: November 13, 2017

Abstract

Contingent convertible capital (CoCo) is a debt instrument that converts to equity or is written off if the issuing bank fails to meet a distress threshold. The conversion increases the issuer's loss-absorption capacity, but results in wealth transfers between CoCo holders and shareholders, which may change risk-shifting incentives to shareholders. Higher risk increases the probability of CoCo conversion, while lowering the wealth transfer. We show that for Principal-Write-Down (PWD) CoCos, the net effect is to always increase risk-shifting incentives, while for equity-converting CoCos, it depends on the extent of dilution after conversion. We integrate the analysis in a game-theoretic optimal capital regulation framework and show that use of PWD or insuffciently dilutive CE CoCos requires higher capital requirements for given asset structure to offset the rising risk-shifting incentives these instruments give rise to.

Keywords: Contingent Convertible Capital, Systemic Risk, Risk Shifting Incentives, Capital Requirements

JEL Classification: G01, G13, G21, G28, G32

Suggested Citation

Chan, Stephanie and van Wijnbergen, Sweder, CoCo Design, Risk Shifting Incentives and Capital Regulation (November 13, 2017). Tinbergen Institute Discussion Paper 16-007/VI, Available at SSRN: https://ssrn.com/abstract=2725980 or http://dx.doi.org/10.2139/ssrn.2725980

Stephanie Chan (Contact Author)

De La Salle University - School of Economics ( email )

2401 Taft Avenue
Manila, Metro Manila 1004
Philippines

Sweder Van Wijnbergen

Universiteit van Amsterdam ( email )

Roetersstraat 11
Amsterdam, 1018 WB
Netherlands
+31 20 525 4011 / 4203 (Phone)
+31-35-624 91 82 (Fax)

Tinbergen Institute

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
217
Abstract Views
1,341
Rank
252,827
PlumX Metrics