Removing Moral Hazard and Agency Costs in Banks: Beyond CoCo Bonds

Birbeck Working Papers in Economics & Finance, BWPEF 1603

48 Pages Posted: 12 Apr 2016

See all articles by Kenjiro Hori

Kenjiro Hori

Birkbeck, University of London

Jorge Ceron

University of London - Birkbeck College

Date Written: February 12, 2016

Abstract

The convex payoffs for equity holders in a corporate structure results in agency costs and moral hazard problems. The implicit government guarantee for banks accentuates these. We believe that the Basel III related bail-in contingent convertible (CoCo) structures do only not solve these problems, but may even aggravate them. In this paper we suggest solutions. The first is to replace the currently issued write down/off and equity-conversion CoCo structures with a market-price equity-conversion CoCo bonds. This mirrors the full dilution effect of an ordinary equity raise in a distressed situation to reduce incentives for high risk-taking by equity holders. The second is to establish a Contingent Equity Base that replaces the incumbent shareholders once the CoCo is triggered. This will finally remove the perverse risk-taking incentives. The valuation of the CEB is then suggested.

Keywords: CoCo bond, agency costs, moral hazard, bail-in, cost of equity

JEL Classification: D82, G21, G28, G32

Suggested Citation

Hori, Kenjiro and Ceron, Jorge, Removing Moral Hazard and Agency Costs in Banks: Beyond CoCo Bonds (February 12, 2016). Birbeck Working Papers in Economics & Finance, BWPEF 1603, Available at SSRN: https://ssrn.com/abstract=2762374 or http://dx.doi.org/10.2139/ssrn.2762374

Kenjiro Hori (Contact Author)

Birkbeck, University of London ( email )

Malet Street
London, London WC1
United Kingdom

Jorge Ceron

University of London - Birkbeck College ( email )

Malet Street
London, WC1E 7HX
United Kingdom

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