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
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: Suggested Citation