Fixed Prices and Regulatory Discretion as Triggers for Contingent Capital Conversion: An Experimental Examination

Abstract

An unresolved issue regarding the implementation of 'contingent capital' bonds regards identifying the best mechanism for triggering the conversion of debt into equity. This paper reports a laboratory experiment that builds on previous work to evaluate the relative desirability of two leading candidate mechanisms: a price informed regulator and a mechanistic fixed-price trigger. We find that the conversion rule in effect determines the desirability of these two mechanisms. When the conversion increases incumbent equity value, a fixed trigger is preferable, but when the conversion decreases value, the reverse holds. Two modifications for improving the regulator mechanism, creating regulator bias (e.g., giving a regulator asymmetric rewards over intervention) and probabilistically providing a regulator with non-market information, only enhance this result.

JEL Classification: C92, G14, G28