Accounting-Finance Seminar

Bank stability and market discipline: The effect of contingent capital on risk taking and default probability

SPEAKER: Dr. Alon Raviv, Brandies & Bar Ilan Universities

05 במרץ 2013, 14:00

בניין רקנאטי ,חדר 408

This paper investigates the effects of financial institutions issuing contingent capital,
a debt security that automatically converts into equity if assets fall below a predeter-
mined threshold. We analyze a tractable form of contingent convertible bonds (coco)

and provide a closed-form solution for the price. We quantify the reduction in default

probability associated with contingent capital as compared to subordinated debt. We

then show that appropriate choice of contingent capital parameters (conversion ratio and

threshold) can virtually eliminate stockholdersincentives to risk-shift, a motivation that

is present when bank liabilities instead include either only equity or subordinated debt.

Importantly, risk-taking incentives continue to be weak during times of nancial dis-

tress. Our ndings imply that contingent capital may be an e¤ective tool for stabilizing

nancial institutions.