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

• Published in: Journal of corporate finance (Amsterdam, Netherlands) Vol. 29; pp. 542 - 560
• Main Authors: Hilscher, Jens, Raviv, Alon
• Format: Journal Article
• Language: English
• Published: Amsterdam Elsevier B.V 01.12.2014; Elsevier Science Ltd
• Subjects: Bank default probability; Bank liabilities; Banking regulation; Bond issues; Contingent capital; Default; Executive compensation; Financial crisis; Financial institutions; Risk management; Risk taking; Stockholders; Studies; Bank default probability; G21; G13; E58; Contingent capital; Executive compensation; Risk taking; Banking regulation; G28; Financial crisis
• ISSN: 0929-1199; 1872-6313
• DOI: 10.1016/j.jcorpfin.2014.03.009

This paper investigates the effects of financial institutions issuing contingent capital, a debt security that automatically converts into equity if assets fall below a predetermined threshold. We decompose bank liabilities into sets of barrier options and present closed-form solutions for their prices. We quantify the reduction in default probability associated with issuing contingent capital instead of subordinated debt. We then show that appropriate choice of contingent capital terms (in particular the conversion ratio) can virtually eliminate stockholders' incentives to risk-shift, a motivation that is present when bank liabilities instead include either subordinated debt or additional equity. Importantly, risk-taking incentives continue to be weak during times of financial distress. Our findings imply that contingent capital may be an effective tool for stabilizing financial institutions. •We show that banks may be stabilized by issuing contingent convertible bonds.•We provide a closed-form solution for the contingent capital price.•Issuing contingent capital lowers banks' default probabilities.•Contingent capital design has important effects on risk-taking incentives.•Well-designed contingent capital can virtually eliminate motivation to change risk.