Abstract
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.
Original language | English |
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Pages (from-to) | 542-560 |
Number of pages | 19 |
Journal | Journal of Corporate Finance |
Volume | 29 |
DOIs | |
State | Published - 1 Dec 2014 |
Bibliographical note
Publisher Copyright:© 2014 Elsevier B.V.
Keywords
- Bank default probability
- Banking regulation
- Contingent capital
- Executive compensation
- Financial crisis
- Risk taking