Addressing Systemic Risk Using Contingent Convertible Debt — A Network Analysis

Abstract

We construct a balance sheet based network model to study the interconnectedness of US banking system. After a simulation analysis of the buffer effect of contingent convertible (CoCo) debt in controlling contagion in the banking network under a theoretically motivated model, we use 13-F filings made to the US Securities and Exchange Commission (SEC) to calibrate the theoretical model. Our results demonstrate that CoCo debt conversion significantly reduces the average number of bank failures, decreases the Delta-CoVaR of the banking system, and thus, mitigates systemic risk. While CoCo debt with dual-trigger is not so efficient as a single trigger design in reducing individual bank failures, the former is more effective at protecting the surviving banks, which leads to improved stability from the perspective of the banking system. Two-tranche CoCo debt can combine the benefits of single trigger and dual trigger CoCo debt. We claim that the different designs of CoCo triggers result in trade-offs for addressing systemic risk, which may be evaluated in a network model developed in this work.