Countercyclical Contingent Capital

Abstract

We analyze the optimal capital structure of a bank issuing countercyclical contingent capital, i.e., notes to be converted in common shares in case of a bad state for the economy. This type of asset reduces the spread of straight debt but is quite expensive. The effect on bankruptcy costs is limited (it is strong when contingent capital is not countercyclical), the asset reduces the asset substitution incentive. Contingent capital is useful for macroprudential regulation, the countercyclical feature is important depending on priorities (moderate the asset substitution incentive or reduce bankruptcy costs).