Abstract
The convex payoffs for equityholders in a corporate structure results in agency costs and moral hazard problems. The implicit government guarantee for banks accentuates these. We believe that the Basel III related bail-in contingent convertible (CoCo) structures do only not solve these problems, but may even aggravate them. In this paper we suggest solutions. The first is to replace the currently issued writedown/off and equity-conversion CoCo structures with a market-price equity-conversion CoCo bonds. This mirrors the full dilution effect of an ordinary equity raise in a distressed situation to reduce incentives for high risk-taking by equityholders. The second is to establish a Contingent Equity Base that replaces the incumbent shareholders once the CoCo is triggered. This will finally remove the perverse risk-taking incentives. The valuation of the CEB is then suggested.
Highlights
When a bank’s solvency is deteriorating the bank usually has three options: issue equity, hoard capital by suspending dividends and share repurchase, or delever
With the recognition of the systemic risk of the sector the new regulations resort to the deviation from absolute priority rule (DAPR) to impose losses on bondholders
As shown in Hori and Martin Cerón (2014), the Deviation from the Absolute Priority Rule (DAPR) leads to agency costs of wealth transfer and value destruction, giving rise to perverse incentives for equityholders that will seek to exploit them
Summary
When a bank’s solvency is deteriorating the bank usually has three options: issue equity, hoard capital by suspending dividends and share repurchase, or delever (decrease assets). Hori and Martin Cerón (2014) investigated the pay-off profiles of CoCo structures in detail, and established that the bailin structures are equivalent to a “CoCo condor” structure written by the bondholders and held by the equityholders, i.e. an additional sale of options by the former to the latter They concluded that the Basel III proposal aggravates the agency costs as a result. Prescott (2011) proposes a dual trigger mechanism which depends on the aggregate systemic risk in the banking sector Both Berg and Kaserer (2011) and Himmelberg and Tsyplakov (2011) model triggers based on the asset value and investigate different designs (mainly of conversion ratios) of CoCo bonds.
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