Shareholder Risk-Taking Incentives in the Presence of Contingent Capital

Abstract

This paper presents a model of shareholders’ willingness to exert effort to reduce the likelihood of bank distress, and the implications of the presence of contingent convertible (CoCo) bonds in the liabilities structure of a bank. Consistent with the existing literature, we show that the direction of the wealth transfer at the conversion of CoCo bonds determines their impact on shareholder risk-taking incentives. We also find that ‘anytime’ CoCos (CoCo bonds trigger-able anytime at the discretion of managers) have a minor advantage over regulator CoCo bonds, and that quality of capital requirements can reduce the risk-taking incentives of shareholders. We argue that shareholders can also use manager-specific CoCo bonds to reduce the riskiness of the bank activities. The issuance of such bonds can increase the resilience of individual banks and the whole banking system. Regulators can use restrictions on conversion rates and/or requirements on the quality of capital to address the impact of CoCo bonds issuance on risk-taking incentives.