Shareholder risk-taking incentives in the presence of contingent capital

Abstract

PurposeThis paper aims to present 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.Design/methodology/approachThis study presents a basic model about the moral hazard surrounding shareholders willingness to exert effort that increases the likelihood of a bank’s success. This study uses a one-shot game and so do not capture the effects of repeated interactions.FindingsConsistent with the existing literature, this study shows that the direction of the wealth transfer at the conversion of CoCo bonds determines their impact on shareholder risk-taking incentives. This study also finds that “anytime” CoCos (CoCo bonds trigger-able anytime at the discretion of managers) have a minor advantage over regular CoCo bonds, and that quality of capital requirements can reduce the risk-taking incentives of shareholders.Practical implicationsThis study argues 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.Originality/valueTo model the risk-taking incentives, authors generally modify the asset processes to introduce components that reflect asymmetric information between CoCo holders and shareholders and/or managers. This paper follows a simpler method similar to that of Holmström and Tirole (1998).