The default contagion of contingent convertible bonds in financial network

Abstract

This paper investigates the impact of contingent convertible (CoCo) bonds on systemic risk using Eisenberg-Noe’s financial network method, in which the network is linked by debt relationships. As an efficient method for addressing the problem of “too big to fail,” CoCo bonds have received widespread attention, particularly because the trigger for CoCo bonds is a systemic risk event. Thus, the impact of CoCo bonds on systemic risk needs to be addressed. To solve this problem, we adopt default contagion and loss amplification due to network linkage to measure systemic risk, from which we can ascertain the potential impact on it of CoCo bonds. The results show that CoCo bonds enhance the spillover effect of the issuer’s default; meanwhile, sufficient CoCo bonds partly offset the impact of default contagion from other banks. Furthermore, CoCo bonds enhance the amplification effect of loss due to network linkage, but the amplification effect diminishes after the bankruptcy cost is considered. Finally, the numerical test provides some insight into how the issuance of writedown (WD) bonds influences commercial banks in China. Our study not only offers suggestions to the regulators of CoCo bonds but also contributes to related studies.