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, where the network is linked by debt relationship. The default contagion and loss amplification due to network linkage measure the systemic risk, from which we can ascertain the potential impact of CoCo bonds on systemic risk. Results show that CoCo bonds enhance the spillover effect of issuer’s default; in the meanwhile, sufficient CoCo bonds partly offset the impact of default contagion from other institutions. In addition, CoCo bonds enhance the amplification effect of loss due to network linkage, but the amplification effect diminishes after considering the bankruptcy cost. Finally, the numerical test is given to provide some insight into how the issuance of write-down (WD) bonds have influences on commercial banks in China.