The impact of CoCo bonds on systemic risk considering liquidity risk

Abstract

This paper investigates the impact of Contingent Convertible (CoCo) bonds on systemic risk in terms of liquidity risk. We compare the differences in default contagion and clearing payments for financial systems with and without CoCo bonds regarding their network and liquidity channels. By analyzing the sensitivity of equilibrium payments and the market price of illiquid assets, we find that CoCo bonds affect the performance of intervention policies by changing the banking system's relative liability matrix and illiquid assets prices. Finally, we illustrate our model using 15 Chinese banks’ annual data in 2017. Results show that CoCo bonds can enhance the risk resilience of issuing banks, but the defaults of issuing banks will lead to systemically broad contagion when an external shock is too large.