Contingent Convertible Research Articles

Capital Regulation Reforms and Bank Risk-Taking in China

ABSTRACT Bank capital stands at the heart of banking regulation aimed at curbing bank risk-taking. This paper examines the impact of the Chinese version of Basel III capital regulation on bank risk-taking in China, by applying panel regressions to a large sample of Chinese commercial banks. Our findings indicate that more Tier 2 contingent convertible (CoCo) bonds as capital instruments in the capital composition may paradoxically increase, rather than decrease, bank risk-taking. This effect is robust to instrumental variable estimation. A channel analysis reveals that this unintended effect primarily arises from a leverage effect. This is due to the strong debt attributes of Chinese Tier 2 CoCo bonds, leading to lower core capital levels. Conversely, no evidence is found for the franchise value effect as a significant driver. Lastly, we confirm that capital constraints influence banks’ capital adjustments and asset risk allocation aligning with regulatory aims. Our paper has significant policy implications for financial regulation, shedding light on the efficacy of Basel III capital regulation while highlighting the limitations of Tier 2 CoCo bonds as capital instruments in China.

Overview of an alternative trigger for DCL

In this research letter, we suggest a novel trigger for Dynamic Control of Leverage (DCL). These instruments are analogous to conventional Contingent Convertible (CoCo) bonds, employed to constrain a firm’s leverage within specified limits, thus minimizing the likelihood of default. Our proposed trigger enables continuous leverage monitoring, bringing in the desired flexibility allowing the conversion to be triggered ahead of the cash payment. This alternative design, building upon the DCL mechanism, has been shown to further reduce the probability of default while preserving the desirable mean-reverting behaviour of the leverage dynamic. We provide evidence of the model’s effectiveness and discuss the implications of its implementation.

Can CoCo-bonds mitigate systemic risk?

After the 2008 financial crisis, the idea of contingent convertible (CoCo) capital was revived as a means to stabilize individual banks, and hence the entire banking system. The purpose of this paper is to empirically test, whether CoCo-bonds indeed improve the stability of the banking system and reduce systemic risk. Using the broadly applied SRISK metric, we obtain contradicting results, which are based on the accounting of the CoCo-bond as debt or equity. This observation is problematic, as CoCo-bonds generally increase the loss-absorbing capacity of a bank. We remedy this shortcoming by proposing an adjustment to the original SRISK formula. Using empirical tests, we show that the undue disparity has been solved by our adjustment, and that CoCo-bonds reduce systemic risk, irrespective of their accounting. Our results are robust to different parametrizations and accounting standards, as well as issuance effects.

Pricing contingent convertibles with idiosyncratic risk

AbstractWe consider capital structure including equity, straight bonds (SBs), and contingent convertibles (CoCos) for nonfinancial firms. We price equity and CoCos by a utility‐based method. We show that benefits from issuing CoCos increase dramatically with idiosyncratic risk and risk aversion. The firm value is concave in CoCos' conversion ratio and the optimal conversion ratio increases with risk aversion and idiosyncratic risk. If risk aversion is sufficiently high, shareholders' risk‐shifting incentives disappear, and the firm issues less CoCos and equity and more SBs as idiosyncratic risk rises. The higher the idiosyncratic risk or risk aversion, the higher the leverage.

Contingent Convertible Obligations and Financial Stability

This paper investigates whether a financial system can be made more stable if financial institutions share risk by exchanging contingent convertible (CoCo) debt obligations. The question is framed in a financial network model of debt and equity interlinkages with the addition of a variant of the CoCo that converts continuously when a bank’s equity–debt ratio drops to a trigger level. The main theoretical result is a complete characterization of the clearing problem for the interbank debt and equity at the maturity of the obligations. We then introduce stylized networks to study when introducing CoCo bonds improves financial stability, as well as specific networks for which CoCo bonds do not provide uniformly improved system performance. To return to the main question, we examine the European Union financial network at the time of the 2011 European Banking Authority stress test to do comparative statics to study the implications of CoCo debt on financial stability. It is found that by replacing all unsecured interbank debt by standardized CoCo interbank debt securities, systemic risk in the European Union will decrease and bank shareholder value will increase.

First Passage Time Model Based on Lévy Process for Contingent Convertible Bond Pricing

This paper develops a general Lévy framework to reduce the pricing problem of contingent convertible (CoCos) bonds to the problem of the first pass time of the triggering process. We consider two Lévy models driven by the derived Brownian motion and the spectrally negative Lévy process. These two Lévy models keep the form of the Lévy process unchanged under the measure transform, which avoids the difficulty that only rare forms of Lévy processes solved the first passage time problem. We use single and double Laplace transform in combination with numerical Fourier inversion to find closed form expressions for the price of CoCos bonds. The results show that the model driven by the spectrally negative Lévy process would provide a more accurate CoCos bonds price when taking into account the phenomenon of jumps in the financial market. Indeed, negative jumps play a much critical role in the pricing of CoCos bonds. This paper underlines the importance of the evaluation of the CoCos bonds by the Lévy process.

Modeling of Contingent Capital Under a Double Exponential JumpDiffusion Model with Switching Regime

This paper discusses a theoretical explanation that relies on investment within the framework of a regime-switching structural model whose investment cost is financed by equity and CoCos. The unexpected return of the project is governed by a continuous and temporal Markov chain. Explicit solutions have been proposed under a regime-switching structural model when the value of the cash flows generated by the firm follows a double-exponential step-distribution diffusion process. The equilibrium price theory under the jump diffusion model was developed using the structural model introduced by Leland (1994) and later extended by Kou (2002) and Chen and Kou (2009). The study focused on the influence of contingent convertibles on investment and financing policies and the inefficiencies related to debt overhang and asset substitution in the presence of an investment option

Which Factors Play a Role in CoCo Issuance? Evidence from European Banks

This article explores the reasons why some banks issue Contingent Convertible (CoCo) bonds, but others do not. To this end, we use a binary logistic model and control for the determinants suggested by the literature. Our findings suggest that larger banks and those with higher Tier 1 capital, higher net loans, higher wholesale funding, lower levels of leverage, and lower risk-weighted assets have a higher tendency to issue CoCos and were the early adopters of this novel financing instrument. Our results also suggest that banks in countries with higher annual growth rate of GDP per capita and those listed as Globally Systematically Important Banks (G-SIBs) were more likely to issue CoCos. These results are difficult to explain by traditional capital structure theory, which assumes that companies voluntarily choose their optimal capital structures, but suggest that banks were more likely to be encouraged or nudged to issue CoCos by following regulators’ advice.

Incentive Effects from Write-down CoCo Bonds: An Empirical Analysis

Abstract Departing from the principle of absolute priority, contingent convertible (CoCo) bonds are particularly exposed to bank losses despite not having ownership rights. In this article we show the link between adverse CoCo bond design and their yields, confirming the existence of market discipline in designated bail-in debt. Specifically, focusing on the write-down feature as a loss-absorption mechanism in CoCo debt, we find a yield premium on this feature relative to equity-conversion CoCo bonds as predicted by theoretical models. Moreover, and consistent with theories on moral hazard, we find this premium to be largest when existing incentives for opportunistic behaviour are largest, while the premium is non-existent if moral hazard is perceived to be small. Overall, our findings support the notion of market discipline through monitoring debt investors and have important implications for the optimal design of CoCos from a regulatory perspective.

Determinants of CoCo issuance: liquidity and risk incentives

PurposeThis paper aims to study the impact of (regulatory and nonregulatory) liquidity on contingent convertible (CoCo) issuance and the relationship between CoCos and asset quality.Design/methodology/approachThe analysis of this study comprises two stages. In the first stage, the authors used a logit model to test whether banks with riskier assets as well as lower solvency and (regulatory and nonregulatory) liquidity are more likely to issue CoCos. In the second stage, the authors used univariate analysis and fixed effects regression to measure the impact of Additional Tier 1 (AT1) CoCos on the quality of the issuer’s assets.FindingsThe study shows that regulatory liquidity ratios are negatively related to CoCo issuance. This study also finds that the likelihood to issue CoCo is higher when banks have lower regulatory capital or are less risky. Asset quality is found to not change significantly after the issuance. All in all, these results suggest that while solvency regulation is primarily regarded as the main motivation for CoCo issuance, liquidity regulation also matters.Research limitations/implicationsDespite the fact that CoCos have been emerging as an alternative way to help banks meet regulatory capital requirements, the paper argues that the relation between liquidity regulation and CoCos should be taken into account.Originality/valueThis study presents an empirical analysis on the CoCos instrument, focusing on the relationship between AT1 CoCos and liquidity regulation. Therefore, it serves to fill a gap in the literature on the underlying forces behind CoCo issuance. Moreover, this study measures the impact of AT1 CoCos issuance on bank risk, particularly on the quality of the issuer’s assets.

The impact of CoCo bonds on banking system's net value

This paper investigates the impact of Contingent Convertible (CoCo) bonds on systemic financial risk by considering the banking system's net value. We first conduct a theoretical analysis of how CoCo bonds affect the net value of banking system by considering the loss contagion and liquidity risk. Then, we use data from 15 Chinese commercial banks to illustrate our results and obtain some interesting findings. Specifically, we provide the changing trend of systemic net value with respect to shocks and the amount of write-down (WD) bonds, showing that WD bonds can save banks from the dilemma. Finally, we present some suggestions for commercial banks.

The default contagion of contingent convertible bonds in financial network

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.

Risk-Taking, Competition and Uncertainty: Do Contingent Convertible (Coco) Bonds Increase the Risk Appetite of Banks?

Risk-Taking, Competition and Uncertainty: Do Contingent Convertible (Coco) Bonds Increase the Risk Appetite of Banks?

Risk-Taking, Competition and Uncertainty: Do Contingent Convertible (CoCo) Bonds Increase the Risk Appetite of Banks?

Risk-Taking, Competition and Uncertainty: Do Contingent Convertible (CoCo) Bonds Increase the Risk Appetite of Banks?

Shareholder risk-taking incentives in the presence of contingent capital

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).

The impact of CoCo bonds on systemic risk considering liquidity risk

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.

The price determinants of contingent convertible bonds

The relationships between contingent convertible (CoCo) bonds and their underlying equities, credit default swap spreads (CDS), interest rates, implied volatilities and foreign exchange rates are studied. Starting with the dynamic correlation of the DCC-GARCH method, it is found that CoCo bonds are most highly correlated to CDS. By constructing the minimum spanning tree of the resulting correlations, the primary link to CDS is confirmed. Implied volatility is found to be a secondary to tertiary link, alternating in importance with equities. Interest rates and FX have little impact.

No-fault default, chapter 11 bankruptcy, and financial institutions

This paper analyzes the costs and benefits of a no-fault-default debt structure as an alternative to the typical bankruptcy process. We show that the deadweight costs of bankruptcy can be avoided or substantially reduced through no-fault-default debt, which permits a relatively seamless transfer of ownership from shareholders to bondholders in certain states of the world. We show that potential costs introduced by this scheme due to risk shifting can be attenuated via convertible debt, and we discuss the relationship of this to bail-in debt and contingent convertible (CoCo) debt for financial institutions. We then explore how, despite the advantages of no-fault-default debt, there may still be a functional role for the bankruptcy process to efficiently allow the renegotiation of labor contracts in certain cases. In sharp contrast to the human-capital-based theories of optimal capital structure in which the renegotiation of labor contract in bankruptcy is a cost associated with leverage, we show that it is a benefit. The normative implication of our analysis is that no-fault-default debt, when combined with specific features of the bankruptcy process, may reduce the deadweight costs associated with bankruptcy. We discuss how an orderly process for transfer of control and a predetermined admissibility of renegotiation of labor contracts can be a useful tool for resolving financial institution failure without harming financial stability.

Risk-taking and Uncertainty: Do Contingent Convertible (CoCo) Bonds Increase the Risk Appetite of Banks?

We assess the impact of contingent convertible (CoCo) bonds and the wealth transfers they imply conditional on conversion on the risk-taking behaviour of the issuing bank. We also test for regulatory arbitrage: do banks try to maintain risk-taking incentives by issuing CoCo bonds, when regulators reduce them through higher capitalisation ratios? While we test for, and reject sample selection bias, we show that CoCo bonds issuance has a strong positive effect on risk-taking behaviour, and so do conversion parameters that reduce dilution of existing shareholders upon conversion. Higher economic volatility amplifies the impact of CoCo bonds on risk-taking.

No-fault Default, Chapter 11 Bankruptcy, and Financial Institutions

This paper analyzes the costs and benefits of a no-fault-default debt structure as an alternative to the typical bankruptcy process. We show that the deadweight costs of bankruptcy can be avoided or substantially reduced through no-fault-default debt, which permits a relatively seamless transfer of ownership from shareholders to bondholders in certain states of the world. We show that potential costs introduced by this scheme due to risk shifting can be attenuated via convertible debt, and we discuss the relationship of this to bail-in debt and contingent convertible (CoCo) debt for financial institutions. We then explore how, despite the advantages of no-fault-default debt, there may still be a functional role for the bankruptcy process to efficiently allow the renegotiation of labor contracts in certain cases. In sharp contrast to the human-capital-based theories of optimal capital structure in which the renegotiation of labor contract in bankruptcy is a cost associated with leverage, we show that it is a benefit. The normative implication of our analysis is that no-fault-default debt, when combined with specific features of the bankruptcy process, may reduce the deadweight costs associated with bankruptcy. We discuss how an orderly process for transfer of control and a predetermined admissibility of renegotiation of labor contracts can be a useful tool for resolving financial institution failure without harming financial stability. Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.