Cocos, Contagion and Systemic Risk

Arbeitspapier

CoCo’s (contingent convertible capital) are designed to convert from debt to equity when banks need it most. Using a Diamond-Dybvig model cast in a global games framework, we show that while the CoCo conversion of the issuing bank may bring the bank back into compliance with capital requirements, it will nevertheless raise the probability of the bank being run, because conversion is a negative signal to depositors about asset quality. Moreover, conversion imposes a negative externality on other banks in the system in the likely case of correlated asset returns, so bank runs elsewhere in the banking system become more probable too and systemic risk will actually go up after conversion. CoCo’s thus lead to a direct conflict between micro- and macroprudential objectives. We also highlight that ex ante incentives to raise capital to stave off conversion depend critically on CoCo design. In many currently popular CoCo designs, wealth transfers after conversion actually flow from debt holders to equity holders, destroying the latter’s incentives to provide additional capital in times of stress. Finally the link between CoCo conversion and systemic risk highlights the tradeoffs that a regulator faces in deciding to convert CoCo’s, providing a possible explanation of regulatory forbearance.

Object Details

• Language: Englisch

References and Relationships

• Bibliographic citation: Series: Tinbergen Institute Discussion Paper ; No. 14-110/VI/DSF79

Classification and Topics

• Classification: Wirtschaft ; Financial Crises ; Banks; Depository Institutions; Micro Finance Institutions; Mortgages ; Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
• Subject: Contingent Convertible Capital ; Contagion ; Systemic Risk ; Bank Runs ; Global Games

Contributors, Places and Time

• Event: Geistige Schöpfung
• (who): Chan, Stephanie ; van Wijnbergen, Sweder
• Event: Veröffentlichung
• (who): Tinbergen Institute
• (where): Amsterdam and Rotterdam
• (when): 2014

Further information

• Handle: http://hdl.handle.net/10419/107823
• Last update: 10.03.2025, 11:44 AM CET