Hostname: page-component-8448b6f56d-tj2md Total loading time: 0 Render date: 2024-04-18T12:10:09.368Z Has data issue: false hasContentIssue false
  • English
  • Français

Contingent Capital: The Case of COERCs

Published online by Cambridge University Press:  08 July 2014

George Pennacchi ,
Theo Vermaelen  and
Christian C. P. Wolff
George Pennacchi
Affiliation:
gpennacc@illinois.edu, College of Business, University of Illinois Urbana-Champaign, 1206 S 6th St, Champaign, IL 61820
Theo Vermaelen
Affiliation:
theo.vermaelen@insead.edu, Finance Area, INSEAD, Boulevard de Constance, Fontainebleau, Cedex 77305, France
Christian C. P. Wolff
Affiliation:
christian.wolff@uni.lu, Luxembourg School of Finance, University of Luxembourg, 4 rue Albert Borschette, Luxembourg L-1246, Luxembourg and Centre for Economic Policy Research (CEPR).
Get access Rights & Permissions [Opens in a new window]

Abstract

This paper introduces and analyzes a new form of contingent convertible: a call option enhanced reverse convertible (COERC). If an issuing bank’s market value of capital breaches a trigger, COERCs convert to many new equity shares that would heavily dilute existing shareholders, except that shareholders have the option to purchase these shares at the bond’s par value. COERCs have low risk: They are almost always fully repaid in cash. Yet, they reduce government bailouts by replenishing a bank’s capital. COERCs’ design also avoids problems with market-value triggers, such as manipulation or panic, while reducing moral hazard and debt overhang.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 49 , Issue 3 , June 2014 , pp. 541 - 574
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2014 

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Adrian, T., and Shin, H. S.. “Liquidity and Leverage.” Journal of Financial Intermediation, 20 (2010), 418–437.CrossRefGoogle Scholar
Albul, B.; Jaffee, D.; and Tchistyi, A.. “Contingent Convertible Bonds and Capital Structure Decisions.” Working Paper, University of California, Berkeley (2010).Google Scholar
Barucci, E., and Del Viva, L.. “Dynamic Capital Structure and the Contingent Capital Option.” Annuals of Finance, 9 (2013), 337–364.Google Scholar
Basel Committee on Banking Supervision. “Global Systematically Important Banks: Assessment Methodology and the Additional Loss Absorbency Requirement.” Bank for International Settlements (Nov. 2011).Google Scholar
Berg, T., and Kaserer, C.. “Does Contingent Capital Induce Excessive Risk-Taking and Prevent an Efficient Recapitalization of Banks?” Journal of Financial Intermediation, forthcoming (2014).Google Scholar
Bolton, P., and Samama, F.. “Capital Access Bonds: Contingent Capital with an Option to Convert.” Economic Policy, 27 (2012), 277–316.Google Scholar
Bond, P.; Goldstein, I.; and Prescott, E.. “Market-Based Corrective Actions.” Review of Financial Studies, 23 (2010), 781–820.CrossRefGoogle Scholar
Boyle, P. “Options: A Monte Carlo Approach.” Journal of Financial Economics, 4 (1977), 323–328.Google Scholar
Bühler, W., and Trapp, M.. “Time-Varying Credit Risk and Liquidity Premia in Bond and CDS Markets.” Centre for Financial Research Working Paper No. 09-13, University of Cologne (2009).Google Scholar
Bulow, J., and Klemperer, P.. “Market-Based Bank Capital Regulation.” Working Paper, Stanford University and University of Oxford (2013).CrossRefGoogle Scholar
Calomiris, C., and Herring, R.. “How to Design a Contingent Convertible Debt Requirement That Helps Solve Our Too-Big-to-Fail Problem.” Journal of Applied Corporate Finance, 25 (2013), 39–62.Google Scholar
Collin-Dufresne, P., and Goldstein, R.. “Do Credit Spreads Reflect Stationary Leverage Ratios?” Journal of Finance, 56 (2001), 1929–1957.Google Scholar
Cox, J.; Ingersoll, J.; and Ross, S.. “A Theory of the Term Structure of Interest Rates.” Econometrica, 53 (1985), 385–408.Google Scholar
De Groen, W. P. “A Closer Look at Dexia: The Case of Misleading Capital Ratios.” CEPS Commentaries (Oct. 19, 2011).Google Scholar
De Jonghe, O. “Bank to the Basics in Banking? A Micro-Analysis of Banking System Stability.” Journal of Financial Intermediation, 19 (2010), 387–417.CrossRefGoogle Scholar
Demsetz, R., and Strahan, P.. “Diversification, Size, and Risk at U.S. Bank Holding Companies.” Journal of Money, Credit, and Banking, 29 (1997), 300–313.Google Scholar
Duan, J. C., and Simonato, J.-G.. “Estimating and Testing Exponential-Affine Term Structure Models by Kalman Filter.” Review of Quantitative Finance and Accounting, 13 (1999), 111–135.Google Scholar
Duffie, D. “A Contractual Approach to Restructuring Financial Institutions.” In Ending Government Bailouts as We Know Them, Schulz, G., Scott, K., and Taylor, J., eds. Stanford, CA: Hoover Press (2010).Google Scholar
Flannery, M. “No Pain, No Gain: Effecting Market Discipline via Reverse Convertible Debentures.” In Capital Adequacy beyond Basel: Banking, Securities and Insurance, Scott, H. S., ed. Oxford: Oxford University Press (2005).Google Scholar
Flannery, M. “Market Value Triggers Will Work for Contingent Capital Investments.” Working Paper, University of Florida (2009a).Google Scholar
Flannery, M. “Stabilizing Large Financial Institutions with Contingent Capital Certificates.” Working Paper, University of Florida (2009b).Google Scholar
Flannery, M. “Contingent Capital Instruments for Large Financial Institutions: A Review of the Literature.” Annual Review of Financial Economics, forthcoming (2014).Google Scholar
Flannery, M., and Rangan, K.. “What Caused the Bank Capital Build-Up of the 1990s?” Review of Finance, 12 (2008), 391–429.Google Scholar
Glasserman, P., and Nouri, B.. “Contingent Capital with a Capital Ratio Trigger.” Management Science, 58 (2012a), 1816–1833.Google Scholar
Glasserman, P., and Nouri, B.. “Market-Triggered Changes in Capital Structure: Equilibrium Price Dynamics.” Working Paper, Columbia University (2012b).Google Scholar
Haldane, A. “Capital Discipline.” Paper presented at American Economic Association Meetings, Denver, CO (2011).Google Scholar
Hillion, P., and Vermaelen, T.. “Death Spiral Convertibles.” Journal of Financial Economics, 71 (2004), 381–415.Google Scholar
Hilscher, J., and Raviv, A.. “Bank Stability and Market Discipline: The Effect of Contingent Capital on Risk Taking and Default Probability.” Journal of Corporate Finance, forthcoming (2014).CrossRefGoogle Scholar
Treasury, HM. “Risk, Reward and Responsibility: The Financial Sector and Society.” Available at hm-treasury.gov.uk (2009).Google Scholar
Jensen, M., and Meckling, W.. “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.” Journal of Financial Economics, 3 (1976), 305–360.Google Scholar
Jurek, J., and Yang, H.. “Dynamic Portfolio Selection in Arbitrage.” Working Paper, Harvard University (2007).Google Scholar
Kashyap, A.; Rajan, R.; and Stein, J.. “Rethinking Capital Regulation.” Federal Reserve Bank of Kansas City Economic Symposium on Maintaining Stability in a Changing Financial System (2008).Google Scholar
McDonald, R. “Contingent Capital with a Dual Price Trigger.” Journal of Financial Stability, 9 (2013), 230–241.CrossRefGoogle Scholar
Memmel, C., and Raupach, P.. “How Do Banks Adjust Their Capital Ratios?” Journal of Financial Intermediation, 19 (2010), 509–528.CrossRefGoogle Scholar
Merrouche, O., and Mariathasan, M.. “The Manipulation of Basel Risk-Weights.” Journal of Financial Intermediation, 23 (2014), 300–321.Google Scholar
Merton, R. C. “On the Pricing of Corporate Debt: The Risk Structure of Interest Rates.” Journal of Finance, 29 (1974), 449–470.Google Scholar
Modigliani, F., and Miller, M. H.. “The Cost of Capital, Corporation Finance and the Theory of Investment.” American Economic Review, 48 (1958), 261–297.Google Scholar
Myers, S. “Determinants of Corporate Borrowing.” Journal of Financial Economics, 5 (1977), 147–175.Google Scholar
Pan, J. “The Jump-Risk Premia Implicit in Options: Evidence from an Integrated Time-Series Study.” Journal of Financial Economics, 63 (2002), 3–50.Google Scholar
Pennacchi, G. “The Effects of Setting Deposit Insurance Premiums to Target Insurance Fund Reserves.” Journal of Financial Services Research, 17 (2000), 153–180.Google Scholar
Pennacchi, G. “A Structural Model of Contingent Bank Capital.” Working Paper, University of Illinois (2011).Google Scholar
Rosenthal, L., and Young, C.. “The Seemingly Anomalous Price Behavior of Royal Dutch Shell and Unilever nv/plc.” Journal of Financial Economics, 26 (1990), 123–141.CrossRefGoogle Scholar
Squam Lake Working Group on Financial Regulation. “An Expedited Resolution Mechanism for Distressed Financial Firms: Regulatory Hybrid Securities.” Working Paper, Council on Foreign Relations (2009).Google Scholar
Sundaresan, S., and Wang, Z.. “On the Design of Contingent Capital with a Market Trigger.” Working Paper, Columbia University (2011).Google Scholar
Zhou, C. “The Term Structure of Credit Spreads with Jump Risk.” Journal of Banking and Finance, 25 (2001), 2015–2040.Google Scholar