Shareholder risk-taking incentives in the presence of contingent capital

What is it about?

Quick summary Contingent convertible (CoCo) bonds can recapitalise a bank on a going concern basis, while the bank is still solvent. However, this feature can make the holders of CoCo bonds more exposed to risk-shifting by the current shareholders. This paper investigates the impact of the issuance of CoCo bonds on the risk-taking incentives. We show that the design of CoCo bonds contracts (especially the conversion rate) is the main factor determining this impact. We propose remedies, and suggest ways through which regulators can use CoCo bonds to increase the resilience of banks. What we do We analyse the impact contingent convertible (CoCo) bonds on the ex-ante incentives of the current shareholders and the managers of the issuer. CoCo bonds can convert to equity capital or have their principal written down, when a predetermined trigger is hit. For most CoCo bonds the trigger is normally the fall of CET1 (core equity tier 1) to risk-weighted assets ratio below a certain threshold. Following Holmstrom and Tirole (1998), we develop a basic model (game) in which there is moral hazard surrounding the exertion of effort by shareholders, which changes the likelihood of a bank’s success. Our model examines the impact of CoCo bonds issuance on the risk-taking incentives of the issuer. It also investigates the main factors affecting this impact, some of which represent the tools available to the regulator to address risk-taking implications of CoCo bonds. Additionally, we explore the implications of the issuer’s discretion over conversion when ‘anytime CoCos’ are issued, capital quality limits, and misalignment of shareholders and mangers incentives. What we find In line with past papers, we find that the issuance of CoCo bonds can increase the risk-taking incentives if their conversion stipulates a wealth transfer from CoCo holders to shareholders. Conversely, CoCo bonds with wealth transfer from shareholders to CoCo holders reduce these incentives. We investigate the effects of a new type of CoCo bonds, proposed by practitioners, which can be converted at the discretion of the issuing bank -usually referred to as ‘anytime CoCos’. We show that these bonds have a minor advantage over regular CoCo bonds as they may convert slightly earlier, when they are accompanied with properly-designed conversion rate, which make it costly for the shareholders to wait until the predetermined trigger is hit. More stringent quality of capital limits (i.e. requiring banks to cover larger share of their capital requirements with CET1 capital rather than Additional Tier 1 (AT1) capital) can reduce shareholder appetite to take excessive risks when CoCo bonds are issued, by increasing their stake of in the value of the bank. Policy Implications Shareholders and regulators can use CoCo bonds to control the riskiness of banks. Shareholders can include manager-specific CoCo bonds (which make shirking very costly for managers) in the compensation schemes of the managers. Similarly, regulators can increase the resilience of individual banks and the whole banking system by imposing restrictions on the conversion rates of CoCo bonds and limits on quality of capital.

Featured Image