Faculty of Economics and Business Administration Publications Database

Contingent capital makes credit crunches less likely – but do banks want to have it?

Heldt, Klaus
Koziol, Christian
Volume: 8
Number: 2
Pages: 175 - 196
Month: March
ISSN-Print: 1863-6683
Link External Source: Online Version
Year: 2014
Keywords: Capital structure; Bank regulation; Loan granting; Credit crunch; Contingent capital

We analyze whether the use of CoCo bonds as a financing instrument improves credit supply and therefore reduces the likelihood of a credit crunch. In our simple model, banks decide about granting an additional loan. In case of the bank violating the regulatory constraint, it needs to issue equity associated with adjustment costs. The contribution of the paper is threefold: First, this simple model explains credit crunches in the sense that the loan decision does not only depend on loan characteristics but also on the bank’s prospects. Second, CoCo bonds can always be designed such that all loans with non-negative net present value are granted, which prevents the danger of a credit crunch. Third, banks might not want to issue CoCo bonds even though these instruments help to improve credit supply. This problem primarily concerns banks with favorable prospects, thereby challenging the notion that CoCo bonds should be issued in good times as a protection during bad times.