Faculty of Economics and Business Administration Publications Database

Bank Financing with Structured Products – How to make Contingent Convertibles work

Koziol, Christian
Volume: 68
Number: 2
Pages: 108 - 128
ISSN-Print: 0042-059x
ISSN-Online: 0042-059x
Link External Source: Online Version
Year: 2014

In the aftermath of the 2008 financial crisis, contingent convertible bonds have been proposed as the panacea for distressed financial institutions. However, few CoCo bonds have been issued so far. We review the literature and explore different rationales why banks might be reluctant to issue CoCo bonds. In the second part of our analysis, we introduce a simple continuous-time framework to investigate the effect of the CoCo bond design on risk-taking and loan granting incentives. We find that both the conversion ratio and the conversion threshold need to be sufficiently high such that there is a wealth transfer from equity holders to debt holders at conversion. This particular CoCo bond design successfully mitigates the asset substitution problem as well as a credit crunch. Consequently, the regulator should not only advocate the mandatory use of CoCo bonds, but also prescribe the specific design which ensures a punitive wealth transfer at conversion.