Dynamic capital structure and the contingent capital option

The financial crisis has emphasized the difficulties for financial companies to raise funds through conventional liabilities. In this environment, hybrid securities are becoming popular. In this paper we study the optimal capital structure of a company issuing a particular type of hybrid security: perpetual contingent capital, i.e., debt that converts into equity under some conditions. A two-period model with endogenous bankruptcy for a company with equity, straight debt and contingent capital is analyzed. We investigate the instrument under different conversion rules: automatic or optimally chosen by equity holders. We show that contingent capital reduces the coupon of straight debt and expected bankruptcy costs but can require a high spread. A trigger imposed by the regulatory authority in terms of par value of debt may induce a little use of contingent capital with an increase of bankruptcy costs.     

CoCo Bonds,Conversion Prices and Risk Shifting Incentives. How Does the Conversion Ratio Affect Management's Behaviour?

The aim of this paper is to analyze risk shifting incentives for managers and shareholders of the financial institution issuing a CoCo bond. We assess the role of the conversion price settlement in enhancing both shareholders’ and management's discipline. Three recent contingent reverse convertible deals are analyzed, with the intention of showing how shareholder conversion returns are linked to the conversion ratio. The findings demonstrate that, in the case of an ingoing or ongoing crisis, a poor settlement of the conversion ratio could exacerbate both debt overhang and risk shifting issues. This will end in discouraging bank management from issuing new equity and from investing in low risk assets. We argue that a contingent bond triggered on Basel III capital requirement ratios and having a significantly discounted conversion price reduces risk shifting incentives. Moreover, we illustrate how the unexpected wealth transfers between CoCo bondholders and shareholders tends to zero when the bond face value is higher than the current stock market price and there is a concentration of bond subscribers. Accordingly, regulators should consider and oversee not only the conversion trigger but also all the other features of a contingent capital security, especially the conversion ratio.     

Does the market discipline banks? New evidence from regulatory capital mix

While bank capital requirements permit a bank to freely substitute between equity and subordinated debt, lenders and investors view debt and equity as imperfect substitutes. It follows that, after controlling for the level of regulatory capital, the mix of debt in capital isolates the role that the market plays in disciplining banks. I document that the mix of debt in capital affects bank behavior, but only when investors can impose real constraints. In particular, the mix of debt reduces the probability of failure and future distress for BHC-affiliated institutions (where the investor has control rights through an equity position) and for stand-alone banks before the Basel Accord (when debt issues included restrictive covenants). However, substituting equity for subordinated debt at the bank holding company level or in stand-alone banks since the Basel Accord (where the investor has few protections) only increases the probability of distress and failure.     

How to Design a Contingent Convertible Debt Requirement That Helps Solve Our Too‐Big‐to‐Fail Problem*

As bank regulatory reform tries to come to grips with the lessons of the financial crisis, several experts have proposed that some form of contingent convertible debt (CoCo) requirement be added to the prudential regulatory toolkit. In this article, the authors show how properly designed CoCos can be used not just to absorb losses, but more importantly to encourage banks to recognize losses and replace lost equity in a timely way, as well as to manage risk more effectively. Their proposed CoCos requirement strengthens management's incentives to promptly replace lost capital and enhance risk management by imposing major costs on the managers and existing shareholders of banks that fail to do so. Key elements of the proposal are that conversion of the CoCos into equity would be (1) triggered at a high trigger ratio of equity to assets (long before the bank is near an insolvency point), (2) determined by a market trigger (using a 90‐day moving average market equity ratio) rather than by supervisory discretion, and (3) significantly dilutive to shareholders. The only clear way for bank managements to avoid such dilution would be to issue equity into the market. Under most circumstances—barring an extremely rapid plunge of a bank's financial condition—management should be able and eager to replace lost capital in a timely way; as a result, dilutive conversions should almost never occur. Banks would face strong incentives to maintain high ratios of true economic capital relative to risky assets, and to manage their risks effectively. This implies that “too‐big‐to‐fail” financial institutions would not be permitted to approach the point of insolvency; they would face strong incentives to recapitalize long before that point. And if they should fail to issue new equity in a timely manner, the CoCos conversion would provide an alternative means of recapitalizing banks well before they reach the brink of insolvency. Thus, a CoCos requirement would go a long way to resolving the “too‐big‐to‐fail” problem. Such a CoCos requirement would not only increase the effectiveness of regulation, but also reduce its cost. It would be less costly for banks to raise CoCos than equity, reflecting both the lower adverseselection costs of CoCos issuance and the potential tax advantages of debt. And precisely because of the low probability of CoCo conversion, the Cocos would be issued at relatively modest (if any) discounts to otherwise comparable but straight subordinated debt. Thus requiring a mix of equity and appropriately designed CoCos would be less costly to banks, and would entail less of a reduction in the supply of loans than would a much higher book equity requirement alone.     

Contingent capital with a dual price trigger

This paper evaluates a form of contingent capital for financial institutions that converts from debt to equity if two conditions are met: the firm's stock price is at or below a trigger value and the value of a financial institutions index is also at or below a trigger value. This structure potentially protects financial firms during a crisis, when all are performing badly, but during normal times permits a bank performing badly to go bankrupt. I discuss a number of issues associated with the design of a contingent capital claim, including susceptibility to manipulation, whether conversion should be for a fixed dollar amount of shares or a fixed number of shares; uniqueness of the share price when contingent capital is outstanding; the susceptibility of different contingent capital schemes to different kinds of errors (under and over-capitalization); and the losses likely to be incurred by shareholders upon the imposition of a requirement for contingent capital. I also present an illustrative pricing example.     

Subordinated Debt,Market Discipline,and Bank Risk

This paper demonstrates that subordinated debt (subdebt thereafter) regulation can be an effective mechanism for disciplining banks. By reducing the chance that managers of distressed banks can take value‐destroying actions to benefit themselves, subdebt regulation may encourage banks to lower asset risk. Moreover, subdebt regulation and bank capital requirements can be complements for alleviating the banks’ moral hazard problems. To make subdebt regulation effective, regulators may need impose ceilings on the interest rates of subdebt, prohibit collusion between banks and subdebt investors, and require subdebt to convert into the issuing bank's equity when the government provides assistance to the bank.     

Aligning Incentives at Systemically Important Financial Institutions: A Proposal by the Squam Lake Group

To address the moral hazard problem that can motivate bank executives to take excessive risks and to fail to raise capital when needed, a group of 13 distinguished financial economists recommends that systemically important financial institutions be required to issue contingent convertible debt (CoCos) and to hold back a substantial share—as much as 20%—of the compensation of employees who can have a meaningful impact on the survival of the firm. This holdback should be forfeited if the firm's capital ratio falls below a specified threshold. The deferral period should be long enough—the authors suggest five years—to allow much of the uncertainty about managers' activities to be resolved before the bonds mature. Except for forfeiture, the payoff on the bonds should not depend on the firm's performance, nor should managers be permitted to hedge the risk of forfeiture. The threshold for forfeiture should be crossed well before a firm violates its regulatory capital requirements and well before its contingent convertible securities convert into equity. The Swiss Bank UBS has paid bonuses to its top 6,500 executives that have been structured in exactly this way. Management forfeits its deferred compensation if the bank's regulatory capital ratio falls below 7.5%, and its contingent convertible debt is set up to convert into equity if the bank's capital ratio falls below 5%.     

The Squam Lake Report: Fixing the Financial System*

In these excerpts from The Squam Lake Report, fifteen distinguished economists analyze where the global financial system failed, and how such failures might be prevented (or at least their damage better contained) in the future. Although there were many contributing factors to the crisis—including “agency” problems throughout the financial system and a bankruptcy code poorly suited for reorganizing financial firms—at the core of the problem is a potential conflict between the risk-taking proclivity of financial institutions and the interests of the economy at large that must be managed at least in part through more effective regulation. The Squam Lake Report provides a nonpartisan plan to transform the regulation of financial markets in ways designed to limit systemic risk while preserving—to the extent possible and prudent—the economies of scale and scope that justify the existence of today's large financial institutions. To reduce the risks that large banks will fail, the authors call for higher capital requirements based on more effective assessments of the risks of bank assets and liabilities, as well as a new systemic regulator that should be part of the central bank. To reduce the costs of failure when it occurs, the authors propose that banks be required to create “living wills” laying out their plan to sell assets or shut down operations in the event of financial trouble. As part of that plan, regulators are urged to “aggressively encourage” banks to issue “contingent” debt capital securities that convert into equity.     

CONTINGENT CAPITAL: INTEGRATING CORPORATE FINANCING AND RISK MANAGEMENT DECISIONS

Financial executives of companies that face a sharp increase in business or financial risks have two basic ways of protecting the solvency and strategic viability of their organizations: they can transfer those risks using insurance or derivatives; or they can raise additional capital, typically by issuing equity, to cushion the firm against the higher expected volatility. But CFOs now also have a third means of managing risk, known as "contingent capital," that effectively combines capital raising and risk management.
A contingent capital facility gives a company the right to raise capital after the realization of a loss arising from one or more specified risks, thus ensuring access to capital in potentially difficult times. For example, Swiss Re recently granted Michelin a five-year right to issue ten-year subordinated debt at a fixed spread over LIBOR, though only under conditions in which the tire maker expects its own earnings to be down. To the extent that it eliminates the need to keep more capital on the balance sheet, the use of such contingent capital has the potential to increase shareholder value by reducing a company's overall cost of capital. This article provides an introduction to some recent innovations in contingent capital, along with discussion of their role in integrating corporate finance and risk management.     

Contingent Capital vs. Contingent Reverse Convertibles for Banks and Insurance Companies

During the credit and liquidity crisis in 2007 and 2008, banks found themselves largely unable to raise significant new equity quickly from parties other than sovereign wealth funds and governments. Some banks have thus recently begun to consider contingent capital as a means of pre‐arranging recapitalizations for future crises. Contingent capital is a type of put option that entitles a company to issue new securities on pre‐negotiated terms, often following the occurrence of one or more risk‐based triggering events. This article compares the economic merits of a new security—a “contingent reverse convertible” or CRC—against more traditional forms of contingent capital. In November 2009, Lloyds Banking Group plc issued “Enhanced Capital Notes”—subordinated debt that converts into common stock if Lloyds's core regulatory capital falls below 5% of its regulatory risk‐weigh ted assets. This CRC is not strictly speaking a form of contingent capital, but it does give banks the potential to recapitalize themselves quickly in the face of a crisis without having to turn to governments and taxpayers. One important limitation of CRCs is that because they do not generate new cash for a bank at the time of conversion, they are unlikely to stop a liquidity crisis once it has begun. More traditional contingent capital facilities, by contrast, do put cash in the hands of the issuer at the time the facility is drawn. But even for those inclined to use CRCs, it may be unrealistic to expect many other institutions to imitate the structure of the Lloyds offering. Persuading existing investors to take a more subordinated position in a bank's capital structure and write a put option to the bank on its own stock will be neither cheap nor easy. For this reason, the more traditional solutions used to date may have more success with banks, though arriving at a price that helps issuers and satisfies investors will be a challenge for those structures as well.     

Can subordinated debt constrain banks’ risk taking?

This paper presents a model in which requiring banks to issue a proper amount of subordinated debt can constrain their risk taking both before and after debt issuance. The main idea is that the prospect of issuing debt motivates banks to invest in safe assets before debt issuance; holding such assets then constrains their risk taking after debt issuance. The model helps understand the existing empirical findings, and offers a new testable prediction. It also suggests that: (1) regulators should set the amount of subordinated debt within a range; and (2) subordinated debt cannot entirely substitute for equity capital.     

Bank Competition,Risk, and Subordinated Debt

This paper studies a dynamic model of banking in which banks compete for insured deposits, issue subordinated debt, and invest in either a prudent or a gambling asset. The model allows banks to choose their level of risk after the interest rate on subordinated debt is contracted. We show that requiring banks to issue a small amount of subordinated debt can reduce their gambling incentives. Moreover, when equity capital is more expensive than subordinated debt, adding a subordinated debt requirement to a policy regime that only uses equity capital requirements is Pareto improving.

Distance to default,subordinated debt,and distress indicators in the banking industry*

The recent financial crisis has highlighted the inadequacy of present supervisory arrangements to identify reliable ex‐ante indicators of banking distress. For a sample of US bank holding companies, we analyse the extent to which distance to default based on market data can be explained using accounting‐based indicators of risk. We show that a larger number of bank fundamentals help predict default for institutions that issue subordinated debt. For banks that issue sub‐debt, we find that higher charter values and low bank capitalizations further increase the power of bank fundamentals to predict default risk.     

Are contingent convertibles going-concern capital?

Contingent convertibles (CoCos) are intended to either convert to new equity or be written down prior to failure while a bank is a going-concern. Yet, in the first actual test case, CoCos never converted before its bank failed. We develop a model that predicts that CoCos lead to less (more) extreme stock returns and have yields greater than (similar to) standard subordinated debt yields if investors do (do not) expect them to convert or be written down prior to failure. These predictions are tested using data on CoCos issued by European banks during 2011 to 2017. We find evidence that equity conversion CoCos reduce stock return variance and several other measures of downside risk, consistent with the perception that they are going-concern capital. However, we also provide event study evidence that recent regulatory actions reduced the CoCo–subordinated debt yield spread, which indicates a diminished investor belief that CoCos are going-concern capital.     

Countercyclical contingent capital

We analyze the optimal capital structure of a bank issuing countercyclical contingent capital, i.e., notes to be converted into common shares in poor macroeconomic conditions. A comparison of the main effects produced by the countercyclical asset with the simple equity-debt capital structure, the non-countercyclical contingent capital and the countercyclical callable bond is conducted. We demonstrate that this type of asset reduces the spread of straight debt and is effective in reducing the asset substitution incentive. The reduction of bankruptcy costs is strong only when the countercyclicality feature is removed. Contingent capital is useful for macroprudential regulation and we show that the countercyclical feature is important depending on priorities (moderate the asset substitution incentive or reduce bankruptcy costs).     

Increasing profitability through contingent convertible capital: Empirical evidence from European banks

This study investigates the effects of using additional tier 1 (AT1) capital instruments on bank profitability. It is motivated by the fact that the use of contingent convertible bonds (CoCo bonds) instead of equity offers a tax shield and incentives for efficient risk taking. I empirically analyze a panel dataset of 231 banks from EEA countries as well as Switzerland from 2014 to 2018. My analysis shows that the potential tax shield partly determines the use of CoCo bonds, and that the use of CoCo bonds instead of equity as AT1 capital significantly increases bank profitability.     

Sources of Financing,Profitability and Productivity: First Evidence from Matched Firms

This paper contributes to the literature on capital structure and firm performance. Using firm‐level data covering over 11,000 firms from 47 countries over a recent period of 1997‐2007, we address the effect of different sources of financing on corporate performance, employing a matching process, which allows an adequate `like‐for‐like’ comparison between high and low level of financing by firms. Robust to different matching estimators, the main findings are consistent with the theories of capital structure, in that firms with high debt‐to‐equity ratio tend to have lower returns to shareholders (profitability) and lower internal efficiency (productivity). The results become more robust when we separate the firms into advanced and emerging country‐groups or countries with high/low levels of financial development. Given the lower level of leverage below 50% on average in emerging markets (or in countries with lower level of financial reforms), firms in these economies face lower risk of financial distress and thereby less adverse effect on firm profitability and productivity, relative to their counterparts in advanced economies. We also find that retained earnings and equity financing improve performance, while debt financing by firms particularly in the form of bank loans leads to lower performance, although not so in the case of debt raised through issuing bonds.     

Investor information and bank instability during the European debt crisis

Outside of financial crises, investors have little incentive to produce private information on banks’ short-term liabilities held as information-insensitive safe assets. The same does not hold during crises. We compare the information effects of different policy interventions. We measure information production using credit default swap spreads during the Global Financial Crisis and the European debt crisis. We study abnormal information production around major events and find that capital injections reduced abnormal information production while early European stress tests increased it. High levels of information production predict bank balance sheet contraction and higher government expenditures to support financial institutions.     

Inefficient liquidity creation

We present a model in which intermediaries create liquidity by issuing safe debt. Two types of intermediaries emerge: Traditional banks that create liquidity by issuing equity and holding assets to maturity, and market-based intermediaries that create liquidity by selling assets in fire sales in downturns. We show that the reliance on market-based intermediation is necessarily too high, but liquidity creation is not. It can also be too low as the endogenous fire-sale risk can push liquidity creation below its optimum. We argue that standard capital or liquidity regulation are ineffective, and optimal macroprudential regulation should instead target market-based intermediation.