What’s the contingency? A proposal for bank contingent capital triggered by systemic risk |
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| Institution: | 1. Technische Universität Bergakademie Freiberg, Schlossplatz 1, DE-09599 Freiberg, Germany;2. University of Edinburgh Business School, EH8 9JS, 29 Buccleuch Place, Edinburgh, UK;3. Dongbei University of Finance and Economics, Department of Finance and Economics, No. 217 JianShan St., Shahekou District, Dalian 116025 Liaoning, PR China;4. University of Vaasa, Department of Accounting and Finance, FI-65101, P.O. Box 700 Vaasa, Finland |
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| Abstract: | Contingent capital (coco) automatically recapitalizes the banking system during financial crises if the trigger mechanism is properly designed. We propose a dual trigger mechanism based on: (1) aggregate systemic risk in the banking system, measured using CATFIN, and (2) the individual bank’s contribution to overall systemic risk, measured using delta CoVaR. The dual trigger is highly correlated with system-wide insolvency risk and prices systemic risk. We set different triggers for banks, insurance companies and broker-dealers. Using the 99% cut-off, systemic coco issued by Lehman and Bear Stearns would have been triggered in November 2007, months prior to their actual demise. |
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| Keywords: | Contingent capital Callable put option Dual trigger exercise price Systemic risk |
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