Office of Financial Research (OFR) Working Paper – CoCos, Bail-In, and Tail Risk

by Sabrina I. Pacifici on January 24, 2013

CoCos, Bail-In, and Tail Risk, by Nan Chen, Paul Glasserman, Behzad Nouri and Markus Pelger

  • “Contingent convertibles (CoCos) and bail-in debt for banks have been proposed as potential mechanisms to enhance financial stability. They function by converting to equity when a bank approaches insolvency. We develop a capital structure model to analyze the incentives created by these forms of contingent capital. Our formulation includes firm-specific and market-wide tail risk in the form of two types of jumps and leads to a tractable jump diffusion model of the firm’s income and asset value. The firm’s liabilities include insured deposits and senior and subordinated debt, as well as convertible debt. Our model combines endogenous default, debt rollover, and jumps; these features are essential in examining how changes in capital structure to include CoCos or bail-in debt change incentives for equity holders. We derive closed-form expressions to value the firm and its liabilities, and we use these to investigate how CoCos affect debt overhang, asset substitution, the firm’s ability to absorb losses, the sensitivity of equity holders to various types of risk, and how these properties interact with the firm’s debt maturity profile, the tax treatment of CoCo coupons, and the pricing of deposit insurance. We examine the effects of varying the two main design features of CoCos, the conversion trigger and the conversion ratio, and we compare the effects of CoCos with the effects of reduced bankruptcy costs through orderly resolution.”
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