Please use this identifier to cite or link to this item: http://hdl.handle.net/10419/87525
Authors: 
Martynova, Natalya
Perotti, Enrico
Year of Publication: 
2012
Series/Report no.: 
Tinbergen Institute Discussion Paper 12-106/IV/DSF41
Abstract: 
We study the effect of going-concern contingent capital on bank risk choice. The possibility of debt for equity conversion forces deleveraging in highly levered states, when risk incentives are worse. The additional equity reduces endogenous risk shifting by diluting returns in high states. An optimally designed trigger and convertible debt amount trades off this risk reduction against its debt dilution effect. Interestingly, contingent capital may be less risky in equilibrium than traditional debt, as its lower priority is compensated by reduced endogenous risk. Its effectiveness in risk reduction depends critically on the informativeness of the trigger. Adopting a noisy market trigger produces excess conversion (type II error), while an accounting trigger converts too infrequently (type I error) because of regulatory forbearance.
Subjects: 
Risk shifting
Financial Leverage
Contingent Capital
JEL: 
G13
G21
G28
Document Type: 
Working Paper

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