Contingent Convertible Obligations and Financial Stability

TL;DR

This paper models how contingent convertible bonds can enhance financial stability by sharing risk among banks, showing that replacing unsecured debt with CoCos reduces systemic risk and benefits shareholders.

Contribution

It provides a theoretical framework for analyzing CoCos in financial networks and demonstrates their potential to improve stability through empirical analysis of the EU stress test.

Findings

Replacing unsecured interbank debt with CoCos reduces systemic risk.

CoCos increase bank shareholder value in the EU network.

Theoretical characterization of the clearing problem with CoCos.

Abstract

This paper investigates whether a financial system can be made more stable if financial institutions share risk by exchanging contingent convertible (CoCo) debt obligations. The question is framed in a financial network model of debt and equity interlinkages with the addition of a variant of the CoCo that converts continuously when a bank's equity-debt ratio drops to a trigger level. The main theoretical result is a complete characterization of the clearing problem for the interbank debt and equity at the maturity of the obligations. We then introduce stylized networks to study when introducing contingent convertible bonds improves financial stability, as well as specific networks for which contingent convertible bonds do not provide uniformly improved system performance. To return to the main question, we examine the EU financial network at the time of the 2011 EBA stress test to do comparative statics to study the implications of CoCo debt on financial stability. It is found that by replacing all unsecured interbank debt by standardized CoCo interbank debt securities, systemic risk in the EU will decrease and bank shareholder value will increase.