Contingent Convertible Bonds in Financial Networks

TL;DR

This paper investigates how the structure of interbank networks affects the effectiveness of contingent convertible bonds (CoCos) in enhancing financial stability, revealing that network topology can sometimes increase fragility.

Contribution

It demonstrates that network structure critically influences CoCos' effectiveness, showing that certain configurations can inadvertently increase financial fragility and that lightly interconnected networks are more robust.

Findings

Network structure impacts CoCos' ability to stabilize banks.

Lightly interconnected networks are more resilient to shocks.

In some cases, CoCos can increase systemic fragility.

Abstract

We study the role of contingent convertible bonds (CoCos) in a complex network of interconnected banks. By studying the system's phase transitions, we reveal that the structure of the interbank network is of fundamental importance for the effectiveness of CoCos as a financial stability enhancing mechanism. Our results show that, under some network structures, the presence of CoCos can increase (and not reduce) financial fragility, because of the occurring of unneeded triggers and consequential suboptimal conversions that damage CoCos investors. We also demonstrate that, in the presence of a moderate financial shock, lightly interconnected financial networks are more robust than highly interconnected networks. This makes them a potentially optimal choice for both CoCos issuers and buyers.