Research Seminar

February 18  at  4.40 pm, room  3211  (Shabolovka st., 26) ICEF held the Research Seminar
Speaker: Sergey Tsyplakov (Moore School of Business, the University of South Carolina)

February 18  at  4.40 pm, International Colleage of Economics and Finance and International Laboratory of Financial Economics held Research Seminar in Finance
Speaker: Sergey Tsyplakov (Moore School of Business, the University of South Carolina)
Theme: «Incentive Effects of Contingent Capital»
Venue: Shabolovka st., 26, building 3, room 3211

Abstract: Contingent Capital bonds — also known as contingent convertibles (or CoCos) — are bonds that automatically write-down or convert to equity when the financial health of the issuer (typically a bank) deteriorates to a pre-defined threshold or trigger. This paper uses a model of dynamic capital structure choice to show how the contractual terms of CoCos affect future capital structure incentives, and hence the pricing of such liabilities. The conversion ratio is particularly important. If conversion is dilutive for equity investors, we show that banks will actively seek to reduce expected dilution costs by pursuing low leverage ratios leading to lower borrowing costs. On the other hand, if conversion ratios write down bond principal without diluting shareholders, then banks have perverse incentives to pursue higher leverage and capital destructive policies resulting in wider credit spreads. Finally, we show that despite the obvious private and social benefits of dilutive CoCos, banks may choose not to issue them “midstream” since a large fraction of the benefits are captured by existing bondholders. These findings suggest that the contractual terms of CoCos — conversion ratios in particular — warrant more attention than they have received to date.

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