“Incentive Effects of Contingent Capital” by Sergey Tsyplakov
University of South Carolina
Charles P. Himmelberg
Goldman Sachs & Co.
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 destructuve 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 terms of CoCos – conversion ratios in particular – warrant more attention than they have received to date.