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Contingent Capital Instruments for Large Financial Institutions: A Review of the Literature

Contingent Capital Instruments for Large Financial Institutions: A Review of the Literature As the recent financial crisis unfolded, a new financial instrument—contingent convertible (coco) bonds—was widely considered as a mechanism for promptly recapitalizing overlevered financial institutions. Essentially, the conversion feature of coco bonds would replace supervisory discretion about banks’ capital adequacy with rules specifying when new equity was required. Academics and regulators conjectured that including sufficient cocos in a bank’s capital structure could substantially insulate taxpayers from private investment losses. This potential fostered a literature evaluating the effect of cocos on bank and financial sector stability, risk-taking incentives, and corporate governance. I review this literature and suggest that regulatory capital definitions should be expanded to include substantial amounts of carefully designed coco bonds as a partial substitute for common equity in regulatory capital requirements. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Annual Review of Financial Economics Annual Reviews

Contingent Capital Instruments for Large Financial Institutions: A Review of the Literature

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Publisher
Annual Reviews
Copyright
Copyright © 2014 by Annual Reviews. All rights reserved
ISSN
1941-1367
eISSN
1941-1375
DOI
10.1146/annurev-financial-110613-034331
Publisher site
See Article on Publisher Site

Abstract

As the recent financial crisis unfolded, a new financial instrument—contingent convertible (coco) bonds—was widely considered as a mechanism for promptly recapitalizing overlevered financial institutions. Essentially, the conversion feature of coco bonds would replace supervisory discretion about banks’ capital adequacy with rules specifying when new equity was required. Academics and regulators conjectured that including sufficient cocos in a bank’s capital structure could substantially insulate taxpayers from private investment losses. This potential fostered a literature evaluating the effect of cocos on bank and financial sector stability, risk-taking incentives, and corporate governance. I review this literature and suggest that regulatory capital definitions should be expanded to include substantial amounts of carefully designed coco bonds as a partial substitute for common equity in regulatory capital requirements.

Journal

Annual Review of Financial EconomicsAnnual Reviews

Published: Dec 1, 2014

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