Coco Design, Risk Shifting Incentives and Financial Fragility
Stephanie Chan (University of Amsterdam)
Cocos (contingent convertible capital) are debt instruments that turn to equity whenever the issuing bank?s equity ratio falls below a certain threshold. Their use to increase banks? Loss-absorption capacity has recently been codified by the BIS as well as the FSB. However, we show that their design matters: if conversion leads to a wealth transfer from CoCo holders to equity holders, it gives rise to undesirable risk-shifting by banks. Moreover, the incentives for risk-shifting increase as the financial environment becomes more fragile. As a result, CoCos may encourage, instead of mitigate, the creation of a financial crisis. In order to sidestep these consequences, their use by banks must be tempered by increasing capital requirements, and as such, they cannot be treated as true substitutes for equity.
Central Counterparty Capitalization and Misaligned Incentives
Wenqian Huang (VU University Amsterdam)
Central Counterparties (CCPs) are systemic nodes in financial markets. An insolvent CCP will greatly threaten financial stability. However, CCPs are not naturally benevolent intermediaries that internalize this negative externality. We consider the capitalization problem of a profit-maximizing CCP with limited liability. The misaligned incentives give rise to a trade off between large realized gains from trade and large default losses. Without capital requirement, the CCP is inclined to lower collateral requirement, which leads to CCP insolvency. To fix the problem, regulators could set optimal capital requirement that incentivizes proper CCP risk management and preserves market discipline as well.