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Keywords:

  • contingent reverse convertibles;
  • CoCo bond;
  • risk shifting incentives;
  • bank stability;
  • conversion ratio;
  • G21;
  • G13;
  • G28;
  • G32

The aim of this paper is to analyze risk shifting incentives for managers and shareholders of the financial institution issuing a CoCo bond. We assess the role of the conversion price settlement in enhancing both shareholders’ and management's discipline. Three recent contingent reverse convertible deals are analyzed, with the intention of showing how shareholder conversion returns are linked to the conversion ratio. The findings demonstrate that, in the case of an ingoing or ongoing crisis, a poor settlement of the conversion ratio could exacerbate both debt overhang and risk shifting issues. This will end in discouraging bank management from issuing new equity and from investing in low risk assets. We argue that a contingent bond triggered on Basel III capital requirement ratios and having a significantly discounted conversion price reduces risk shifting incentives. Moreover, we illustrate how the unexpected wealth transfers between CoCo bondholders and shareholders tends to zero when the bond face value is higher than the current stock market price and there is a concentration of bond subscribers. Accordingly, regulators should consider and oversee not only the conversion trigger but also all the other features of a contingent capital security, especially the conversion ratio.