On the Design of Contingent Capital with a Market Trigger

Authors

  • SURESH SUNDARESAN,

  • ZHENYU WANG

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    • Sundaresan is with Columbia University, Graduate School of Business. Wang is with Indiana University, Kelley School of Business. We are grateful for the comments from the seminar and conference participants in the NY Fed Workshop on Contingent Capital, BIS, ECB, Toulouse Economics Group, Columbia Business, Law, and Engineering Schools, Wisconsin (Madison), Richmond Fed, Indiana (Bloomington), Exeter, SAIF, Seattle, Drexel, Baruch, the Moody's Conference, FIRS conference, IFMR, UBC Summer Conference, and FMC2 Bank Resolution Mechanism Conference. We especially thank Anat Admati, Pierre Collin-Dufresne, Doug Diamond, Mark Flannery, Ken Garbade, Paul Glasserman, Larry Glosten, Charles Goodheart, Christopher Hennessy, Bev Hirtle, Ravi Jagannathan, Weiping Li, Jamie McAndrews, Bob McDonald, Stewert Myers, George Pennacchi, Ned Prescott, Adriano Rampini, Marc Saidenberg, Joao Santos, Ernst Schaumburg, Chester Spatt, Kevin Stiroh, James Vickery, Cam Harvey (Editor), the anonymous Associate Editor, and the anonymous referees for helpful remarks. Julia Dennett and Kevin Pan provided excellent research assistance.


ABSTRACT

Contingent capital (CC), which aims to internalize the costs of too-big-to-fail in the capital structure of large banks, has been under intense debate by policy makers and academics. We show that CC with a market trigger, in which direct stakeholders are unable to choose optimal conversion policies, does not lead to a unique competitive equilibrium unless value transfer at conversion is not expected ex ante. The “no value transfer” restriction precludes penalizing bank managers for taking excessive risk. Multiplicity or absence of equilibrium introduces the potential for price uncertainty, market manipulation, inefficient capital allocation, and frequent conversion errors.

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