Contingent Capital Structure

This paper studies the optimal financing contract of a bank with risk-shifting incentives and private information, in an environment with macroeconomic uncertainty. Leverage mitigates adverse selection problems owing to debt information-insensitivity, but leads to excessive risk-taking. I show that the optimal leverage is procyclical in the laissez-faire equilibrium, and contingent convertible (CoCo) bonds emerge as part of the implementation of the optimal contingent capital structure. However, the equilibrium entails excessive leverage and risk-taking, due to a bank’s private incentives to minimise market mispricing of its securities. It is socially optimal to impose countercyclical capital requirements, implemented by CoCo bonds in addition to straight debt and equity. ∗I am grateful to Ulf Axelson, Mike Burkart, Vicente Cuñat, Amil Dasgupta, Daniel Ferreira, Denis Gromb, Anastasia Kartasheva, Bob Nobay, Dimitri Vayanos, Theo Vermaelen, David Webb, Kathy Yuan and audiences at the European Finance Association 2013 conference, INSEAD, the London FIT Network at LBS and LSE for helpful comments. Contact: [email protected].