Abstract
This paper investigates whether a financial system can be made more stable if financial institutions share risk by exchanging contingent convertible (CoCo) debt obligations. The question is framed in a financial network model of debt and equity interlinkages with the addition of a variant of the CoCo that converts continuously when a bank's equity-debt ratio drops to a trigger level. The main theoretical result is a complete characterization of the clearing problem for the interbank debt and equity at the maturity of the obligations. We then introduce stylized networks to study when introducing CoCo bonds improves financial stability, as well as specific networks for which CoCo bonds do not provide uniformly improved system performance. To return to the main question, we examine the European Union financial network at the time of the 2011 European Banking Authority stress test to do comparative statics to study the implications of CoCo debt on financial stability. It is found that by replacing all unsecured interbank debt by standardized CoCo interbank debt securities, systemic risk in the European Union will decrease and bank shareholder value will increase.
Original language | English |
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Pages (from-to) | 158-187 |
Number of pages | 30 |
Journal | SIAM Journal on Financial Mathematics |
Volume | 14 |
Issue number | 1 |
DOIs | |
State | Published - Feb 2023 |
Keywords
- banking regulation
- interbank networks
- network valuation
- stress testing
- systemic risk