Are non-dilutive CoCo Bonds a necessary evil?
This paper empirically documents the prevalence of nondilutive CoCos, despite the initial envisioning that CoCos need to be dilutive to penalise and deter bank shareholders’ risk-taking.
Banks predominantly issue non-dilutive contingent convertible bonds (CoCos), contrary to the suggestion that CoCos should be dilutive to reduce risk-taking. In an agency model of two moral hazards, this research shows that, although dilutive CoCos deter ex ante risk-taking and prevent banks from being undercapitalised, penalising shareholders of a distressed bank with dilution leads to ex post risk-shifting. CoCos’ design and risk implications depend on bank capitalisation: equity-constrained banks prefer nondilutive CoCos because they maximise the financing capacity by tackling ex post risk shifting only. Non-dilutive CoCos can be used to implement the constrained social optimum for highly leveraged banks, and regulators can induce appropriate CoCo designs with capital regulations.
The published version of the paper Nondilutive CoCo Bonds: A Necessary Evil? is available at City Research Online
The paper has been published in The Review of Corporate Finance Studies.
