Fighting Fire with Gasoline: CoCos in Lieu of Equity

I use a dynamic model of banking to study how the design of contingent convertible bonds (CoCo) affects the shareholder-debtholder problem. CoCos replacing an equivalent portion of straight debt may fail to mitigate the distress and bankruptcy risk. This is because the anticipated positive wealth transfer upon trigger breach exacerbates the risk-taking incentives of shareholders. Debt overhang increases since equity issues would delay the trigger. Overall, the results indicate that using CoCos in attempt to meet the more stringent capital requirements of Basel III is likely to have the opposite effect to that which was intended by the regulator. Further, I discuss how the design of CoCo can be improved to mitigate its negative effect.