Friday, December 23, 2011

PENNACCHI George, VERMAELEN Theo,
WOLFF Christian C.P.
Contingent Capital: The Case of COERCs
INSEAD Working Paper 2011/133/FIN 
revised version of 2011/51/FIN


This paper introduces, analyzes, and values a new form of contingent convertible (CoCo), a Call Option Enhanced Reverse Convertible (COERC). Issued as a bond, it converts to new shareholders’ equity if a bank’s market value of capital falls below a pre-specified trigger. The COERC avoids the problems with market based triggers such as “death spirals” as a result of manipulation or panic. A bank that issues COERCs also has a smaller incentive to choose investments that are subject to large losses. Furthermore, COERCs reduce the problem of “debt overhang,” the disincentive to replenish shareholders’ equity following a decline. The low risk of COERCS should increase their appeal to risk-averse bondholders.