Tuesday, April 22, 2014

Contingent Capital: The Case for COERCs

PENNACHI George, VERMAELEN Theo, WOLFF Christian
Read the working paper
INSEAD Working Paper 2014/32/FIN revised version of 2011/133/FIN

This paper introduces and analyzes a new form of contingent convertible: a Call Option Enhanced Reverse Convertible (COERC). If an issuing bank’s market value of capital breaches a trigger, COERCs convert to many new equity shares that would heavily dilute existing shareholders, except that shareholders have the option to purchase these shares at the bond’s par value. COERCs have low risk: they are almost always fully repaid in cash. Yet, they reduce government bailouts by replenishing a bank’s capital. COERCs’ design also avoids problems with market-based triggers, such as manipulation or panic, while reducing moral hazard and debt overhang.