On the Design of Contingent Capital with a Market Trigger

  • Author(s): Suresh Sundaresan, Zhenyu Wang
  • Published: Mar 01, 2014
  • DOI: 10.1111/jofi.12134

ABSTRACT

Contingent capital (CC), which aims to internalize the costs of too‐big‐to‐fail in the capital structure of large banks, has been under intense debate by policy makers and academics. We show that CC with a market trigger, in which direct stakeholders are unable to choose optimal conversion policies, does not lead to a unique competitive equilibrium unless value transfer at conversion is not expected ex‐ante. The “no value transfer” restriction precludes penalizing bank managers for taking excessive risk. Multiplicity or absence of equilibrium introduces the potential for price uncertainty, market manipulation, inefficient capital allocation, and frequent conversion errors.

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