Seminar: CoCos, Bail-In, and Tail Risk


             Department of Systems Engineering and Engineering Management
                                  The Chinese University of Hong Kong

Title: CoCos, Bail-In, and Tail Risk
Speaker: Prof. Chen Nan
Date: September 14th, 2012 (Friday)
Time: 4:30 p.m. - 5:30 p.m.
Venue: Room 513,
            William M.W. Mong Engineering Building  (Engineering Building Complex Phase 2)

We develop a capital structure model to analyze the incentives created by contingent convertibles (CoCos) and bail-in debt, two variants of debt that converts to equity as a bank nears or reaches financial distress. Our formulation includes firm-specific and marketwide tail risk in the form of two types of jumps and leads to a tractable jump-diffusion model of the firm\'s income and asset value. The firm\'s liabilities include insured deposits and senior and subordinated debt, as well as convertible debt. An essential feature of our model is endogenous default, in the sense of Leland (1994), meaning that the option to declare bankruptcy is exercised optimally by equity holders; this feature is necessary to examine how changes in capital structure to include CoCos or bail-in debt change incentives for equity holders.

We derive closed-form expressions to value the firm and its liabilities, and we use these to investigate how CoCos affect debt overhang, asset substitution, the firm\'s ability to absorb losses, the sensitivity of equity holders to various types of risk, and how these properties interact with the firm\'s debt maturity profile, the tax treatment of CoCo coupons, and the pricing of deposit insurance. We examine the effects of varying the two main design features of CoCos, the conversion trigger and the conversion ratio, and we compare the effects of CoCos with the effects of reduced bankruptcy costs through orderly resolution. Across a wide set of considerations, we find that CoCos generally have positive incentive effects when the conversion trigger is not set too low.

The debt tax shield and tail risk in the firm\'s income and asset value have particular impact on the effects of CoCos. We also identify a phenomenon of debt-induced collapse that occurs when a firm issues CoCos and then takes on excessive additional debt: the added debt burden can induce equity holders to raise their default barrier above the conversion trigger, effectively changing CoCos to junior straight debt; equity value experiences a sudden drop at the point at which this occurs. Finally, we calibrate the model to past data on specific banks to see what impact CoCos might have had on the financial crisis.


Professor Chen Nan graduated from the Department of Probability and Statistics at Peking University in 1998, and he received his Master of Science degree in Probability and Statistics in 2001 at Peking University, his Master of Philosophy and Ph. D degrees in 2006 at Columbia University, USA. He joined the Department of System Engineering and Engineering Management at the Chinese University of Hong Kong in 2006. His research interests include financial engineering and risk management.

************************* ALL ARE WELCOME ************************
Host:  Prof. Hong Cheng

Tel :  (852) 3943-8300


Enquiries : Prof. Nan Chen or Prof. Sean X. Zhou
                  Department of Systems Engineering and Engineering Management


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Friday, September 14, 2012 - 08:30 to 09:30