Contingent Capital: The Case for COERCs

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. Unlike other CoCos, a substantial number of new shares are issued to COERC investors at conversion, but the bank’s original shareholders have the option to repurchase these shares at the bond’s par value to avoid heavy dilution. As a result, COERC investors would almost always receive their bond’s par value in cash at conversion. Compared to other proposed forms of CoCos, the COERC has lower credit risk when bank assets can experience sudden, large declines in value. Moreover, the COERC structure eliminates concerns of an equity price “death spiral ” 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