Can CoCo-Bonds Mitigate Systemic Risk?

Abstract

After the 2007 financial crises, the idea of contingent convertible (CoCo) capital was revived and manifold proposed as a means to stabilize individual banks, and hence the entire banking system. The purpose of this paper is to empirically test, whether CoCo-bonds indeed improve the stability of the banking system and reduce systemic risk. Using the broadly applied SRISK metric, we obtain contradicting results, based on the classification of the CoCo-bond as debt or equity. We remedy this short-coming by proposing an adjustment to the original SRISK formula that now correctly accounts for CoCo-bonds. Using empirical tests, we show that the undue disparity has been solved by our adjustment, and that CoCo-bonds reduce systemic risk.