Contingent Capital, Tail Risk, and Debt-Induced Collapse
Paul Glasserman, Columbia University, United States
Date:
13 Apr 2015
Time:
4.00pm – 5.00pm
Venue:
I³ Building, 21 Heng Mui Keng Terrace, Seminar Room Level 1
(This seminar is brought to you by the NUS Finance and Risk Management Cluster, jointly hosted by Centre for Quantitative Finance and Risk Management Institute)
About the Speaker
Paul Glasserman is the Jack R. Anderson Professor of Business at Columbia Business School, where he serves as research director of the Program on Financial Studies. His research interests include risk management, financial stability, and Monte Carlo methods. In 2011-2012, he was on leave from Columbia, working at the Office of Financial Research in the U.S. Treasury department, where he currently serves as a part-time consultant. His work with the OFR has included research on stress testing, financial networks, contingent capital, and counterparty risk. He has previously held visiting positions at the Federal Reserve Bank of New York, Princeton University, and NYU. Paul received the 2008 Lanchester Prize for his book “Monte Carlo Methods in Financial Engineering.” He is also a past recipient of the Erlang Prize in applied probability and Risk magazine’s Quant of the Year award. Paul served as senior vice dean of Columbia Business School in 2004-2008 and was interim director its Sanford C. Bernstein Center for Leadership and Ethics in 2005-2007.
Abstract
Contingent capital in the form of debt that converts to equity as a bank approaches financial distress offers a potential solution to the problem of banks that are too big to fail. We study the design of these contingent convertible bonds and their incentive effects on issuing firms. We develop a structural model with endogenous default, debt rollover, and tail risk in the form of downward jumps in asset value. We show that once a firm issues contingent convertibles, the shareholders’ optimal bankruptcy boundary can be at one of two levels: a lower level with a lower default risk or a higher level at which default precedes conversion. An increase in the firm’s total debt load can move the firm from the first regime to the second, a phenomenon we call debt-induced collapse because it is accompanied by a sharp drop in equity value. We show that setting the contractual trigger for conversion sufficiently high avoids this hazard. With this condition in place, we investigate the effect of contingent capital and debt maturity on capital structure, debt overhang, and asset substitution. We also calibrate the model to past data on the largest U.S. bank holding companies to see what impact contingent convertible debt might have had under the conditions of the financial crisis. This is joint work with Nan Chen, Behzad Nouri, and Markus Pelger.
