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BWPEF 1603
Kenjiro Hori and Jorge Martin Ceron
Removing Moral Hazard and Agency Costs in Banks: Beyond CoCo Bonds

The convex payoffs for equityholders in a corporate structure results in agency costs and moral hazard problems. The implicit government guarantee for banks accentuates these. We believe that the Basel III related bail-in contingent convertible (CoCo) structures do only not solve these problems, but may even aggravate them. In this paper we suggest solutions. The first is to replace the currently issued writedown/off and equity-conversion CoCo structures with a market-price equity-conversion CoCo bonds. This mirrors the full dilution effect of an ordinary equity raise in a distressed situation to reduce incentives for high risk-taking by equityholders. The second is to establish a Contingent Equity Base that replaces the incumbent shareholders once the CoCo is triggered. This will finally remove the perverse risk-taking incentives. The valuation of the CEB is then suggested.

Keywords: CoCo bond; agency costs; moral hazard; bail-in; cost of equity

JEL Classification: D82, G21, G28, G32

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