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Chinese Journal of Management Science ›› 2020, Vol. 28 ›› Issue (11): 71-79.doi: 10.16381/j.cnki.issn1003-207x.2020.11.008

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Pricing of the Contingent Convertible Bond with Countercyclical Buffer Mechanism

WANG Wen-hua, QIN Xue-zhi, WANG Lin   

  1. School of Economics and Management, Dalian University of Technology, Dalian 116024, China
  • Received:2018-03-28 Revised:2019-02-01 Online:2020-11-20 Published:2020-12-01

Abstract: The unexpected bankruptcy of systemically important financial institutions (SIFIs) may even trigger a global economy-wide recession like the global financial crisis of 2007-2009, such that the government regulators have to bail out the troubled SIFIs with taxpayers' money. However, these governments' bailouts will certainly lead to annoying moral hazard problems. In order to enhance the loss absorption capacity of SIFIs and reduce the actual economic impact of its bankruptcy, Basel III proposed in 2012 that SIFIs need to aggrandize countercyclical capital buffers (CCyB) when systemic risks caused by excess credit growth accumulate to a certain risky extent. CCyB is expected to ensure that SIFIs has sufficient capital buffers to cope with future economic and financial crises.
A contingent convertible bond with countercyclical buffer mechanism (CoCoCb) which is based on the proposals of dual-trigger CoCos in Squam Lake working group, McDonald and Allen and Tang is employed to restrain the moral hazard problems. CoCoCb is expected to promote a more resilient banking sector. When systemic risks accumulate to a certain risky extent, investors could put back CoCoCb at a predetermined discount price in order to avoid potential huge losses. The put-back mechanism provides the issuing bank with a way to recapitalize, which is similar to the primary purpose of the CCyB. Alternatively, investors could convert the bond into common contingent convertible bond (CoCo). Therewith, CoCo could be automatically converted into common equity if the issuer falls into financial distress. The automatic conversion mechanism keeps the CoCoCb with more power in loss absorbing capacity.
Based on the Black-Scholes model, Jarrow-Turnbull mode and the default-free assumption, a closed-form pricing formula for a zero-coupon CoCoCb is obtained. In addition, the countercyclical buffer property, loss absorbing capacity and investor-friendly property of CoCoCb are also analyzed. A set of data is exployed from the official website of Bank for International Settlements from March 31, 1962 to June 30, 2017, which includes quarterly data on credit and GDP in a total of 39 countries and regions, including the ratio of credit to GDP, the long-term trend of credit and GDP, and the gap between credit and GDP. Credit here refers to generalized credit, and Chinese credit data refers to the total non-financial private sector credit calculated by the People's Bank of China.
Consequently, the event of that the credit and GDP gap value increases to the peak is subject to the Poisson process; an appropriate putting-back ratios ensure that CoCoCb combines countercyclical buffer property and loss absorbing capacity.

Key words: contingent convertible bond, countercyclical buffer property, loss absorbing capacity

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