A First Approximation to the Cost of Contingent Capital for Canadian Banks

This paper develops and calibrates a structural model of contingent capital. The model can be calibrated to specific institutions and used to provide quantitative guidance on important practical issues. For instance this paper appears to be the first to consider the problem of empirically determining reasonable terms of conversion, specifically those that ensure that seniority is respected upon conversion and that equity investors are not rewarded for poor performance. The model assumes that conversion is triggered by the institution's capital ratio falling below a predefined lower threshold and allows for considerable flexibility in the terms of conversion. In contrast to the existing literature we avoid the implicit assumption that debt is serviced via the issue of new equity, by explicitly incorporating debt service in asset value dynamics. Using data from the Canadian banking sector we illustrate how the model can be calibrated to specific institutions. Assuming 1.85% of total liabilities are contingent and that conversion is triggered by a CET1 ratio below 5% we find that, for the representative Canadian institution, a reasonable range for a fixed conversion price is between 45% and 52% of the institution's stock price at issuance. For conversion prices in this range we find that when contingent capital is introduced (i) the cost of senior debt is halved and is insensitive to the conversion price, (ii) the cost of contingent debt increases rapidly with the conversion price and (iii) the overall cost of debt is always reduced. In addition we find that the cost of contingent debt is far less sensitive to the level of the conversion trigger when the terms of conversion impose a fixed loss at conversion than it is when they specify a fixed conversion price