Contingent convertible bonds (CoCo): impact on shareholder wealth dilution and risk management

Purpose This article investigates how the capital structure of a bank financed by equity, conventional bonds, contingent convertible (CoCo) bonds, and deposits is affected by the dilution of shareholders' wealth. Capital dilution results from the conversion of CoCo bonds into a predetermined number of shares when a particular leverage ratio threshold is reached. Design/methodology/approach An analytical formula was developed for the values of CoCo and conventional bonds by combining two European barrier call options used to conceptualize shareholder value. The proportion of shares held by current shareholders and the fraction held by investors who converted their securities into shares are expressed precisely in order to examine the dilution issue. Findings Numerical evaluations indicate that CoCo bonds generally enhance shareholder wealth by lowering bankruptcy risks, until the dilution effect counterbalances this advantage. Practical implications The results presented in this paper can offer various benefits to banks, investors, and regulators. First, leverage ratios are used to trigger equity conversion, rather than conventional capital ratios. Second, the results support the notion that CoCo bonds boost both shareholder wealth and bank value by reducing the likelihood of costly bankruptcies. Finally, the research emphasizes the importance of selecting appropriate parameters when structuring CoCo bonds. Originality/value The results provide evidence that CoCo bonds improve bank value and shareholder wealth by reducing default risk, enhancing financial stability and bank soundness, and increasing shareholder wealth through reduced bankruptcy risk.