Convertible Bonds and Bank Risk-Taking

We study the effect of going-concern contingent capital on bank risk choice. Optimal conversion ahead of default forces deleveraging in highly levered states, when risk incentives are worse. The equity infusion reduces endogenous risk shifting by diluting returns in high states. Interestingly, contingent capital may be less risky in equilibrium than traditional debt, as its lower priority is compensated by reduced endogenous risk. Its effectiveness in risk reduction depends critically on the informativeness of the trigger. We show that adopting a noisy market trigger produces excess conversion (type II error), while a noisy accounting trigger converts too infrequently (type I error) because of regulatory forbearance.