Bank Contingent Capital: Valuation and the Role of Market Discipline

This paper develops a structural model to evaluate contingent capital notes (CCN) of Basel III under alternative regulatory closure rules. Our dynamic model has a fixed default barrier and at specific discrete time points an additional higher default barrier depending on the closure threshold. The closed-form expressions of CCN and subordinated debts (SD) in the simple Merton model are presented to understand the convex relationship between the price and capital ratio trigger of CCN and to examine the effects of closure rules on CCN and SD through their derivatives’ properties. Our numerical results in the more general model show that a lax closure rule increases the price of SD and distorts the risk information of issuing banks, but not so for CCN. The policy implications are that CCN are more effective than SD in terms of enhancing market discipline because the price/yield information of CCN is more sensitive to the issuing bank’s risk than SD and will not be distorted by regulatory closure rules.