Contingent convertible bonds and financial instability in an agent-based model

In 2008, excessive risk-taking by banks resulted in significant losses, leading to bank bankruptcies and taxpayer-funded bailouts. To prevent this from happening again, regulators now require banks to hold larger and higher quality capital and utilize bail-in mechanisms. As a result, Contingent Convertible Bonds (CoCos) have emerged as a new asset class, converting into shares or being written off when banks’ asset-liability ratios exceed a threshold. This paper assesses CoCos’ effectiveness in stabilizing the banking sector and their impact on the economy using an agent-based macroeconomic model. Monte Carlo simulations reveal that CoCos, if activated in a crisis, partially replace costly bailouts, preventing bank failures and enhancing capital adequacy ratios. Stabilization benefits are positive for the economy up to a certain volume, beyond which negative effects on consumption and GDP emerge. CoCos may also destabilize the financial sphere, affecting market confidence, creating feedback loops, and fostering financial contagion between banks. Two recommendations for prudential regulation include careful consideration of CoCos in the Basel framework and ensuring clarity in their operation for investors to mitigate market disruptions.