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Optimal Volatility, Covenants and Cost of Capital Under Basel III Bail-in

Author

Listed:
  • Kenjiro Hori

    (Department of Economics, Mathematics & Statistics, Birkbeck)

  • Jorge Martin Ceron

    (Department of Economics, Mathematics & Statistics, Birkbeck)

Abstract
This paper investigates three consequences of the new financial regulation: the agency costs, the monitoring costs and the effect on banksÂ’ cost of capital. For the first, the shareholdersÂ’ behaviour is analysed as a trade-off between the value of the bank and its volatility by using an indifference curve model of the bankÂ’s choice of optimal risk. While the first-best optimal risk maximises the value of the bank, the shareholders select suboptimally high risks under bail-in structures. This leads to both the wealth transfer and the value destruction agency costs. For the second, as a result of these consequences of the DAPR (Deviation from the Absolute Priority Rule) the bondholders are forced to closely monitor the bank behaviour. Requiring higher rate of return for higher risk, reflecting the costs of monitoring, is shown to alleviate the agency problems. Different types of covenants are proposed as an efficient way of implementing this solution. For the third, the impact of the new bail-in structure and the monitoring costs on the WACC of 16 largest European banks is estimated, and is shown to increase the cost of capital by between 75% and 110%.

Suggested Citation

  • Kenjiro Hori & Jorge Martin Ceron, 2015. "Optimal Volatility, Covenants and Cost of Capital Under Basel III Bail-in," Birkbeck Working Papers in Economics and Finance 1502, Birkbeck, Department of Economics, Mathematics & Statistics.
    • Handle: RePEc:bbk:bbkefp:1502
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    Download full text from publisher

    File URL: https://eprints.bbk.ac.uk/id/eprint/15277
    File Function: First version, 2015
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    Cited by:

    1. Kenjiro Hori & Jorge Martin Ceron, 2016. "Removing Moral Hazard and Agency Costs in Banks: Beyond CoCo Bonds," Birkbeck Working Papers in Economics and Finance 1603, Birkbeck, Department of Economics, Mathematics & Statistics.

    More about this item

    Keywords

    Indifference curves; CoCo; Bail-in; Covenants; WACC.;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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