Countercyclical Contingent Capital

We analyze the optimal capital structure of a bank issuing countercyclical contingent capital, i.e., notes to be converted into common shares in poor macroeconomic conditions. A comparison of the main effects produced by the countercyclical asset with the simple equity-debt capital structure, the non-countercyclical contingent capital and the countercyclical callable bond is conducted. We demonstrate that this type of asset reduces the spread of straight debt and is effective in reducing the asset substitution incentive. The reduction of bankruptcy costs is strong only when the countercyclicality feature is removed. % and potentially the countercyclical asset could produced higher expected bankruptcy costs %This type of asset reduces the spread of straight debt %but is quite expensive. %The effect on bankruptcy costs is limited it is strong when contingent capital is not countercyclical Contingent capital is useful for macroprudential regulation and we show that the countercyclical feature is important depending on priorities (moderate the asset substitution incentive or reduce bankruptcy costs).