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    Optimal volatility, covenants and cost of capital under Basel III bail-in

    Hori, Ken and Ceron, Jorge Martin (2015) Optimal volatility, covenants and cost of capital under Basel III bail-in. Working Paper. Birkbeck College, University of London, London, UK.

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    Abstract

    This paper investigates three consequences of the new financial regulation: the agency costs, the monitoring costs and the effect on banks’ cost of capital. For the first, the shareholders’ behaviour is analysed as a trade-off between the value of the bank and its volatility by using an indifference curve model of the bank’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%.

    Metadata

    Item Type: Monograph (Working Paper)
    Additional Information: ISSN 1745-8587: BWPEF 1502
    Keyword(s) / Subject(s): Indifference curves, CoCo, Bail-in, Covenants, WACC
    School: Birkbeck Schools and Departments > School of Business, Economics & Informatics > Economics, Mathematics and Statistics
    Depositing User: Administrator
    Date Deposited: 20 May 2016 09:34
    Last Modified: 20 May 2016 09:34
    URI: http://eprints.bbk.ac.uk/id/eprint/15277

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