The Role of Contingent Capital Structure in Signaling and Information Disclosure

Abstract

This paper advocates two novel advantages of contingent convertible securities in capital structure in (1) signaling, and (2) information disclosure. First, in order to signal his type, the good banker should be punished for poor performance and rewarded otherwise. Since the banker knows better about events occurring in the near future (i.e., the interim states) than final cash flows to be realized in the distant future, the former are better performance indicators, thereby providing contingent securities with additional signaling power. Nevertheless, this advantage needs to be supported by a positive cost of misreporting interim states. Second, even if misreporting is costless, contingent capital structure still has an advantage over non-contingent capital in its ability to mitigate ex-post information asymmetries, since it has more degrees of freedom in setting payoffs to fine-tune the issuer's truth-telling incentives. This paper thus sheds some new light on the design of CoCos and the regulation of contingent capital.