The deadweight costs of financial distress limit many firms' incentive to include a lot of (tax-advantaged) debt in their capital structures. It is therefore puzzling that firms do not make advance arrangements to recapitalize themselves if large losses occur. Financial distress may be particularly important for large banking firms, which national supervisors are reluctant to let fail. The supervisors' inclination to support large financial firms when they become troubled mitigates the ex ante incentives of market investors to discipline these firms. This chapter proposes a new financial instrument that forestalls financial distress without distorting bank shareholders' risk-taking incentives. Reverse convertible debentures (RCD) would automatically convert to common equity if a bank's market capital ratio falls below some stated value. RCD provide a transparent mechanism for unlevering a firm if the need arises. Unlike conventional convertible bonds, RCD convert at the stock's current market price, which forces shareholders to bear the full cost of their risk-taking decisions. Surprisingly, RCD investors are exposed to very limited credit risk under plausible conditions.
Keywords: capital structure; recapitalization; financial instruments; financial risk; credit risk; banks
Chapter. 11260 words. Illustrated.
Subjects: Financial Markets
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