Countercyclical Contingent Capital

We analyze the capital structure of a company issuing countercyclical contingent capital as suggested in the recent debate, i.e., notes that can be converted in common shares of the bank in case of a bad state for the economy. A dynamic capital structure model with endogenous bankruptcy for a company with equity, straight debt and contingent capital is analyzed. 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), the asset reduces the asset substitution incentive.