How to Design a Contingent Convertible Debt Requirement That Helps Solve Our Too‐Big‐to‐Fail Problem*

Abstract

As bank regulatory reform tries to come to grips with the lessons of the financial crisis, several experts have proposed that some form of contingent convertible debt (CoCo) requirement be added to the prudential regulatory toolkit. In this article, the authors show how properly designed CoCos can be used not just to absorb losses, but more importantly to encourage banks to recognize losses and replace lost equity in a timely way, as well as to manage risk more effectively. Their proposed CoCos requirement strengthens management's incentives to promptly replace lost capital and enhance risk management by imposing major costs on the managers and existing shareholders of banks that fail to do so. Key elements of the proposal are that conversion of the CoCos into equity would be (1) triggered at a high trigger ratio of equity to assets (long before the bank is near an insolvency point), (2) determined by a market trigger (using a 90‐day moving average market equity ratio) rather than by supervisory discretion, and (3) significantly dilutive to shareholders. The only clear way for bank managements to avoid such dilution would be to issue equity into the market. Under most circumstances—barring an extremely rapid plunge of a bank's financial condition—management should be able and eager to replace lost capital in a timely way; as a result, dilutive conversions should almost never occur. Banks would face strong incentives to maintain high ratios of true economic capital relative to risky assets, and to manage their risks effectively. This implies that “too‐big‐to‐fail” financial institutions would not be permitted to approach the point of insolvency; they would face strong incentives to recapitalize long before that point. And if they should fail to issue new equity in a timely manner, the CoCos conversion would provide an alternative means of recapitalizing banks well before they reach the brink of insolvency. Thus, a CoCos requirement would go a long way to resolving the “too‐big‐to‐fail” problem. Such a CoCos requirement would not only increase the effectiveness of regulation, but also reduce its cost. It would be less costly for banks to raise CoCos than equity, reflecting both the lower adverseselection costs of CoCos issuance and the potential tax advantages of debt. And precisely because of the low probability of CoCo conversion, the Cocos would be issued at relatively modest (if any) discounts to otherwise comparable but straight subordinated debt. Thus requiring a mix of equity and appropriately designed CoCos would be less costly to banks, and would entail less of a reduction in the supply of loans than would a much higher book equity requirement alone.

Coco Design, Risk Shifting and Financial Fragility

“…For a capital structure containing CoCos, they found conversion ratios such that the resulting equity vega (derivative with respect to asset variance) is equal to zero. This is akin to the suggestion of Calomiris and Herring (2013) on having CoCos which are sufficiently dilutive. On the other hand, Martynova and Perotti (2015) claim that both convert-to-equity and principal writedown CoCos can mitigate risk-shifting if the trigger level is set properly.…”

Contingent Convertible Bonds as an Alternative to Strengthen Banks' Ability in Financing a Real Economy

“…On this background a lot of empirical studies have been performed, for example Albul, Jaffee & Tchistyi (2012) who developed models to derive a probability of bankruptcy from elements of a capital base of various banks. Calomiris and Herring (2013) perform a comprehensive analysis on various fundamentals to built-in properly trigger points and their work is using some conclusions of other academics and practitioners in this field, for example Duffie (2009), Segoviano andGoodhart (2009), Gersbach (2010), Miles, Marcheggiano & Yang (2011), Flannery (2005 and others.…”

“…So, CoCos should have embedded some incentives for banks to upgrade their systems of risk assessment and management. A measure of a share capital used by Basel is just an accounting one underestimating a real economic value of capital that leads to problems with timely losses' recognition (Calomiris & Herring, 2013). It then seems to be a unique opportunity for regulators and supervisors to precisely design an instrument that would force bankers to analyse on a daily basis the performance of their relevant business lines and assets.…”

“…Or, the British supervisor, FSA, recognised as one of the most effective in the world, failed to assess properly a financial health of Northern Rock. Just few weeks before a bankruptcy of this bank FSA has issued the approval to use in NR an AIRB for risk weights of its mortgages which helped to reduce its regulatory capital by 30% and pay it off to its shareholders (Calomiris & Herring, 2013).…”

“…The same can be observed when a market value of Lehman Brothers is concerned. So, if supervisors have ordered Lehman to issue CoCos with trigger based on a market value of its prices then such a fall in market price would trigger a conversion of debt into shares long before its insolvency (Calomiris & Herring, 2013). Of course, a certain range of a market volatility of prices is a normal feature in the markets.…”