Lessons from the collapse in hybrid bank capital securities

Abstract

This paper addresses the lessons that can be learned from the rise and fall of the market for hybrid bank capital securities during this decade's credit boom and bust. It is uncertain whether bank capital securities are going to survive as an asset class after the dramatic collapse in prices and the erosion of confidence among market participants. We examine the potential mis-pricing of the additional risks inherent in subordinated bank debt versus senior securities prior to the crisis. Using a cross-section of European banks, we ask whether there is a relationship between the issuance of hybrid bank capital securities and solvency risk, which became manifest in government bail-outs and the nationalisation of financial institutions. Finally, we argue that it could be beneficial to the stability of the financial sector if bank executives' compensation comprised a significant portion of subordinated debt.