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E-MailThe following post comes to us from Charles Calomiris, the Henry Kaufman Professor of Financial Institutions at Columbia Business School, and Richard J. Herring, the Jacob Safra Professor of International Banking at the Wharton School, University of Pennsylvania.
In our paper, Why and How to Design a Contingent Convertible Debt Requirement, which was recently made publicly available on SSRN, we develop a proposal for a contingent capital (CoCo) requirement. We show that CoCos can play a unique role alongside a standard minimum book value of equity ratio requirement. If properly designed, a CoCo requirement can provide a more effective solution to the “too-big-to-fail” problem, by ensuring adequate capital relative to risk, and it can do so at a lower cost than a simple equity requirement. A proper CoCo requirement can provide strong incentives for the prompt recapitalization of banks after significant losses of equity, or for the proactive raising of equity capital when risk increases. Consequently, it can also provide strong incentives for effective risk governance by regulated banks, and can reduce forbearance (supervisory reluctance to recognize losses).
Different proposals for CoCo requirements reflect different purposes, including the facilitation of bail-ins, the signaling of bank risk, and the encouragement of timely voluntary offerings of equity into the market by banks that have suffered significant loss. We argue that the third of these motives is the most important, especially for dealing with the “too-big-to-fail” problem.
The emphasis on the need to incentivize the timely issuance of equity informs our discussion of the proper design of CoCo contracts that would be implemented by the CoCo requirement. We show that, to be maximally effective, (a) a large amount of CoCos (relative to common equity) should be required; (b) CoCo conversion should be based on a market value trigger, defined using a moving average of a “quasi market value of equity ratio” (QMVER); (c) all CoCos should convert if conversion is triggered; and (d) the conversion ratio should be dilutive of preexisting equity holders.
Our proposed CoCo requirement does not suffer from a potential problem of multiple equilibria. Judging as best we can from the experience of the recent crisis, our proposed requirement would have been very effective in encouraging the timely replacement of lost capital early in the crisis. Arguably, if a CoCo requirement had been in place in 2007, the disruptive failures of large financial institutions, and the systemic meltdown after September 2008, could have been avoided.
The full paper is available for download here.
One Comment
our proposed requirement would have been very effective in encouraging the timely replacement of lost capital early in the crisis. Arguably, if a CoCo requirement had been in place in 2007, the disruptive failures of large financial institutions,