Effective Regulation - Part 5: Ending "Too Big To Fail"

The fifth installment in our series on effective regulation

Shielding taxpayers with contingent capital

The large increase in the range of institutions that were deemed to be “too big to fail” during the financial crisis, and the resulting expansion in the government-sponsored safety net that emerged, pose significant challenges to reforming the financial system.

Systemic regulation and a new resolution authority are two proposed solutions to these problems. Systemic regulation might reduce the frequency and severity of crises, but it is unlikely that crises can be eliminated entirely. In fact, systemic regulation might actually increase the risk of another crisis by encouraging risky behavior. Similarly, even a well-designed resolution authority could lead to more “bailouts” by making the resolution process easier and less expensive. Ultimately, reform must effectively eliminate the concept of “too big to fail” if it is to succeed.

One of the most promising proposals for substantially eliminating “too big to fail” is contingent capital. Structured as debt that converts into common equity when a firm is in financial distress, contingent capital is a form of self-insurance for systemically important firms. Correctly structured, it would force firms to recapitalize early and quickly, before localized problems could spiral into a systemic crisis.

How might this kind of capital work? A firm is deemed to be systemically important because it provides fundamental services, services so important and so intertwined with the basic structure of the financial system that stopping or even interrupting them could disrupt the economy. While these services must be maintained, the shareholders and bondholders of systemically important firms do not need special protection. Contingent capital allows a firm to continue to provide these essential services, even as that firm is recapitalized at the expense of its shareholders and contingent bondholders.

Back-tests indicate that contingent capital triggered by a process modeled after the U.S. “stress test” would have allowed the firms that were included in the stress test to recapitalize without taxpayer funds. The keys to making continent capital effective are: (1) converting before the firm is insolvent; (2) using a broad definition of risk, including all off-balance-sheet items; and (3) applying a consistent, stress-based assessment of likely loan losses. Further, making conversion highly dilutive to existing shareholders has the effect of incentivizing both shareholders and the firm’s management to raise capital well before the firm reaches the mandatory conversion point. The back-tests also indicate that contingent capital could be more effective in improving financial firm incentives than a simple increase in regulatory capital requirements would be.

However, contingent capital could also be structured in ways that would make it ineffective or even dangerous. Standard regulatory capital ratios have proved to provide an inadequate early warning system for financial firms facing trouble. They would, therefore, be ineffective if used as part of a contingent capital regime. Additionally, conversion triggers that are based on market prices (rather than on comprehensive capital ratios) might actually exacerbate bank runs, rather than prevent them. So while the promise of contingent capital is great, it must be structured with tremendous care.

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