Contingent Capital: Possibilities, Problems and Opportunities
Not an easy equation to solve
Contingent capital has emerged as a possible solution to the “too big to fail” problem, but the discussion of its merits and shortcomings has proven to be complex. This piece is a guide to contingent capital that first establishes a common vocabulary, and then outlines the differing needs and preferences of the participants in a potential contingent capital market.
At its core, contingent capital is a security that recapitalizes a troubled financial firm without recourse to taxpayer funds. In doing so, it can contain the fallout from a single bank failure and potentially the follow-on failures that can spiral into a systemic crisis. While the underlying recapitalization function of contingent capital is relatively straightforward, “why,”“when” and “how” it operates can vary substantially.
Existing proposals tend to fall into one of two broad buckets. The first is gone-concern contingent capital, which operates when a firm is near insolvency, and is thus a resolution mechanism. The second is going concern contingent capital, which operates well before resolution mechanisms come into play, potentially containing financial distress at an early stage. Both seek to reduce the economic and systemic consequences of a bank failure by placing business liabilities ahead of financial ones, but they differ in their timing and in the degree of reorganization involved.
Well-structured contingent capital can be a positive for banks
Whether going- or gone-concern, developing effective contingent capital securities requires a range of decisions on key structuring points. Participants in a potential contingent capital market – the issuing financial firms, investors and regulators – will likely favor different structures. Thus it will be critical to strike an appropriate balance between their competing interests, so that a sizeable, cost-effective market can develop.
A key issue for investors will be their ability to assess the health of a financial firm. Enforcing more rigorous and standardized disclosure requirements that improve transparency is critical in this regard. While much remains uncertain, it appears likely that contingent capital securities will – in one form or another – be part of the future bank capital landscape. If they are structured well, they can be a positive for global banks and a viable solution to too big to fail.