Tarullo Speaks on Contingent Capital

Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve System, gave a speech at the Council of Institutional Investors meeting, Washington DC, 13 April 2010.

A second proposal that has received considerable attention is to require large financial institutions to hold so-called contingent capital, which is basically debt that converts to common equity as a result of some predefined triggering event. There are actually two distinct concepts that may be characterized as “contingent” capital. The first is a requirement for a specified kind of capital instrument to be issued by the firm – one that would have debtlike characteristics in normal times but would convert to equity upon the triggering event. The other is a requirement that all instruments qualifying as Tier 2 regulatory capital convert to common equity under specified circumstances, such as a determination that the firm would otherwise be on the brink of insolvency.

Frankly, the distinction between the two concepts is not immediately apparent to me!

The market discipline effects of both variants could be considerable, since holders of certain kinds of capital instruments would know that their debt-like interests in the firm would be lost if the firm’s financial situation deteriorated. However, there are also significant questions about the feasibility of both. The specification of the trigger is critical. If supervisors can trigger the conversion, investors cannot be certain as to when the government will exercise the trigger. That uncertainty would make it difficult to price a convertible capital instrument and diminish investors’ willingness to hold it. Tying the trigger to the capital level of the firm runs headlong into the serious problem that capital has traditionally been a lagging indicator of the health of a firm. Using a market-based trigger could invite trading against the trigger, which, in extreme cases, could lead to a so-called death spiral for the firm’s stock.

I am in full agreement with his identification of a major problem with supervisory triggers. I will add that if supervisors trigger conversion when the bank is merely in trouble, the triggering of conversion will almost certainly also trigger a run on the bank, converting trouble into the kiss of death.

Capital levels … I will add that capital levels can be manipulated. Lehman’s Repo 105 transactions, last discussed on March 17, are merely a glaring example.

Market based trigger … I agree that trading against the trigger could very well occur. However, extreme cases leading to a death-spiral will be avoided under my proposal which leads to conversion at a set price if the common trades below that set price. No death-spiral there! However, it is true that a cascade could occur: conversion 1 throws a lot of common on the street, which gets sold, lowering the price, triggering conversion 2 … it is not immediately clear to me, however, that this should be a regulatory concern: at the end of the process, you have a bank in which every single penny of capital has been converted to common equity. Isn’t that a good thing? However, a valid argument can be made that it will be harder to sell new common if it’s only a buck or two above the first of a series of conversion prices. Ain’t NUTHIN perfect!

Despite the work that has been done on contingent proposals, it is not yet clear if there is a
viable form of contingent capital that would increase market discipline and provide additional equity capital in times of stress without raising the price of the convertible debt close to common equity levels. The appeal of the concept is such as to make further work very worthwhile but, for the moment at least, there is no proposal ready for implementation.

But what is the alternative? If the trigger is too remote, it won’t get priced properly and will only be triggered way too late in process. If it’s triggered too late, it won’t help much, as S&P has commented.

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