Contingent Capital: Squam Lake Working Group

The papers of the Squam Lake Working Group , a very distinguished group of academics, are published by the Council on Foreign Relations (which seems rather strange, but there you go), who also publish the periodical Foreign Affairs, which I love but don’t have time to read any more.

The Squam Lake paper titled An Expedited Resolution Mechanism for Distressed Financial Firms: Regulatory Hybrid Securities is of great interest, albeit lamentably short on detail.

Most notably, they propose a double trigger for conversion:

A bank’s hybrid securities should convert from debt to equity only if two conditions are met. The first requirement is a declaration by regulators that the financial system is suffering from a systemic crisis. The second is a violation by the bank of covenants in the hybrid-security contract.

This double trigger is important for two reasons. First, debt is valuable in a bank’s capital structure because it provides an important disciplining force for management. The possibility that the hybrid security will conveniently morph from debt to equity whenever the bank suffers significant losses would undermine this productive discipline. If conversion is limited to only systemic crises, the hybrid security will provide the same benefit as debt in all but the most extreme periods.

Second, the bank-specific component of the trigger is also important. If conversion were triggered solely by the declaration of a systemic crisis, regulators would face enormous political pressure when deciding whether to make such a declaration. Replacing regulatory discretion with an objective criterion creates more problems because the aggregate data regulators might use for such a trigger are likely to be imprecise, subject to revisions, and measured with time lags. And, perhaps most important, if conversion depended on only a systemic trigger, even sound banks would be forced to convert in a crisis. This would dull the incentive for these banks to remain sound.

I don’t like the first trigger, the declaration by regulators that a systemic crisis exists. First, there is more than one regulator, which will lead, at the very least, to delays while simultaneous announcements are arranged and, at worst, to political kerfuffles regarding cross-border banks if there is no widespread agreement.

Secondly, it introduces an element of political uncertainty regarding conversion, which will lead to the political pressure they allude to in their discussion of the second trigger.

Thirdly, I just plain don’t trust the regulators.

It will be noted that the group skims rather lightly over the justification for the first trigger!

The group also suggests using Tier 1 Capital Ratios as a trigger:

What sort of covenant would make sense for the bank-specific trigger? One possibility, which we find appealing, would be based on the measures used to determine a bank’s capital adequacy, such as the ratio of Tier 1 capital to risk-adjusted assets.

I don’t like it, for reasons which have been discussed in my posts Contingent Capital: Reverse Convertible Debentures and Lloyds bank to Issue Contingent Capital with Tier 1 Ratio Trigger?. Tier 1 ratios are too easy for a bank and regulators to manipulate, do not measure the degree of investor confidence in an institution and do not provide a framework for market arbitrage. As a bank’s situation deteriorates, the price response of the hybrid should gradually become more-and-more equity-like, which suggests a market based approach rather than the binary now-it’s-debt-now-it’s-equity paradigm implied by an all-or-nothing conversion based on calculated figures. I have not seen anything yet to shake my belief that a fixed-rate conversion with a trigger based on the trading price of the common is the best solution.

The authors discuss the conversion rate:

In addition to the triggers, this new instrument will have to specify the rate at which the debt converts into equity. The conversion rate might depend, for example, on the market value of equity or on the market value of both equity and the hybrid security. Conversions based on market values, however, can create opportunities for manipulation. Bondholders might try to push the stock price down by shorting the stock, for example, so they would receive a larger slice of the equity in the conversion. Using the average stock price over a longer period, such as the past twenty days, to measure the value of equity makes this manipulation more difficult, but it opens the door for another manipulation. If the stock price falls precipitously during a systemic crisis, management might intentionally violate the trigger and force conversion at a stale price that now looks good to the stockholders. Finally, in some circumstances, a conversion ratio that depends on the stock price can lead to a “death spiral,” in which the dilution of the existing stockholders’ claims that would occur in a conversion lowers the stock price, which leads to more dilution, which lowers the price even further.

An alternative approach is to convert each dollar of debt into a fixed quantity of equity shares, rather than a fixed value of equity. There are at least two advantages of such an approach. First, because the number of shares to be issued in a conversion is fixed, death spirals are not a problem. Second, although management might consider triggering conversion (for example, by acquiring a large number of risky assets) to avoid a required interest or principal payment on the debt, this would not be optimal unless the stock price were so low that the shares to be issued were worth less than the bond payment. Thus, management would want to intentionally induce conversion only when the bank is struggling. The advantages and disadvantages of different conversion schemes are complicated, however, and will require both further study and detailed input from the financial and regulatory community.

It seems that they believe that a problem with the conversion at a fixed rate is the potential for manipulation of the trigger terms by management. This would be avoided with a market-based trigger.

5 Responses to “Contingent Capital: Squam Lake Working Group”

  1. […] have previously discussed the Squam Lake proposals; I think they need a little […]

  2. […] more interest is the proposed trigger: “if the government feel it has to step in”. The Squam Lake double trigger has attracted some support, but as noted in my commentary on the BoE Financial Stability Report, I […]

  3. […] discusses the Flannery and Squam Lake proposals previously discussed on PrefBlog: The Flannery and Squam Lake proposals di er in the […]

  4. […] will remember the Squam Lake proposal on contingent capital, which I didn’t like, but was a whole lot better than OSFI’s idiotic […]

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