Category: Contingent Capital

Contingent Capital

Flaherty Pushes Contingent Capital

Julie Dickson recently wrote an opinion piece for the Financial Times that was startling in its lack of rigour, absence of detail and non-existent support in OSFI’s published papers. This bumbling approach to a serious issue has now been adopted by Canada’s finance minister, her boss:

While some countries may choose to pursue an ex ante systemic risk levy or a tax, I do not believe that this would be an appropriate tool for all countries. Such a levy would remove capital from an institution to an external fund or to general government revenues, which could result in weakening an institution’s ability to absorb losses. A global levy could also result in excessive risk taking as a result of a perceived government guarantee against an institution’s failure. In my view, contingent capital is aligned with the principles above and should be considered. As noted in the attached Financial Times editorial by Julie Dickson, the Canadian Federal Superintendent of Financial Institutions, contingent capital would create a notional systemic risk fund embedded in the capital structures of financial institutions. Embedded contingent capital would force the costs of excessive risk taking to be removed from taxpayers and placed on to the right people – shareholders and subordinated debt holders – thus improving market discipline and significantly reducing moral hazard in the banking sector. Moreover, for the same reduction in credit intermediation, contingent capital has the advantage over a levy or charge of leaving capital available in the institution to facilitate a more stable provision of credit during economic downturns.

Contingent Capital

DBRS Addresses Contingent Capital

DBRS has announced a policy on contingent capital.

DBRS has today clarified its approach to rating a subset of hybrids and other debt capital instruments whose features include principal write-downs or conversions to lower positioned instruments, if certain trigger events occur. See DBRS Methodology, “Rating Bank Subordinated Debt and Hybrid Capital Instruments with Contingent Risks” April 2010.

“Principal write-downs” were used in the recent Rabobank issue. “Conversions to lower positioned instruments” (which, presumably, includes the possible conversion of Innovative Tier 1 Capital to preferred shares, which has been around for ages), is the mainstream proposal and was used in the ground-breaking Lloyds deal (which was poorly structured due to the high conversion price).

The DBRS Methodology: Rating Bank Subordinated Debt and Hybrid Capital Instruments with Contingent Risks notes:

This view that most hybrids are closer to debt than equity was evident in the global fi nancial crisis. Despite all their ‘bells and whistles’, most of these bank capital instruments could not be converted into equity to help struggling banks absorb losses and bolster their capital while they were still operating. The main benefi t for bank equity capital came when banks made exchange offers for hybrids, either at less than par or for equity instruments. The limited contribution to equity capital is consistent with DBRS’s perspective on the function of these instruments for banks. In analyzing the contribution of bank capital instruments to a bank’s capitalization, DBRS does not generally give any signifi cant equity credit for hybrid instruments, although we recognize their full value in meeting regulatory requirements.

They classify triggering events as:

In assessing the additional risk of these contingent features, an important factor is the ease of tripping the triggers that cause the adverse event to occur. The easier the triggers are to trip, the greater the additional risk for the hybrid holder. DBRS organizes the ease of tripping triggers into four broad categories:
• Level 4 “Very Hard”, e.g., Bank is insolvent or has been seized
• Level 3 “Hard”, e.g., Bank has exhausted most of its capital, but is not technically insolvent
• Level 2 “Easier”, e.g., Bank no longer meeting minimum regulatory requirements
• Level 1 “Easiest”, e.g., Capital ratio falls below a level set above minimum requirements
For those instruments where the trigger event requires the bank to be insolvent or seized by the authorities, DBRS views the risk as similar to debt instruments.

Julie Dickson’s op-ed advocated – eseentially – a Level 4 trigger – but, of course, she is trying to get something for nothing: equity capital priced like debt. The solution I advocate, a conversion into stock if the stock trades below a certain level, is a Level 1 solution; more expensive for the banks, but on the other hand, actually has a hope of accomplishing something. YOU CAN’T GET SOMETHING FOR NOTHING FOREVER! Hasn’t the last few years convinced anybody of that?

The fi rst step is evaluating the elevated risk posed by the specifi c features of each instrument. For some instruments, the combinations are relatively straightforward. An instrument with triggers that are hard to trip and resulting positions that are above preferreds is viewed as having elevated risk. For instruments with triggers that are easier to trip and resulting positions that are comparable to preferreds, the risk is viewed as being very elevated. Under DBRS’s approach certain instruments with contingent features can pose exceptional risk, if their triggers are the easiest to trip and the resulting position for holders is closer to common equity. One factor in rating these instruments below preferred shares could be that tripping the triggers could occur without preference shares being impacted or leave them in a preferential position relative to the converted instruments. Outside these straightforward combinations, there are a number of combinations that involve judgment in making the assessment of risk (See Exhibit 1). or those instruments where the write-downs or conversions to lower positioned instruments can be reversed, if the bank survives, the risk to investors remains largely the same as it would be in the absence of the feature. That is, investors face losses only if the bank is declared insolvent.

There seems to be acceptance of the idea that it will be possible for subordinated debt to leapfrog prefs and become equity; and I don’t understand this idea at all. Once you allow leapfrogging, investing becomes a lottery. Let all elements of capital have a mandatory conversion into equity at some point, says I; and make it clear that leapfrogging is not likely.

In my proposal, where prefs would trigger/convert at 50% of the common price at time of issue and sub-debt would trigger/convert at 25%, leapfrogging is sort of possible. You could issue a pref, wait a few years (decades?) until the common price doubles, then issue sub-debt. But that’s fine, that’s allowed. All the regulators should be worried about is the risk at the time of sale to the public.

DBRS also published a not-very-interesting Methodology
Rating Bank Subordinated Debt and Hybrid Instruments with Discretionary Payments
. They used it when downgrading Dexia’s sub-debt today, amongst other actions.

Contingent Capital

Dickson Supports Regulatory Trigger for Contingent Capital

The Financial Post reports:

Ms. Dickson, head of the Office of the Superintendent of Financial Institutions, spelled out her case in the Financial Times yesterday. Her comments, along with those yesterday from Royal Bank of Canada chief executive Gordon Nixon, represent the latest attempts by officials to head off new global financial regulations that could be damaging to Canada.

In a Times opinion piece, Ms. Dickson noted proposals to impose a global bank tax or surcharges on “systemically important” banks have not been universally accepted, with Canada leading the way in opposition to a bank tax.

Instead, she suggested a new scheme in which bank debt would be converted into equity in the event lenders run into trouble. This “embedded contingent capital” would apply to all subordinated securities and would be at least equivalent in value to the common equity.

“This would create a notional systemic risk fund within the bank itself — a form of self-insurance prefunded by private investors to protect the solvency of the bank,” she wrote in the Times.

“What would be new is that investors in bank bonds would now have a real incentive to monitor and restrain risky bank behaviour, to avoid heavy losses from conversion to equity.”

The debt-to-equity conversion would be triggered when the regulator is of the opinion that a financial institution is in so much trouble that no other private-sector investor would want to acquire the asset.

It is very odd that Canadians are reading about Canadian bank regulation in a foreign newspaper. I can well imaging that the Financial Times is more commonly found on the breakfast tables of global decision makers than the Financial Post or the Globe and Mail … but I would have expected a major statement of opinion to be laid out in a speech published on OSFI’s website, which could then be accompanied by opinion pieces in foreign publications.

OSFI’s communication strategy, however, has been notoriously contemptuous of Canadians and markets in general for a long time. The same Financial Post article claims:

Some bank CEOs have grown impatient with Ms. Dickson and Jim Flaherty, the Minister of Finance, who have asked lenders to refrain from raising dividends and undertaking acquisitions — unless they are financed by share offerings that keep their capital ratios high — until there is greater certainty about new financial rules.

It would be really nice if there was a published advisory somewhere, so that the market could see exactly what is being said – but selective disclosure is not a problem if the regulators do it, right?

One way or another, I suggest that a regulatory trigger for contingent capital would be a grave mistake. Such a determination by any regulator will be the kiss of death for any institution in serious, but survivable, trouble; therefore, it is almost certain not to be used until it’s too late. Triggers based on the contemporary price of the common relative to the price of the common at the time of issue of the subordinated debt are much preferable, as I have argued in the past.

Ira Stoll of Future of Capitalism quotes the specifics of the piece (unfortunately, I haven’t read the original. Damned if I’m going to pay foreigners to find out what a Canadian bureaucrat is saying) as:

The second question is what triggers the conversion of the contingent capital. She writes, “An identifiable conversion trigger event could be when the regulator is ready to seize control of the institution because problems are so deep that no private buyer would be willing to acquire shares in the bank.”

in which case it is not really contingent capital at all; it’s more “gone concern” capital, without a meaningful difference from the currently extant and sadly wanting subordinated debt. The whole point of “contingent capital” is that it should be able to absorb losses on a going concern basis.

Update: On a related note, I have sent the following inquiry to OSFI:

I note in a Financial Post report(
http://www.nationalpost.com/opinion/columnists/story.html?id=6bb93a4f-b0c0-4d2a-bcd7-be7e6750e212
) the claim that “Despite the low yields, Nagel says the regulatory authorities have given their approval for rate resets to continue to count as Tier 1 capital. But he said the authorities have not been as kind for continued issues of so-called innovative Tier 1 securities.”

Is this an accurate statement of the facts? Has OSFI given guidance on new issue eligibility for Tier 1 Capital, formally or informally, to certain capital market participants that has not been released via an advisory published on your website? If so, what was the nature of this informal guidance?

We will see what, if anything, comes of that.

Update: I have just gained (free!) access to Ms. Dickson’s piece, Protecting banks is best done by market discipline, a disingenuous title if ever there was one. There’s not much detail; but beyond what has already been said:

The conversion trigger would be activated relatively late in the deterioration of a bank’s health, when the value of common equity is minimal. This (together with an appropriate conversion method) should result in the contingent instrument being priced as debt. Being priced as debt is critical as it makes it far more affordable for banks, and therefore has the benefit of minimising the effect on the cost of consumer and business loans.

She does not specify a conversion price, but implies that it will be reasonably close to market:

As an example, consider a bank that issues $40bn of subordinated debt with these embedded conversion features. If the bank took excessive risks to the point where its viability was in doubt and its regulator was ready to take control, the $40bn of subordinated debt would convert to common equity, in a manner that heavily diluted the existing shareholders. While other, temporary measures might also have to be taken to help stabilise the bank in the short run, such capital conversion would significantly replenish the bank’s equity base.

On conversion, the market would be given the message that the bank had been solidly re-capitalised with common equity, and not that it was still in trouble and its common equity had been bolstered only modestly.

I am very dubious about the claimed message to the market, given the conversion trigger. Frankly, this idea doesn’t look like much more than a regulatorially imposed, somewhat prepackaged bankruptcy – which is something the regulators can do already.

At the height of the crisis, how would you have felt about putting new capital into a company – as either debt or equity – that had just undergone such a process?

Update: I will also point out that the more remote the contingent trigger, the less likely it is to be valued properly.

Update, 2010-4-22: Dickson’s essay has been published on the OSFI website.

Contingent Capital

Greenspan Endorses Contingent Capital

Alan Greenspan has lost a little of his mystique since McCain said he continue as Fed Chairman after death, but he’s still one of the most knowledgable people out there.

He has delivered a speech at the Brookings Institute that is of great interest.

I can’t find a copyable paper (update: Dealbreaker has one), so you’ll just have to read the speech yourselves or rely on my paraphrases!

He notes that not a single hedge fund has defaulted on debt throughout the crisis, though many have suffered large losses and been forced to liquidate.

The crash of 1987 and the dotcom bubble bursting led the Fed to believe that financial bubbles had disengaged from the real economy.

He strongly doubts that stability can be achieved in the context of a competitive economy.

Capital and liquidity address all the regulatory shortcomings that were exposed by the crisis. Capital has the advantage that it is not necessary to identify which part of the financial structure is most at risk.

The behaviour of CDS spreads in the wake of the Lehman default and TARP imply that the “well capitalized” requirement for total bank capital should be 14%, not 10%, subject to some Herculean assumptions. This will allow bank equity to earn a competitive return while not constricting credit.

The solution, in my judgment, that has at least a reasonable chance of reversing the extraordinarily large “moral hazard” that has arisen over the past year is to require banks and possibly all financial intermediaries to hold contingent capital bonds, that is, debt which is automatically converted to equity when equity capital falls below a certain threshold. Such debt will, of course, be more costly on issuance than simple debentures, but its existence could materially reduce moral hazard.

The global housing bubble was driven by lower long-term rates, not policy rates. Home mortgage 30-year rates led the Case-Shiller index by 11 months with R-squared of 0.511, compared with Fed Funds, R-squared = 0.216 and and eight-month lead. This makes sense because housing is a long-term asset.

Some people (silly people) get this muddled because the correlation between Fed Funds and 30-year mortgages is 0.83 (until 2002). But the relationship delinked, which was the Greenspan Conundrum, so up yours.

Taylor’s wrong. He equates housing starts (supply) with demand. But starts don’t drive prices, it’s the other way ’round. Builders look at housing prices, not the Fed Funds rate. What’s more the correlation between house prices and consumer prices is small to negative.

Some people (silly people) believe that low Fed Fund rates lowered ARM teaser rates and led to increased demand. But the balance of probabilities is that the decision to buy preceded the decision on financing. Anyway, the correlation of Taylor rule deviations with house prices is statistically insignificant (Dokko, Jane, et al., “Monetary Policy and the Housing Bubble”, Finance & Economics Discussion Series, Federal Reserve Board, Dec. 22, 2009)

Any attempt to instigate a “Systemic Regulator” is ill-advised and doomed to fail. Their models and forecasting ain’t gonna be any better than anybody else’s.

Contingent Capital

Rabobank Issues € 1.25-billion Contingent Capital

Rabobank has announced that it:

successfully issued a EUR 1.25 billion, benchmark 10 year fixed rate Senior Contingent Note (“SCN”) issue, priced at an annual coupon of 6.875%, reflective of a premium to Rabobank subordinated debt paper, as well as a meaningful discount to where we believe Rabobank would be able to complete a hybrid Tier 1 offering.
The transaction enables Rabobank to further enhance the Bank’s creditworthiness, as the offering is designed to ensure that Rabobank’s Core Capital is strengthened in the very unlikely event that the Bank’s Equity Ratio were to fall below 7%. Rabobank has always been amongst the most conservative banks in the world, and this transaction, which effectively hedges tail risk, once again demonstrates the bank’s unwavering commitment to prudence. Finally, the offering anticipates on future (expected) regulatory requirements which are widely expected to be introduced in the near future, and to recognize the value of contingent buffers of capital.

Given the novelty of the transaction structure, an interactive and highly intensive execution process was adopted, starting with the wall-crossing of a limited number of large credit buyers, in the days leading up to Rabobank’s annual results on March 4th, followed by a very intensive 4-day marketing effort across London, Paris and Frankfurt in the week of March 8th during which the product and the issuer’s credit were discussed with over 80 institutional investors.

Having garnered total orders in excess of EUR 2.6 billion, from more than 180 different accounts, it was decided to formally launch and price a more than twice oversubscribed EUR 1.25 billion offering on Friday March 12.

Rabobank has € 38.1-billion equity against € 233.4-billion Risk Weighted Assets, so I suspect that their current equity ratio is about 16.3%, although I cannot find a copy of the prospectus to nail down the definition. One source claims:

Lloyds’ deal, unlike the Rabobank structure, was to a large degree based on substituting existing subordinated debt for the new security. The “trigger”, the point at which the Lloyds debt would convert into equity in the bank, was set for when the bank’s core Tier 1 ratio fell below 5%. Rabobank, by contrast, has a trigger of 7% of its equity capital ratio, at which point the notes will be written down to 25% of their original value and paid off immediately.

However, converting the equity capital ratio, a much simpler measure of shares divided by debt, to a core Tier 1 trigger actually means the Rabobank trigger sits at about 5.5%. compared to Lloyds’, according to one banker on the deal.

Bloomberg claims:

Rabobank hired Bank of America Merrill Lynch, Credit Suisse Group AG, Morgan Stanley and UBS AG to organize presentations, according to Marc Tempelman, a managing director in Bank of America’s financial institutions group. The notes will be written down to 25 percent of face value and repaid if the bank’s capital as a percentage of assets is less than 7 percent.

Rabobank has 29.3 billion euros of equity capital, which it defines as member certificates and retained earnings, according to Tempelman. To trigger the contingent capital notes, capital levels would have to fall by 12.9 billion euros, he said.

This will take a while to think about.

There’s a degree of first loss protection, sure: if the bank loses less than € 12.9-billion, there’s no loss to noteholders. But then the loss gets triggered … equity holders (as defined) have lost 44% and this leads to a 75% loss for noteholders!

This isn’t a bond, it’s an insurance policy. And the presumption that the trigger is based on financial statements is a temptation for all kinds of jiggery pokery. AND in the event that the loss is triggered, there will be cash leaving the firm.

If anybody can find a prospectus, please let me know.

There is speculation that Royal Bank of Scotland is mulling over issuance of a similar structure.

Contingent Capital

Payoff Structure of Contingent Capital with Trigger = Conversion

As Assiduous Readers will know, I advocate that contingent capital be issued by banks with the conversion trigger being the decline of the common stock below a certain price; should conversion be triggered, the conversion into equity of the preferreds / Innovative Tier 1 Capital / Sub Debt should be at that same price.

The Conversion/Trigger price should be set at issue-time of the instrument and, I suggest, be one-half the issue-time price of the common in the case of Tier 1 Capital, with a factor of one-quarter applied for Tier 2 capital. Note that in such a case, Tier 2 capital will not be “gone concern” capital; it will be available to meet losses on a going-concern basis, but the small probability of the issuer’s common losing three-quarters of its value should make it easier, and cheaper, to sell.

Anyway, one nuance to this idea is that the conversion feature will be supportive of the preferreds price in times of stress, since the preferred will convert at face value into current market price of common.

In other words, say the price of both common and preferred has nearly, but not quite, halved, but the situation appears to be stabilizing. In such an event, some investors will buy the preferreds in the hope that conversion will be triggered since they will be paid full face value for the preferred in market value of the common. Therefore, the preferreds will be bid up – at least to some extent – in times of stress.

Let us say that issues exist such that the conversion/trigger price is $25, but the price of the preferreds has declined such that the effective conversion price is $20. The payoff diagram in terms of the common stock price then looks like this:


Click for Big

This diagram assumes that the conversion/strike price is $25, and that the preferreds are trading for 80% of face value.

Thus, an investor contemplating the purchase of the preferreds at 80% of face value will make $5 per share if the common dips just below the trigger price and stays there; he will only realize a loss if the price of the common goes below 80% of the conversion price. This is in addition to any calculations he might make as to the intrinsic value of the preferred if it doesn’t convert, of course.

This payoff diagram can be analyzed into component options:


Click for Big

In this diagram, I have offset the payoff diagrams for the options slightly in order that they be more readily distinguished.

It may be seen that the payoff structure can be replicated with three options:

  • Long Call, strike $20
  • Short Put, strike $20
  • Short Call, strike $25

What’s the point? Well, there isn’t one, really. But I wanted to point out the supportive effect of the conversion feature on the preferreds – even in times of stress! – and show how the payoffs could be replicated or hedged in such a case. Doubtless, more mulling over this dissection will lead to more conclusions being drawn about the relative behaviour of preferred and common prices in such a scenario of extreme stress.

Contingent Capital

Contingent Capital Criticized

The Telegraph recently published a story Mervyn King’s plan for bank capital ‘will backfire’:

Bankers and shareholders, however, fear that the act of converting cocos into equity would be a “red flag” to the market, prompting counterparties to withdraw funds and sparking a liquidity crisis like those at Lehman Brothers and Northern Rock. They say it would act as an “accelerator into distress”.

One senior bank executive said: “The point of conversion would kill the bank. Everyone would pull their liquidity out.” The sentiment was echoed by a leading institutional shareholder, who said: “Institutions don’t like them. If cocos ever converted, that bank would be toast.” Among investors, cocos are colloquially known as “death spiral convertibles”.

I agree that this is the case if there is any discretion at all in the conversion decision, whether this discretion is exercised by the regulators or the issuer. I will also agree that it may very well be the case if some degree of discretion is exercised – which would be the case if regulatory capital triggers are used. If a bank announces in its quarterly results enough losses and provisions to result in ratios being just under or just over the trigger point, there will be an immediate suspicion of jiggery-pokery.

However, I am more dubious about the potential for self-feeding collapse if the trigger I advocate – the price of the common stock – is utilized.

Bankers have also identified a second cause for concern, which they term “negative convexity”. They say coco holders would hedge their position by shorting the bank’s shares as capital ratios fell close to the conversion level.

Paul Berry, from Santander’s global banking and markets’ division, has explained: “As the share price falls, the likelihood increases of conversion. Holders, who do not wish to have any exposure to the share, sell shares to hedge this risk. This selling sends the stock lower, resulting in further stock selling.

“This will send the share price into a terrible self-reinforcing spiral downwards.”

Geez, it’s nice to see the phrase “negative convexity” used in a daily general interest newspaper! Negative convexity is indeed a problem; but one that can be minimized by ensuring that the trigger price is equal to the conversion price. I will certainly agree that the poorly structured Lloyds bank deal, which provides no first-loss protection to the noteholders on conversion, will definitely have that effect.

If structured properly and present in good quantity, contingent capital will simply replace the fire-sales of common shares that were common during the crisis. For instance:
1) Royal Bank sells contingent capital when their stock is trading at $50. In such a situation, I suggest that the conversion and trigger price for Tier 1 Capital (preferred shares and Innovative Tier 1 Capital) be $25.00 (one-half the issue-time price of the common; for Tier 2 Capital the conversion/trigger would be one-quarter of this price)
2) Royal Bank gets into trouble.
3) Share price drops to $25.
4) Royal Bank doesn’t need to sell equity. Instead, the previously issued Tier 1 Capital converts (at $25). They can sell new Tier 1 Capital with a conversion/trigger price of $12.50, instead.

It is, of course, certain that there will be selling pressure on the common when it’s at $30 from the Tier 1 Capital holders (directly and through the options market). However, in the absence of the convertible instruments, there will also be selling pressure based on expectations of new issuance. I suggest that the presence of Contingent Capital structured in this manner will reduce uncertainty, which is the vital thing.

I recently published an opinion piece on Contingent Capital.

Contingent Capital

Moody's Discusses Contingent Capital

Moody’s has discussed Rating considerations for contingent capital securities, which has made its way (via Info-Prod Research (Middle East)) to iStockAnalyst under the title Moody’s Publishes Rating Considerations for Bank Contingent Capital Securities:

Moody’s Investors Service said today in anew report that it would rate a contingent capital security that mayconvert into common equity only if it can reasonably assess when thesecurity’s conversion would likely occur. The rating on a bank’scontingent capital security, if it were to be rated, would likely be non-investment-grade, regardless of the bank’s financial strength.

“We will consider rating bank contingent capital securities that convertinto common equity, but only if their triggers are objective andmeasurable,” said Senior Vice President Barbara Havlicek. In determining whether a trigger is “objective and measurable,” Moody’sanalysis will focus on the definition of the trigger. For financial statement-based triggers, the analysis will include consideration of theaccounting principles used in the preparation of financial statements,the timing and intervals at which the trigger levels are beingdetermined, and the securities laws in a given jurisdiction that couldimpact the quality of financial reporting. Moody’s will not rate any contingent capital security where conversion into common equity is at the option of the issuing bank or is tied to the breach of triggers that are unrelated to the financial health of thebank. Moody’s will also not rate any contingent capital security thatuses a credit rating in a conversion trigger. Additionally, at this time, Moody’s will not rate contingent capital securities where conversion into common equity is subject to thediscretion of regulators or the breach of regulatory capital triggers.

As I’ve said before, using regulatory capital triggers is thoroughly insane. What if the prescribed calculation changes? What if the regulatory minimum rises above the trigger point?

.However, in the future, if clear regulatory rule sets develop that would significantly enhance the predictability of a triggering event, Moody’s may then assign a rating. Any rating Moody’s assigns to a contingent capital security would be no higher than the rating on the issuing bank’s non-cumulative preferredsecurities. The rating on the contingent capital security would also likely be non-investment-grade, regardless of the bank’s financial strength.

Contingent Capital

BoC's Longworth Supports Contingent Capital

David Longworth, Deputy Governor of the Bank of Canada, delivered a speech to the C D Howe Institute, Toronto, 17 February 2010, titled Bank of Canada liquidity facilities – past, present, and future. It’s a good review of the actions taken by the BoC during the credit crunch to address liquidity problems, albeit lamentably short of meat.

For instance, he emphasizes the importance of penalty rates in avoiding moral hazard:

Fifth, and finally, the Bank should mitigate the moral hazard of its intervention. Such measures include limited, selective intervention; the promotion of the sound supervision of liquidity-risk management; and the use of penalty rates as appropriate.

but nowhere attempts to quantify the penalties that were actually applied.

One of the things that scares me about the regulatory response to the crisis is the central counterparty worship. Mr. Longworth lauds the BoC’s role in:

Encouraging and overseeing the implementation of liquidity-generating infrastructure, such as a central counterparty for repo trades, that help market participants self-insure against idiosyncratic shocks

Central counterparties reduce the role of market discipline in the interbank marketplace by offering a third party guarantee of repayment; I can therefore lend a billion to Dundee Bank with the same confidence that I lend to BNS. Additionally, they soak up bank capital; the counterparty has to be capitalized somehow and it may be taken as a given that the total bank capital devoted to the maintenance of the central counterparty will be greater than the bank capital devoted to the maintenance of a distributed system. Finally, while I agree that a central counterparty will decrease the incidence of systemic collapse, I assert that it will increase the severity; I claim that basic engineering good practice will seek to reduce the incidence of catastrophic single point failure, not increase it!

He also addressed the headline issue, noting the potential for:

Requiring the use of contingent capital or convertible capital instruments, perhaps in the form of a specific type of subordinated debt, to help ensure loss absorbency and thus reduce the likelihood of failure of a systemically important institution.

Footnote: The BCBS press release of 11 January 2010 entitled, “Group of Central Bank Governors and Heads of Supervision reinforces Basel Committee reform package,” announces that the “Basel Committee is reviewing the role that contingent capital and convertible capital instruments could play in the regulatory capital framework.” See also “Considerations along the Path to Financial Regulatory Reform,” remarks by Superintendent Julie Dickson, Office of the Superintendent of Financial Institutions, 28 October 2009

I have added a link in the above to the PrefBlog review of the Dickson speech; I will attend to the BIS press release shortly.

Most of the commentary I’ve seen discusses contingent capital solely as the concept applies to subordinated debt; I will assert that logically, if the subordinated debt is liable to become common equity, then more junior elements of capital such as preferred shares must also have this attribute.