PrefBlog

Alan S. Blinder, the Gordon S. Rentschler Memorial Professor of Economics and Public Policy at Princeton University and former Vice-Chairman of the Fed’s Board of Governors, gave a wonderfully informative and chatty speech at the Federal Reserve Bank of Boston conference at Chatham, Massachussets, on October 23, 2009 titled
It’s Broke, Let’s Fix It: Rethinking Financial Regulation.

One quote I simply must highlight is:

After all, regulatory failure on a grand scale was one major cause of the mess.

However, at the moment I am more interested in his thoughts on Contingent Capital than anything else:

I myself am attracted to a particular idea for “contingent capital” suggested recently by the Squam Lake Working Group on Financial Regulation, an ad hoc panel of academic experts. Under the proposal, regulators would have the power, by declaring a systemic crisis, Their idea, which derives from Mark Flannery’s (2005) clever earlier proposal for “reverse convertible debentures,” is to require certain banks to issue a novel type of convertible bond. Conventional convertible debt gets exchanged for equity at the option of the bondholder; and because this option has value, convertible debt bears lower interest rates than ordinary debt. The proposed new form of convertible debt would reverse the optionality by giving it to the regulators instead.

Under the proposal, regulators would have the power, by declaring a systemic crisis, to force holders of these special convertibles (but not holders of other debt instruments) to convert to equity. As in many cases, one key question is price—specifically, how large an interest rate premium would investors demand to cover the risk that their bonds could be converted into equity against their will? If this premium proved to be very large, these new convertibles would be a very expensive form of “capital” that banks might shun, preferring ordinary equity instead. Only experience will tell. —thus giving banks more equity capital (and less debt) just when they need it most. Naturally, the existence of such an option would detract from the value of the bond and therefore would make the interest rate on reverse convertibles higher than on ordinary debt. Indeed, if the requirement was limited to TBTF institutions, as seems appropriate, that higher interest rate on a fraction of their debt would constitute a natural penalty cost for being TBTF. Furthermore, the spread on this new type of debt over regular debt could become a useful market indicator of the likelihood of a systemic crisis.

As in many cases, one key question is price—specifically, how large an interest rate premium would investors demand to cover the risk that their bonds could be converted into equity against their will? If this premium proved to be very large, these new convertibles would be a very expensive form of “capital” that banks might shun, preferring ordinary equity instead. Only experience will tell.

I have previously discussed the Squam Lake proposals, as well as the original Flannery paper; I think they need a little work. My major objections are that:

• It mixes book value with market value; theoretically suspect and leading in times of stress to unpredictable – probably procyclical – results, and
• by incorporating regulatory discretion into the conversion trigger, it unnecessarily introduces regulatory uncertainty into the evaluation of the investment, as well as encouraging regulatory capture and even corruption.

He breaks my heart by advocating credit ratings by government agencies:

But many observers think the fundamental problem lies deeper: with the issuer-pays model. As long as rating agencies are for-profit companies, paid by the issuers of the securities they rate, the agencies will have a natural tendency to try to please their customers—just as any business does. Unfortunately, the most obvious alternative, switching to an investors-pay model, is probably infeasible except in markets with very few investors. Otherwise, information flows too readily, and everyone wants to free ride. What to do? The way out of this dilemma, it seems to me, is to arrange for some sort of third-party payment. The government (e.g., the SEC) or an organized exchange or clearinghouse seem to be the natural alternative payers. In either case, they could raise the necessary funds by levying a user-fee on all issuers.

He also discusses the separation of prop trading from vanilla banking:

For example, the Group of Thirty (2009, p. 28)—hardly a bunch of wild-eyed radicals–recently concluded that, “Large, systemically important banking institutions should be restricted in undertaking proprietary activities that present particularly high risks…and large proprietary trading should be limited by strict capital and liquidity requirements.” That’s not quite a ban, but it’s getting close.

But there is a downside. Roping off “proprietary trading” from other, closely-related activities of banks is not as easy as it sounds. For example, banks buy and sell securities, foreign exchange, and other assets for their clients all the time. Often, such buying and selling is imperfectly synchronized or leaves banks with open positions for other reasons. Does that constitute “proprietary trading”? Furthermore, market-making has obvious synergies with dealing on behalf of clients. Do we want to label all such activities as “proprietary trading”? The point is: There is no bright line. That is why Adair Turner (2009), the chairman of Britain’s FSA, concluded that “we could not proceed by a binary legal distinction—banks can do this but not that—but had to focus on the scale of position-taking and the capital held against position-taking.”

I say – yes. we do want to label all such activities as “proprietary trading”; and the fact that there is no bright line is just something we’ll have to get used to. As previously urged on PrefBlog, I suggest that there be two regulatory regimes – for investment banks and vanilla banks, the former imposing relatively heavier capital charges on long term positions, the latter imposing relatively heavier charges on short term positions. It won’t be perfect, by any stretch of the imagination; but it will allow each type of institutions to make decisions on a tactical basis, according to their marginal value.

One of the things that brought down the investment banks was that they engaged in buy-and-hold strategies, which are more properly the province of vanilla banks, which have (or should have!) the expertise and controls in place to look beyond the next portfolio flip.

This entry was posted on Saturday, October 31st, 2009 at 8:24 pm and is filed under Contingent Capital, Interesting External Papers. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.