HM Treasury Discusses Contingent Capital

Her Majesty’s Treasury has released a discussion document on the role of banks titled Risk, reward and responsibility: the financial sector and society, which discusses contingent capital among other things:

In the recent crisis existing subordinated debt and hybrid capital largely failed in its original objective of bearing losses. Going-concern capital instruments often failed to bear losses because banks felt unable to cancel coupon payments or not call at call-dates (even though it was more expensive to refinance), in part for fear of a negative investor reaction as well as due to the legal complexity of the instruments. Gone-concern capital such as Lower Tier 2 has often failed to bear losses in systemic banks as governments have been forced to step in to prevent insolvency in part to prevent further systemic impacts on debt-holders such as insurance companies. CRD 2, the first in a series of forthcoming packages amending the Capital Requirements Directive, sets out criteria for the eligibility of hybrid capital instruments as original own funds of credit institutions. It also provides a limit structure for the inclusion of hybrid capital instruments in own funds.

Box 3.D reviews academic proposals for Contingent Capital:

Debt-for-Equity Swap – Raviv (2004) [1]
The proposal is for debt that pays its holder a fixed income unless the value of the bank’s capital ratio falls below a predetermined threshold (based on a regulatory measurement). In this event, the debt is automatically converted to the bank’s common equity according to a predetermined conversion ratio (the principal amount may change upon conversion).

Contingent capital certificates – Flannery (2009) [2]

Similar to the above, contingent capital certificates are debt that pays a fixed payment to its holders but converts into common stock when triggered by some measure of crisis. In contrast to the above this would be a market-based measure, with conversion occurring if the issuer’s equity price fell below some pre-specified value. The converted debt would buy shares at the market price of common equity on the day of the conversion rather than at a predetermined price.

Capital Insurance – Kashyap, Rajan and Stein (2008) [3]

Under this proposal, the insurer would receive a premium for agreeing to provide an amount of capital to the bank in case of systemic crisis. The insurer would be required to hold the full insured amount, to be released back to the insurer once the policy matures. The policy would pay out upon the occurrence of a ‘banking systemic event’, for which the trigger would be some measure of aggregate write-offs of major financial institutions over a year-long period. Long-term policies would be hard to price and therefore a number of overlapping short-term policies maturing at different dates are proposed.

Tradable Insurance Credits – Caballero, Kurlat (2009) [4]

The central bank would issue tradable insurance credits, which would allow holders to attach a central bank guarantee to assets on their balance sheet during a systemic crisis. A threshold level or trigger for systemic panic would be determined by the central bank. An attached tradable insurance credit is simply a central bank backed Credit Default Swap (CDS).

1 Bank Stability and Market Discipline: Debt-for-Equity Swap versus Subordinated Notes. Raviv, Alon. 2004.

2 Contingent Tools Can Fill Capital Gaps, Mark Flannery, American Banker; 2009, Vol. 174 Issue 117.

3 Rethinking Capital Regulation Kashyap, Rajan, Stein, paper prepared for Federal Reserve Bank of Kansas City symposium on “Maintaining Stability in a Changing Financial System”, Jackson Hole, Wyoming, August, 2008

4 The “Surprising” Origin and Nature of Financial Crises: A Macroeconomic Policy Proposal, Ricardo J. Caballero and Pablo Kurlat, August 2009

As has been discussed on PrefBlog (as recently as last week), Flannery’s proposal makes most sense to me. The Capital Insurance proposal has been used in Canada, with the RBC CLOCS, but I am not convinced that such elements are reliable in terms of a crisis – to a large degree, this will simply shift the uncertainty and fear of a crisis onto the insurance providers.

Update, 2010-6-13: The Kashyap paper is available on-line.

One Response to “HM Treasury Discusses Contingent Capital”

  1. […] An older paper on Contingent Capital is Rethinking Capital Regulation by Kashyap, Rajan & Stein, referenced but not previously linked in HM Treasury Discusses Contingent Capital. […]

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