Magazine article American Banker

VIEWPOINT: Contingent Tools Can Fill Capital Gaps

Magazine article American Banker

VIEWPOINT: Contingent Tools Can Fill Capital Gaps

Article excerpt

Byline: Mark J. Flannery

The recently completed stress tests provide estimated capital deficiencies for 19 large U.S. institutions. Much of this "capital gap" was quickly filled by the issuance of standard equity or debt instruments.

The market's willingness to purchase bank shares and uninsured debt bodes well for the current state of the financial system. At the same time, traditional capital instruments cannot fully address public policy concerns about bank stability.

Bankers and bank investors find it more profitable to operate with leverage. But this leverage creates the threat of financial instability.

A new type of capital instrument could permit reasonable levels of bank leverage while stabilizing financial institutions. These securities have been labeled "contingent capital certificates." They would be less expensive for bankers in normal times but would protect customers (and taxpayers) if a bank suffered unexpected losses.

Equity capital protects an institution's depositors and other customers from credit and trading losses. Though the Basel accord recognizes some bond liabilities as Tier 2 capital, bank supervisors have been unwilling to impose losses on bank debtholders. Instead, governments have issued costly guarantees or purchased large amounts of bank equity.

Protecting debtholders has a vital benefit for public policy. Bank debt absorbs losses only if the bank enters some sort of bankruptcy procedure, which obliterates the confidence upon which modern banking firms rely so heavily. Counterparties cannot be sure how or when they would be repaid after a bank fails, particularly if it operates in multiple countries. The financial markets therefore pull back from a weak bank, probably hastening its demise.

Because the standard type of bank debt cannot be permitted to suffer losses, regulators support large, troubled banks at taxpayers' expense. The long-run costs of this "too big to fail" policy include severe impediments to the market's future ability to limit risk-taking.

It would be helpful if banks raised equity as losses began to accumulate. However, that is exactly when outside investors are most skeptical and least willing to purchase equity. A far better alternative is to arrange for equity issuance during calmer times.

Contingent capital certificates are sold as debt liabilities that offer periodic, tax-deductible interest payments. Unlike conventional debt obligations, however, the certificates would be converted into new shares if the issuing bank's capital ratio fell too low. If losses absorbed enough of the bank's initial equity, some debt would convert to equity. The resultant leverage reduction would make default less likely.

CCCs would differ from conventional convertible bonds in two important ways. …

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