Aurora Borealis
1 January 2014 CFA Institute Journal Review

How to Design a Contingent Convertible Debt Requirement That Helps Solve Our Too-Big-to-Fail Problem (Digest Summary)

  1. Santosh Pokharel

Recent experience has revealed that banks and financial institutions do not tend to measure or manage risk very well, and consequently, they do not replace lost equity capital in a timely manner. The reason is not because of a lack of skills but rather a lack of the right incentives. Properly designed convertible contingent capital could provide the right incentive for systemically important financial institutions to implement a strong system for risk measurement and management and to raise additional capital or sell assets in a timely manner.

What’s Inside?

The authors argue that neither more equity capital nor intensive supervision, as emphasized by Basel III, are enough to address the problems of risk management and capital adequacy in too-big-to-fail financial institutions. They propose that the right way forward is to create new requirements for convertible contingent capital that provide the right incentive for risk management and capital adequacy and that supplement supervisory oversight with market discipline.

How Is This Research Useful to Practitioners?

The recent financial crisis highlighted the need for a better understanding of banks’ balance sheets. The crisis also underscored that having adequate capital as defined by Basel requirements is not going to be sufficient if banks do not have a proper risk management system in place. It is now well known that banks generally tend to understate risk and fail to identify their exposure to risk.

In terms of Basel III, the focus since the financial crisis has been on more and better-quality capital and intensive supervision. But the authors argue that neither more equity nor intense supervision is going to solve the problem for systemically important financial institutions (SIFIs) or too-big-to-fail banks. Although having more equity capital is a move in the right direction, they contend that more capital will not solve the problem because the solution lies in creating the right incentive for SIFIs to manage risk and maintain adequate capital. Going beyond a certain threshold (9.5% of risk-weighted assets according to the Basel III requirements for SIFIs) for equity requirements does not make sense because the risk of default can be reduced in less costly ways.

The authors propose a convertible contingent capital (CoCo) requirement for banks to maintain the right amount of capital because a properly designed CoCo requirement will establish the right incentives for banks to maintain capital in relation to risk. Although the idea of CoCo requirements has been widely used by banking scholars as a contractual structure for increasing capital in adverse states of the world, this particular proposal differs in the following ways: (1) The amount of CoCo required is a percentage of assets; (2) it calls for the creation of a new ratio based on the 90-day moving average ratio of market value of equity to the sum of market value of equity and face value of debt, called the quasi-market-value-of-equity ratio (QMVER), to use as a trigger for the conversion from bond to equity; and (3) the conversion rate, or the amount of equity to be issued in exchange for the CoCo, is dilutive for current shareholders. These differences provide SIFIs with the right incentives for risk management and to take remedial measures to raise equity well before they face a substantial risk of insolvency.

To create the right incentives, the authors propose the following specific combination of CoCo design features: (1) The amount of CoCo should be set at 10% of the book value of assets, (2) the trigger for QMVER should be set at 8%, and (3) the conversion ratio should be set so that it is 5% dilutive for existing shareholders.

In past financial crises, bank managers and regulators have hesitated to act proactively to raise the capital necessary, either through the sale of assets or new equity, to prevent a crisis precipitated by the loss of assets. Tracking the QMVER ratio would have given at least six months’ warning before the 2008 difficulties at AIG and Lehman Brothers. With the automatic conversion of CoCo or a sale of equity to prevent the dilutive conversion, capital is automatically and proactively raised before the crisis worsens. Banks may also take less risk if they know that the capital to cover losses is more likely to be sourced from the dilution of management and shareholder holdings rather than from a public bailout.

How Did the Authors Conduct This Research?

The authors use a literature review and desk-based study to carry out this research. Their research is not based on empirical findings, and no datasets are used to carry out the research apart from a time-series analysis on QMVER, which is derived from the CRSP database.

Abstractor’s Viewpoint

As the authors mention, the idea of CoCo has been around for a long time and has recently received widespread attention as one of the alternative measures to provide a buffer for a bank’s capital base. This particular proposal is different in that it focuses on three specific features for CoCo. The authors argue that these features help create the necessary incentive for SIFIs to adopt proper risk management systems and raise capital when required. It is unclear whether their specifics will work in the next crisis because the authors’ research/analysis is mostly ex post and lacks original empirical findings.

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