This is the second installment of a series of previews of the papers being presented at the AALS Financial Institutions & Consumer Financial Services Section meeting this Sunday from 9 am to 10:45 am at the Marriott Wardman Park.
If the first paper I previewed looks at the challenges of disintermediation and allocating regulatory responsibility, the second paper that will be presented looks at another fundamental question facing financial institution regulation: how can regulation harness market discipline effectively? Christoph Henkel (Mississippi College School of Law) and Wulf Kaal (Univ. of St. Thomas) take a deep, nuanced look at one approach, contingent capital requirements, in their paper Taking Contingent Capital Seriously – The Prospect of Sequential Triggers in Europe and the United States. Contingent capital describes debt instruments that would automatically convert into equity upon the occurrence of a trigger event (which might be defined in a regulation). The trigger would be set to signal the failing health of a financial institution. Contingent capital provides an additional cushion for failing firms as well as a systemic risk buffer for financial markets.
Here is Henkel and Kaal’s abstract:
Contingent capital has great potential to help make systemically important financial institutions safer and help avoid another financial crisis. United States policy makers may not have fully utilized the potential of contingent capital. A draft by the EU Commission already suggests the mandatory issuance of contingent capital securities in the resolution phase of systemically important banks in Europe. The Dodd Frank Act mandates a study on the feasibility of contingent capital. This article proposes the use of contingent capital with a sequential trigger as an early preventative tool and as a reorganization tool before liquidation and independent of protection under bankruptcy proceedings. The first preventative trigger would convert a fixed amount of debt to equity at a stage when the institution is still sound on a micro prudential basis, but shows early signs of substantial weakening. The second reorganization trigger would increase voting rights for holders of contingent capital after conversion to equity at the reorganization stage. Sequential triggers could incentivize corrective actions by bank management. The second trigger introduces a quasi preparation stage for bankruptcy, independent of management decisions or corrective action by regulators. The proposal would work seamlessly with the regulatory framework proposed by the EU Commission and could provide U.S. policy makers with a new perspective on the multiple uses of contingent capital in the context of bank restructuring.
Contingent capital has emerged as one of the most innovative potential responses to the financial crisis. A few years back, Rob Beard blogged at the Conglomerate on CoCo bonds, one version of contingent capital.
Contingent capital has a long intellectual lineage, including proposals to replace or supplement capital requirements with subordinated debt. However, the track record in Europe of bank subordinated debt serving as a buffer and early warning system during the crisis was less than stellar.
One response to this: subordinated debt instruments were poorly designed. But how should sub debt, contingent capital, or other market discipline instruments be designed? We need to move beyond the “concept car – looks sexy at the auto fair” phase to doing the safety and road testing to make sure the car doesn’t explode in a turnpike pileup. Attention to the engineering details is the real strength of the Henkel and Kaal paper.
Designing these instruments properly is a high stakes job. The challenge facing market discipline proposals is that we most need them to work when markets go haywire. This is a challenge, indeed, for all financial institution regulation.
I look forward to hearing Henkel present the paper and to the comments by discussant Mehrsa Baradan (BYU).
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