Depending on the choice of triggers and conversion rates, contingent capital instruments could be designed specifically to increase capital buffers, ensure prompt recapitalization, or increase loss absorbency before a bank-default event. Moreover, automatic conversion by avoiding fire sales could help avoid contagion in times of systemic stress.Ĭontingent capital instruments are expected to deal with the market failure associated with “too-important” or “too-connected” to fail. This latter “recapitalization gridlock” reflects the unwillingness of shareholders to dilute their equity by share issuance or by “fire sales” in unfavorable market conditions ( Brunnermeier, 2009 Adrian and Shin, 2010). It enables the raising of capital at times when other options are impossible, either owing to unfavorable market conditions or because they are unattractive to shareholders ( Duffie, 2010). Appendix 8.2 details contingent-capital triggers and conversion options and conditions, and Appendix 8.3 compares contingent capital with hybrid and subordinated debt instruments.Ĭontingent capital provides an automatic mechanism for increasing the capital and reducing the debt of a financial institution in times of stress. Appendix 8.1 presents a simple two-period model on how the expectation of a public bailout encourages excessive risk taking and how contingent-convertible bonds can mitigate such excesses. Next, the chapter discusses some recent contingent-capital proposals and the potential role of contingent capital in the framework of crisis prevention and crisis management. The following section focuses on the operational aspects of contingent capital instruments, especially the pros and cons of various triggers and conversion rates and how they could influence the rating and pricing of these instruments. The next section discusses the economic rationale for contingent capital instruments. The rest of this chapter is organized as follows. For example, some have cautioned against using triggers based on systemic risks or regulatory discretion, since these would make pricing these instruments difficult. Others also warn that a conversion could have negative signaling effects, lead to contagion, and be subject to price manipulation ( Sundaresan and Wang, 2010 Goodhart, 2010a). The quality of their design features is key to ensuring their effectiveness and avoiding risks, including systemic ones. Their marketability, including whether there will be sufficient demand for them from traditional investors, is far from granted. These instruments remain largely untested and could have unintended consequences, particularly in times of high market volatility and uncertainty. Furthermore, automatic conversion by avoiding fire sales could help avoid contagion in times of systemic stress.Ĭoncerns have been raised, however, about the operational aspects of CoCos and their implications for market dynamics. It enables the raising of capital at times when other options are impossible, either owing to unfavorable market conditions or because other options are unattractive to shareholders. The Financial Stability Board (FSB) and the European Commission, in their efforts to address risks associated with systemically important financial institutions (SIFIs), are also examining mechanisms that convert debt into equity or the write-off of debt (including unsecured senior debt), based on (i) contractual agreements between banks and investors or (ii) supervisors’ statutory powers in the context of bank resolution.Ĭontingent convertible capital (CoCo) provides an automatic mechanism for increasing the equity capital and reducing the debt of a financial institution in times of stress. The Basel Committee on Banking Supervision (BCBS) has similarly proposed that all non-common equity regulatory capital of internationally active banks be convertible to equity or subject to permanent write-downs when it is determined that the bank is no longer viable. 2 Most recently, Switzerland has proposed a higher regulatory capital requirement (19 percent of risk-weighted assets) for its two largest banks, of which 9 percentage points may be held in the form of contingent-convertible debt. To address moral hazard and the problem that institutions can become too important to fail, proposals for contingent capital are gaining ground. These interventions have not only contributed to a significant increase in sovereign exposures but, in many countries, they have also risked weakening market discipline and worsening moral hazard. In particular, many governments in the crisis-hit countries had to provide unprecedented levels of support to contain the crisis and protect financial stability. The causes of the global financial crisis were multifaceted, but they revealed still unresolved weaknesses in national and international financial oversight and resolution frameworks.
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