Convertible Securities and Bankruptcy Reforms: Addressing Too Big to Fail and Reducing the Fragility of the Financial System*

Eliminating too big to fail should be the first priority of any regulatory reform. But this is easier said than done. As the crisis has taught us, when the systemic risks are perceived to be large, regulators will be very reluctant to close down insolvent firms or impose losses on creditors. So how do we reduce these risks so that regulators can credibly commit to a policy of allowing financial companies to fail and not resort to rescues or bailouts? The author proposes two complementary approaches to this problem: The first is to design capital structures with corrective mechanisms that kick in when a financial firm displays signs of trouble, but still has positive economic capital. To this end, the author endorses the Squam Lake Report's proposal that encourages financial firms to issue convertible debt with an “automatic” provision for converting to equity. In contrast to the Squam Lake proposal, however, the author argues that the conversion to equity should not depend on regulators' decisions and should take place before individual banks and the financial system are in full crisis mode. The second approach is to design a resolution mechanism that will close failing financial firms when early intervention has not led to the firm's recovery. The author argues that the best model for this mechanism is bankruptcy, because of its resolution of claims according to predetermined rules rather than regulatory discretion. However, certain forms of early intervention can also help to lower the costs of permitting firms to fail. For example, the Squam Lake idea that financial institutions be required to develop living wills should make it easier to unwind these firms in an orderly fashion and provide regulators with insight into the degree of systemic risk that these firms impose. The author notes that the challenges associated with getting the executives of healthy banks to plan for their own bankruptcy may indicate that a better use of regulatory resources might be to view the living will as one of the tools of prompt corrective action for firms that become undercapitalized but are still solvent. Once a firm has been declared undercapitalized, regulators would have greater bargaining power to insist on a serious plan for bankruptcy.     

The Squam Lake Report: Fixing the Financial System*

In these excerpts from The Squam Lake Report, fifteen distinguished economists analyze where the global financial system failed, and how such failures might be prevented (or at least their damage better contained) in the future. Although there were many contributing factors to the crisis—including “agency” problems throughout the financial system and a bankruptcy code poorly suited for reorganizing financial firms—at the core of the problem is a potential conflict between the risk-taking proclivity of financial institutions and the interests of the economy at large that must be managed at least in part through more effective regulation. The Squam Lake Report provides a nonpartisan plan to transform the regulation of financial markets in ways designed to limit systemic risk while preserving—to the extent possible and prudent—the economies of scale and scope that justify the existence of today's large financial institutions. To reduce the risks that large banks will fail, the authors call for higher capital requirements based on more effective assessments of the risks of bank assets and liabilities, as well as a new systemic regulator that should be part of the central bank. To reduce the costs of failure when it occurs, the authors propose that banks be required to create “living wills” laying out their plan to sell assets or shut down operations in the event of financial trouble. As part of that plan, regulators are urged to “aggressively encourage” banks to issue “contingent” debt capital securities that convert into equity.     

Aligning Incentives at Systemically Important Financial Institutions: A Proposal by the Squam Lake Group

To address the moral hazard problem that can motivate bank executives to take excessive risks and to fail to raise capital when needed, a group of 13 distinguished financial economists recommends that systemically important financial institutions be required to issue contingent convertible debt (CoCos) and to hold back a substantial share—as much as 20%—of the compensation of employees who can have a meaningful impact on the survival of the firm. This holdback should be forfeited if the firm's capital ratio falls below a specified threshold. The deferral period should be long enough—the authors suggest five years—to allow much of the uncertainty about managers' activities to be resolved before the bonds mature. Except for forfeiture, the payoff on the bonds should not depend on the firm's performance, nor should managers be permitted to hedge the risk of forfeiture. The threshold for forfeiture should be crossed well before a firm violates its regulatory capital requirements and well before its contingent convertible securities convert into equity. The Swiss Bank UBS has paid bonuses to its top 6,500 executives that have been structured in exactly this way. Management forfeits its deferred compensation if the bank's regulatory capital ratio falls below 7.5%, and its contingent convertible debt is set up to convert into equity if the bank's capital ratio falls below 5%.     

Contingent capital with a dual price trigger

This paper evaluates a form of contingent capital for financial institutions that converts from debt to equity if two conditions are met: the firm's stock price is at or below a trigger value and the value of a financial institutions index is also at or below a trigger value. This structure potentially protects financial firms during a crisis, when all are performing badly, but during normal times permits a bank performing badly to go bankrupt. I discuss a number of issues associated with the design of a contingent capital claim, including susceptibility to manipulation, whether conversion should be for a fixed dollar amount of shares or a fixed number of shares; uniqueness of the share price when contingent capital is outstanding; the susceptibility of different contingent capital schemes to different kinds of errors (under and over-capitalization); and the losses likely to be incurred by shareholders upon the imposition of a requirement for contingent capital. I also present an illustrative pricing example.     

The Squam Lake Report: Fifteen economists in search of financial reform

The Squam Lake Report is a volume by economists for economists. It offers the fruits of the labors of 15 top economists who met at Squam Lake, New Hampshire, to discuss financial reform. While somewhat disjointed, and avoiding many important issues, the book is nonetheless a tour du force. Its many recommendations derive from two basic principles: that reformers need to think systemically, and that third-party costs stemming from systemic risk need to be internalized. And its approach is just what you would expect from a group of academic economists. It asks (and answers) questions like: Where did incentives go wrong? What were the sources of market failure? How can we better protect society against negative externalities?.     

Contingent Capital vs. Contingent Reverse Convertibles for Banks and Insurance Companies

During the credit and liquidity crisis in 2007 and 2008, banks found themselves largely unable to raise significant new equity quickly from parties other than sovereign wealth funds and governments. Some banks have thus recently begun to consider contingent capital as a means of pre‐arranging recapitalizations for future crises. Contingent capital is a type of put option that entitles a company to issue new securities on pre‐negotiated terms, often following the occurrence of one or more risk‐based triggering events. This article compares the economic merits of a new security—a “contingent reverse convertible” or CRC—against more traditional forms of contingent capital. In November 2009, Lloyds Banking Group plc issued “Enhanced Capital Notes”—subordinated debt that converts into common stock if Lloyds's core regulatory capital falls below 5% of its regulatory risk‐weigh ted assets. This CRC is not strictly speaking a form of contingent capital, but it does give banks the potential to recapitalize themselves quickly in the face of a crisis without having to turn to governments and taxpayers. One important limitation of CRCs is that because they do not generate new cash for a bank at the time of conversion, they are unlikely to stop a liquidity crisis once it has begun. More traditional contingent capital facilities, by contrast, do put cash in the hands of the issuer at the time the facility is drawn. But even for those inclined to use CRCs, it may be unrealistic to expect many other institutions to imitate the structure of the Lloyds offering. Persuading existing investors to take a more subordinated position in a bank's capital structure and write a put option to the bank on its own stock will be neither cheap nor easy. For this reason, the more traditional solutions used to date may have more success with banks, though arriving at a price that helps issuers and satisfies investors will be a challenge for those structures as well.     

Minimum capital requirements,bank supervision and special resolution schemes. Consequences for bank risk-taking

This paper analyzes the incentive effects of special bank resolution schemes which were introduced during the recent financial crisis. These schemes allow regulators to take control over a systemically important financial institution before bankruptcy. We ask how special resolution schemes influence banks’ risk-taking and whether regulators should combine them with minimum capital requirements. We model a single bank which is supervised by a regulator who receives an imperfect signal about the bank's probability of success. We find that capital requirements are better than resolution from a welfare point of view if the quality of the signal is low, if it is difficult for the bank to attract deposits, or if the project return is low.     

How to Design a Contingent Convertible Debt Requirement That Helps Solve Our Too‐Big‐to‐Fail Problem*

As bank regulatory reform tries to come to grips with the lessons of the financial crisis, several experts have proposed that some form of contingent convertible debt (CoCo) requirement be added to the prudential regulatory toolkit. In this article, the authors show how properly designed CoCos can be used not just to absorb losses, but more importantly to encourage banks to recognize losses and replace lost equity in a timely way, as well as to manage risk more effectively. Their proposed CoCos requirement strengthens management's incentives to promptly replace lost capital and enhance risk management by imposing major costs on the managers and existing shareholders of banks that fail to do so. Key elements of the proposal are that conversion of the CoCos into equity would be (1) triggered at a high trigger ratio of equity to assets (long before the bank is near an insolvency point), (2) determined by a market trigger (using a 90‐day moving average market equity ratio) rather than by supervisory discretion, and (3) significantly dilutive to shareholders. The only clear way for bank managements to avoid such dilution would be to issue equity into the market. Under most circumstances—barring an extremely rapid plunge of a bank's financial condition—management should be able and eager to replace lost capital in a timely way; as a result, dilutive conversions should almost never occur. Banks would face strong incentives to maintain high ratios of true economic capital relative to risky assets, and to manage their risks effectively. This implies that “too‐big‐to‐fail” financial institutions would not be permitted to approach the point of insolvency; they would face strong incentives to recapitalize long before that point. And if they should fail to issue new equity in a timely manner, the CoCos conversion would provide an alternative means of recapitalizing banks well before they reach the brink of insolvency. Thus, a CoCos requirement would go a long way to resolving the “too‐big‐to‐fail” problem. Such a CoCos requirement would not only increase the effectiveness of regulation, but also reduce its cost. It would be less costly for banks to raise CoCos than equity, reflecting both the lower adverseselection costs of CoCos issuance and the potential tax advantages of debt. And precisely because of the low probability of CoCo conversion, the Cocos would be issued at relatively modest (if any) discounts to otherwise comparable but straight subordinated debt. Thus requiring a mix of equity and appropriately designed CoCos would be less costly to banks, and would entail less of a reduction in the supply of loans than would a much higher book equity requirement alone.     

Capital Adequacy Pre- and Postcrisis and the Role of Stress Testing

The financial crisis forced the development of new approaches for determining capital adequacy in banks since extant methods clearly did not prepare banks or their supervisors sufficiently. The success of stress testing as a crisis response tool, particularly in the U.S. in 2009, has led to its adoption postcrisis as the tool of choice for assessing capital adequacy in banks and testing resiliency to economic and financial shocks. But the increased reliance on stress testing in financial peacetime has given rise to a new risk concentration, namely, in the rather narrow set of scenarios and their translation to outcomes and impact on bank financials.     

CoCo Bonds,Conversion Prices and Risk Shifting Incentives. How Does the Conversion Ratio Affect Management's Behaviour?

The aim of this paper is to analyze risk shifting incentives for managers and shareholders of the financial institution issuing a CoCo bond. We assess the role of the conversion price settlement in enhancing both shareholders’ and management's discipline. Three recent contingent reverse convertible deals are analyzed, with the intention of showing how shareholder conversion returns are linked to the conversion ratio. The findings demonstrate that, in the case of an ingoing or ongoing crisis, a poor settlement of the conversion ratio could exacerbate both debt overhang and risk shifting issues. This will end in discouraging bank management from issuing new equity and from investing in low risk assets. We argue that a contingent bond triggered on Basel III capital requirement ratios and having a significantly discounted conversion price reduces risk shifting incentives. Moreover, we illustrate how the unexpected wealth transfers between CoCo bondholders and shareholders tends to zero when the bond face value is higher than the current stock market price and there is a concentration of bond subscribers. Accordingly, regulators should consider and oversee not only the conversion trigger but also all the other features of a contingent capital security, especially the conversion ratio.     

A Review of the Role of Financial Reporting in the Global Financial Crisis

The aim of this article is to review the recent literature that examines the performance of financial reporting in the Global Financial Crisis (GFC). In analysing the GFC a large number of commentators have attributed blame to financial reporting, in particular to the use of fair values (FVs) in reporting financial instruments in bank balance sheets. Based on a review of the emerging evidence, the main conclusions are that: (i) there is no empirical evidence that fair‐value accounting (FVA) during the GFC added to the severity of the crisis; (ii) further research is required to determine whether FVA in the years immediately preceding the crisis exacerbated the GFC because of the possibility that some of the FV gains reported may have been illusory; (iii) the existing literature has largely ignored the role of financial reports in the determination of a firm's cost of capital, although it is through this avenue that, in a crisis, financial reporting could play its most significant role; and (iv) the bulk of the commentary associated with financial reporting and the GFC has revolved around the valuation objective of financial reporting, even though financial reports also have a stewardship objective. Failure of financial reporting to satisfy this objective in the years preceding the GFC could have exacerbated the crisis. More consideration needs to be given to this latter issue to enable a complete assessment of the role of financial reporting in the GFC.     

Transmission of the financial and sovereign debt crises to the EMU: Stock prices,CDS spreads and exchange rates

This paper tests for the transmission of the 2007–2010 financial and sovereign debt crises to fifteen EMU countries. We use daily data from 2003 to 2010 on country financial and non-financial stock market indexes to analyze the stock market returns for three country groups within EMU: North, South and Small. The following results hold for both the North and South European countries, while the smallest countries seem to be relatively isolated from international events. First, we find strong evidence of crisis transmission to European non-financials from US non-financials, but not for financials. Second, in order to test how the sovereign debt crisis affects stock market developments we split the crisis in pre- and post-Lehman sub periods. Results show that financials become significantly more dependent on changes in the difference between the Greek and German CDS spreads after Lehman’s collapse, compared to the pre-Lehman sub period. However, this increase is much smaller for non-financials. Third, before the crisis euro appreciations coincide with European stock market decreases, whereas this relationship reverses during the crisis. Finally, this reversal seems to be triggered by Lehman’s collapse.     

Financial crisis and bank executive incentive compensation

We study the executive compensation structure in 14 of the largest U.S. financial institutions during 2000–2008. We focus on the CEO's purchases and sales of their bank's stock, their salary and bonus, and the capital losses these CEOs incur due to the dramatic share price declines in 2008. We consider three measures of risk-taking by these banks. Our results are mostly consistent with and supportive of the findings of Bebchuk, Cohen and Spamann (2010), that is, managerial incentives matter — incentives generated by executive compensation programs are correlated with excessive risk-taking by banks. Also, our results are generally not supportive of the conclusions of Fahlenbrach and Stulz (2011) that the poor performance of banks during the crisis was the result of unforeseen risk. We recommend that bank executive incentive compensation should only consist of restricted stock and restricted stock options — restricted in the sense that the executive cannot sell the shares or exercise the options for two to four years after their last day in office. The above incentive compensation proposal logically leads to a complementary proposal regarding a bank's capital structure, namely, banks should be financed with considerably more equity than they are being financed currently.     

Dynamic capital structure and the contingent capital option

The financial crisis has emphasized the difficulties for financial companies to raise funds through conventional liabilities. In this environment, hybrid securities are becoming popular. In this paper we study the optimal capital structure of a company issuing a particular type of hybrid security: perpetual contingent capital, i.e., debt that converts into equity under some conditions. A two-period model with endogenous bankruptcy for a company with equity, straight debt and contingent capital is analyzed. We investigate the instrument under different conversion rules: automatic or optimally chosen by equity holders. We show that contingent capital reduces the coupon of straight debt and expected bankruptcy costs but can require a high spread. A trigger imposed by the regulatory authority in terms of par value of debt may induce a little use of contingent capital with an increase of bankruptcy costs.     

Extreme risk spillover network: application to financial institutions

Using the CAViaR tool to estimate the value-at-risk (VaR) and the Granger causality risk test to quantify extreme risk spillovers, we propose an extreme risk spillover network for analysing the interconnectedness across financial institutions. We construct extreme risk spillover networks at 1% and 5% risk levels (which we denote 1% and 5% VaR networks) based on the daily returns of 84 publicly listed financial institutions from four sectors—banks, diversified financials, insurance and real estate—during the period 2006–2015. We find that extreme risk spillover networks have a time-lag effect. Both the static and dynamic networks show that on average the real estate and bank sectors are net senders of extreme risk spillovers and the insurance and diversified financials sectors are net recipients, which coheres with the evidence from the recent global financial crisis. The networks during the 2008–2009 financial crisis and the European sovereign debt crisis exhibited distinctive topological features that differed from those in tranquil periods. Our approach supplies new information on the interconnectedness across financial agents that will prove valuable not only to investors and hedge fund managers, but also to regulators and policy-makers.     

THE BALANCED CAPITAL STRUCTURE

At leading companies, financial executives are becoming business partners rather than just scorekeepers. In this environment, capital structure can be a source of competitive advantage, and financial strategy issues are critical: Should your company buy back shares or issue stock, grow internally or join the M & A boom, issue fixed-rate debt or stay floating? These decisions must be addressed one company at a time, balancing the competing priorities of cost, risk, and flexibility. The most important issue, target leverage, depends on the company's desired risk profile, growth plans, and debt cost considerations. But market conditions are also very important: Can the company access the equity market? How will a repurchase announcement be interpreted? Market conditions also affect the raising of debt capital. Rather than maintaining a constant mix of fixed- to floating-rate debt, companies should shift the mix during high- or low-yield environments. Many other financing issues will effectively be decided by market convention. For example, meeting a company's needs with respect to seniority, maturity structure, call flexibility, and financial covenants is often accomplished simply by choosing the market that most closely matches the firm's cost and risk preferences.     

Contingent convertibles. Solving or seeding the next banking crisis?

A recent proposal to enhance banking stability recommends the use of contingent convertibles (CoCos). Since these hybrid securities are mandatorily converted into equity when banks are in need of a recapitalization, they are credited for reducing banks’ likelihood of financial distress. In this paper, we show within a continuous-time framework that this allegedly beneficial impact hinges critically on the assumption of complete contracts. If contracts are incomplete in the sense that manager-owners enjoy discretion over the risk of the investment program, our analysis shows that CoCo bonds always distort risk taking incentives. Our main contribution is to demonstrate that there exist conditions under which CoCo bond financing increases investors’ wealth, but also increases the bank’s probability of financial distress, so that the banking system as a whole will be destabilized. Thus, individually rational decisions can have systemically undesirable outcomes. Further results indicate that CoCos should be used only in conjunction with devices to control risk shifting incentives.     

CARE/CEASA Roundtable on: Liquidity and Capital Management

Five distinguished banking and accounting scholars explore the role of liquidity at not only the “macro” level of the economy, but also at the level of individual companies. The first of the four main speakers, who is the author of the preceding article, restates his argument that the stability of financial systems can be increased by directing bank regulators and executives to find the optimal combination of liquidity and capital requirements. The second of the four speakers shifts the focus to liquidity management by non‐financial companies, with particular emphasis on their use of lines of credit and their role in helping companies weather the financial crisis. The third speaker places liquidity in the context of capital markets, and presents suggestive evidence that improvements in corporate disclosure and transparency have beneficial effects on both the level and volatility of liquidity in those markets. The panel is rounded out by a discussion of liquidity in corporate bond markets and the proposal of a new way to measure such liquidity.