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.     

A NEW APPROACH TO CAPITAL BUDGETING FOR FINANCIAL INSTITUTIONS

The classic approach to capital budgeting based on the standard Capital Asset Pricing Model (CAPM) says that the hurdle rate (or cost of capital) for any new project or investment should depend only on the riskiness of that investment. Thus, the hurdle rate, and hence the expected value of the investment, should not be affected by the financial policy of the company evaluating the project. Nor should the hurdle rate be influenced by the company's risk management policy, or by the kind of assets it already has on the balance sheet. This article argues that such a “singlefactor” model may be inappropriate for banks and other financial institutions for two main reasons:

• ? it is especially costly for banks to raise new external funds on short notice;
• ? it is costly for banks to hold a buffer stock of equity capital on the balance sheet, even if this equity is accumulated over time through retained earnings.

The single-factor CAPM ignores such costs and, in so doing, understates the true economic costs of “illiquid” bank investments. Illiquid investments require special treatment because they impose risks that, although “diversifiable” by shareholders, cannot be readily hedged by the bank and therefore require it to hold more equity capital. The authors accordingly propose a “two-factor” model for capital budgeting— one in which banks' investment decisions are linked to their capital structure and risk management decisions. One of the key implications of the two-factor model is that a bank should evaluate new investments according to both their correlation with the market portfolio and their correlation with the bank's existing portfolio of unhedgeable risks. The authors describe several potential applications of their model, including the evaluation of proprietary trading operations and the pricing of unhedgeable derivatives positions. They also compare their approach to the RAROC methodology that has been adopted by a number of banks.     

Shadow Banking,Risk Transfer,and Financial Stability

Shadow banking is the process by which banks raise funds from and transfer risks to entities outside the traditional commercial banking system. Many observers blamed the sudden expansion in 2007 of U.S. sub‐prime mortgage market disruptions into a global financial crisis on a “liquidity run” that originated in the shadow banking system and spread to commercial banks. In response, national and international regulators have called for tighter and new regulations on shadow banking products and participants. Preferring the term “market‐based finance” to the term “shadow banking,” the authors explore the primary financial instruments and participants that comprise the shadow banking system. The authors review the 2007–2009 period and explain how runs on shadow banks resulted in a liquidity crisis that spilled over to commercial banks, but also emphasize that the economic purpose of shadow banking is to enable commercial banks to raise funds from and transfer risks to non‐bank institutions. In that sense, the shadow banking system is a shock absorber for risks that arise within the commercial banking system and are transferred to a more diverse pool of non‐bank capital instead of remaining concentrated among commercial banks. The article also reviews post‐crisis regulatory initiatives aimed at shadow banking and concludes that most such regulations could result in a less stable financial system to the extent that higher regulatory costs on shadow banks like insurance companies and asset managers could discourage them from participating in shadow banking. And the net effect of this regulation, by limiting the amount of market‐based capital available for non‐bank risk transfer, may well be to increase the concentrations of risk in the banking and overall financial system.     

CHOOSING THE RIGHT FINANCIAL SYSTEM FOR GROWTH

Well‐functioning financial systems promote economic growth by channeling funds from those who save to those who invest in the productive capacity of economies. What are the main features of a well functioning system? Are well developed capital markets essential to the process? Or are commercial banks and other “private” sources of capital capable of bringing about the same levels of growth and prosperity? In this article, the authors use information about the financial systems of a large number of both developed and developing countries to examine various relationships between a country's financial structure and its overall economic performance. Perhaps most important, the authors report a significantly positive correlation, using data for 34 countries, between the size of a country's financial system—measured by the total of commercial bank assets, equity market capitalization, and bonds outstanding—and economic development (as measured by GDP per capita). At the same time, the authors also provide evidence that banks (or loans) and capital markets (or securities) are complements, not substitutes, in promoting economic development, and that the presence of foreign‐owned banks (though not state‐owned banks) has a positive association with growth. In other words, both private banks and capital markets are likely to play important, though different roles in channeling funds from savers to investors.     

Why European Banks Are Undercapitalized and What Should Be Done About It

Major European banks are significantly undercapitalized as compared to large American banks, and, more importantly, as compared to the capital levels they would need to survive another severe financial crisis. Bank capital shortfalls in Italy, Spain, Germany, France and the United Kingdom, in particular, are largely the consequence of European bank regulations that: (1) apply static risk weights to assets like mortgages and sovereign debt; (2) fail to require an overall market‐based capital ratio that is high enough to enable banks to survive a severe financial crisis; (3) fail to get banks to promptly write down their impaired assets to market value; (4) subject banks to weak stress tests that can create a false impression of capital adequacy; and (5) fail to compel banks to retain sufficient earnings and to raise sufficient capital externally to eliminate capital shortfalls promptly, all apparently out of fear that being tougher might cause investors and customers to lose confidence in the banks. This article summarizes important recent independent bank stress testing that has quantified the capital shortfalls in European banks. The recent highly publicized regulatory interventions to resolve failing European banks were inevitable due to these shortfalls. The authors recommend steps European bank regulators should take to address the problem and to eliminate the risk of serious capital shortfalls. In the absence of such steps, bank depositors, customers, and security holders should be prepared to expect further unwelcome surprises as the risks inherent in allowing undercapitalized banks to operate will continue to materialize in more bank failures.     

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.     

Testing macroprudential stress tests: The risk of regulatory risk weights

We compare the capital shortfall measured by regulatory stress tests, to that of a benchmark methodology — the “V-Lab stress test” — that employs only publicly available market data. We find that when capital shortfalls are measured relative to risk-weighted assets, the ranking of financial institutions is not well correlated to the ranking of the V-Lab stress test, whereas rank correlations increase when required capitalization is a function of total assets. We show that the risk measures used in risk-weighted assets are cross-sectionally uncorrelated with market measures of risk, as they do not account for the “risk that risk will change.” Furthermore, the banks that appeared to be best capitalized relative to risk-weighted assets were no better than the rest when the European economy deteriorated into the sovereign debt crisis in 2011.     

资产透明度、监管套利与银行系统性风险

资产不透明的金融机构过度依赖批发性融资进行监管套利不利于系统性风险的防控。在此背景下,本文首先在经典银行道德风险模型的基础上引入关联性,从资产透明度和监管套利的视角分析银行系统性风险累积的内在机理。而后利用2007-2018年中国上市银行微观数据,构建资产透明度指标和系统性风险指标(SRISK、MES),对理论推论进行实证检验。主要结论有:(1)资产不透明、监管套利会提高银行的系统性风险。(2)监管套利弱化了资产透明度和资本监管机制对银行系统性风险承担的约束作用,资产透明度与资本监管机制在约束系统性风险承担中的协调作用不明显。(3)以大银行为主的债权银行受监管套利的影响相较于受资产透明度的影响更明显。在此基础上,我们对完善金融风险防范体系以及监管机制提出了若干建议。     

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.     

The fading stock market response to announcements of bank bailouts

We analyze the effects on bank valuation of government policies aimed at shoring up banks’ financial conditions during the 2008–2009 financial crisis. Governments injected into troubled institutions massive amounts of fresh capital and/or guaranteed bank assets and liabilities. We employ event study methodology to estimate the impact of government-intervention announcements on bank valuation. Using traditional approaches, announcements directed at the banking system as a whole were associated with positive cumulative abnormal returns, whereas announcements directed at specific banks with negative ones. Findings are consistent with the hypothesis that individual institutions were reluctant to seek public assistance. However, when we correct standard errors for bank-and-time effects, virtually all announcement impacts vanish in Europe, whereas they weaken in the United States. The policy implication is that the large public commitments were either not credible or deemed inadequate relative to the underlying financial difficulties of banks.     

Portfolio rebalancing and the transmission of large-scale asset purchase programs: Evidence from the Euro area

The European Central Bank's large-scale asset purchase program targeted safe assets, but also aimed to impact prices of risky assets. The mechanism for this is the “portfolio rebalancing channel”, where financial institutions’ portfolio decisions impact financial prices more broadly. We examine this mechanism using cross-sectional heterogeneity in how the financial portfolios of different sectors of the European economy were affected around the purchase program. We find evidence of rebalancing. In vulnerable countries, where macroeconomic unbalances and relatively high risk premia remained, we document rebalancing towards riskier securities. In less vulnerable countries, based on granular information for large European banks, we document rebalancing toward bank loans.     

A Look Back at Merton Miller's “Financial Markets and Economic Growth”

The author begins by agreeing with Miller's characterization of the fragility of U.S. banks and of the shortcomings of the Asian model of bank finance‐driven growth. The article also expresses “emphatic agreement” with Miller's arguments that the protection of banks through deposit insurance, regulatory forbearance, and other forms of “bailout” have created costly moral‐hazard problems that encourage excessive risk‐taking. And the author endorses, at least in principle, Miller's main argument that the development of capital markets that do not require the direct involvement of banks should make economies if not less prone to financial crises, then at least more resilient in recovering from them. But having acknowledged the limitations of bank‐centered systems and the value of developing non‐bank alternatives for savers and corporate borrowers, the author goes on to point to the surprising durability of some banking systems outside the U.S.—notably Canada's, which has not experienced major problems since the 1830s. And even more important, the author views banks and capital markets not as “substitutes” for one another, but as mutually dependent “complements” whose interdependencies and interactions must be recognized by market participants and regulators alike.     

Lessons from the Financial Crisis on Risk and Capital Management: The Case of Insurance Companies

This article proposes that risk management be viewed as an integral part of the corporate value‐creation process— one in which the concept of economic capital can provide companies with the financial cushion and confidence to carry out their strategic plans. Using the case of insurance and reinsurance companies, the authors discuss three main ways that the integration of risk and capital management creates value:

• 1 strengthening solvency (by limiting the probability of financial distress);
• 2 increasing prospects for profitable growth (by preserving access to capital during post‐loss periods); and
• 3 improving transparency (by increasing the “information content” or “signaling power” of reported earnings).

Insurers can manage solvency risk by using Enterprise Risk Management (ERM) models to limit the probability of financial distress to levels consistent with the firm's specified risk tolerance. While ERM models are effective in managing “known” risks, we discuss three practices widely used in the insurance industry to manage “unknown” and “unknowable” risks using the logic of real options—slack, mutualization, and incomplete contracts. Second, risk management can create value by securing sources of capital that, like contingent capital, can be used to fund profitable growth opportunities that tend to arise in periods following large losses. Finally, the authors argue that risk management can raise the confidence of investors in their estimates of future growth by removing the “noise” in earnings that comes from bearing non‐core risks, thereby making current earnings a more reliable guide to future earnings. In support of this possibility, the authors provide evidence showing that, for a given level of reported return on equity (ROE), (re)insurers with more stable ROEs have higher price‐to‐book ratios, suggesting investors' willingness to pay a premium for the stability provided by risk management.     

Liquidity creation and bank capital structure in China

This paper investigates the relationship between liquidity creation and bank capital structure in China. We test the so-called “financial fragility-crowding out” hypothesis and the “risk absorption” hypothesis on Chinese banks and find that bank capital is negatively related to liquidity creation, which supports the financial fragility-crowding out hypothesis. In contrast, we find that foreign banks in China have a weaker relationship between liquidity creation and bank capital, which is consistent with the risk absorption hypothesis and findings in prior studies.     

Measuring Integrated Market and Credit Risk in Bank Portfolios: An Application to a Set of Hypothetical Banks Operating in South Africa

The banking crises of the ‘90s emphasize the need to model the connections between financial environment volatility and the potential losses faced by financial institutions resulting from correlated market and credit risks. Due to the number of variables that must be modeled and the complexity of the relationships an analytical solution is not feasible. We present here a numerical solution based on a simulation model that explicitly links changes in the relevant variables that characterize the financial environment and the distribution of possible future bank capital ratios. This forward looking quantitative risk assessment methodology allows banks and regulators to identify potential risks before they materialize and make appropriate adjustments to bank portfolio credit qualities, sector and region concentrations, and capital ratios on a bank by bank basis. It also has the potential to be extended so as to assess the risks of correlated failures among a group of financial institutions (i.e., systemic risk analyses). This model was applied by the authors to the study of the risk profile of the largest South African Banks in the context of the Financial System Stability Assessment program undertaken by the IMF in 1999. In the current study, we apply the model to various hypothetical banks operating in the South African financial environment and assess the correlated market and credit risks associated with business lending, mortgage lending, asset and liability maturity matches, foreign lending and borrowing, and direct equity, real estate, and gold investments. It is shown to produce simulated financial environments (interest rates, exchange rates, equity indices, real estate price indices, commodity prices, and economic indicators) that match closely the assumed parameters, and generate reasonable credit transition probabilities and security prices. As expected, the credit quality and diversification characteristics of the loan portfolio, asset and liability maturity mismatches, and financial environment volatility, are shown to interact to determine bank risk levels. We find that the credit quality of a bank's loan portfolio is the most important risk factor. We also show the risk reduction benefits of diversifying the loan portfolio across various sectors and regions of the economy and the importance of accounting for volatility shocks that occur periodically in emerging economies. Banks with high credit risk and concentrated portfolios are shown to have a high risk of failure during periods of financial stress. Alternatively, banks with lower credit risk and broadly diversified loan portfolios across business and mortgage lending are unlikely to fail even during very volatile periods. Asset and liability maturity mismatches generally increase bank risk levels. However, because credit losses are positively correlated with interest rate increases, banks with high credit risk may reduce overall risk levels by holding liabilities with longer maturities than their assets. Risk assessment methodologies which measure market and credit risk separately do not capture these various interactions and thus misestimate overall risk levels.     

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?.     

How to Evaluate Risk Management Units in Financial Institutions?

Based on the existing Enterprise Risk Management framework and current government regulations, “banks are required to establish risk management units (RMUs) to review and evaluate their risks, monitor them, and to advise top management.” Currently an integral part of the risk governance and management process, RMUs in financial institutions have become increasingly important since the 2007–2008 financial crisis. This article details the authors' creation of an index to evaluate the performance of risk management units in financial institutions, and then examines some of their findings. The index transforms twelve parameters into a simple and convenient index that isolates the RMU's activities from the rest of the organizational risk management process, its risk preferences and the activities of the rest of the units. The index's parameters are divided into three dimensions of the RMU's performance: professionalism, organizational status and relationship with top management and the board. The authors found a positive relationship between their RMUI and some important risk governance characteristics: CROs who are among the five highest paid executives at the bank, banks with at least one independent director serving on the board's risk committee having banking and finance experience and boards with greater efficacy.     

基于共同冲击和异质风险叠加传导的风险传染研究——来自中国上市银行网络的传染模拟

本文将银行系统遭遇外部共同冲击作为研究起点,建立了一个共同冲击和异质风险交互传导与放大的简化模型,冲击的传导包括“原始冲击”、“增量冲击”和“违约冲击”三个风险传染阶段。基于2018年我国15家上市银行的股票收益率和年报数据、2006年至2018年的银行评级数据,本文构建了贝叶斯分层图模型和银行间拆借矩阵,并利用蒙特卡洛模拟测度不同触发银行所引发的系统性风险损失、单个银行的系统性风险杠杆能力(文中定义为“传染乘数”指标)以及政府监管介入的效果。模拟结果显示:共同冲击损失远大于异质风险损失;规模和网络关联性是决定传染乘数的重要因素,且当规模因素不突出时,网络关联性对传染乘数的决定作用相对更强,极容易出现小规模、高关联性银行具有较高的传染乘数;当银行风险资产损失率在10%至25%之间时,造成系统性风险损失的杠杆能力普遍增强;政府监管介入能较好地降低系统性风险。本研究的相关结论为系统性风险的监管设计提供经验证据和参考。