In his most expansive remarks on financial services since he took control of the Federal Reserve Bank of New York, William Dudley signaled strong support on Tuesday for forcing struggling large banks to convert debt into equity, and added details for how such a proposal might work.
Dudley, speaking Tuesday to the Institute of International Bankers, said the "introduction of a contingent capital instrument seems likely to hold real promise."
Reflecting the public's wariness of government bailouts, Dudley said conversions put both shareholders and executives on the chopping block.
"If the bank encounters difficulties, triggering conversion, shareholders would be automatically and immediately diluted," he said. "This would create strong incentives for bank managements to manage not only for good outcomes on the upside of the boom, but also against bad outcomes on the downside."
In the immediate aftermath of the financial crisis, many regulators focused their attention on filling capital holes before financial institutions toppled. Dudley did not rule out possible capital hikes but appeared to find the idea of contingent capital preferable.
"We have to figure out the best way to get where we want to go," he said. "Maybe it's buffers. Maybe it's contingent capital. Maybe it's a mixture of the two."
As regulators from around the globe restructure the Basel II framework, Dudley's comments sent the message that regulators were moving away from simply raising capital requirements on the largest banks. "Relative to simply raising capital requirements, contingent capital has the potential to be more efficient, because the capital arrives as equity only in the bad states of the world when it is needed," he said.
Dudley and Fed Chairman Ben Bernanke have both lent support to the creation of contingent capital — a new type of debt instrument that converts to equity — but missing from the discussion until Tuesday was any sense of how the idea would work in practice. Central to the debate is whether the conversion should be triggered by a decline in an institution's book or market value. Dudley said action should be taken when a bank's equity collapses.
"While, in principle, [conversion] could be tied solely to regulatory measures of capital, it might work better tied to market-based measures because market-based measures tend to lead regulatory-based measures," he said. "Also, if tied to market-based measures, there would be greater scope for adjustment of the conversion terms in a way to make the instruments more attractive to investors and, hence, lower cost capital instruments to the issuer. The conversion terms could be generous to the holder of the contingent capital instrument."
Dudley went so far as to speculate that the history of the financial crisis might have been different had banks made debt conversions.
"Rather than banks clumsily evaluating whether to cut dividends, raise common equity and/or conduct exchanges of common equity for preferred shares, and market participants uncertain about the willingness and ability of firms to complete such transactions and successfully raise new capital, contingent capital would have been converted automatically into common equity when market triggers were hit," he said. "If these contingent buffers were large, … then the worst aspects of the banking crisis might have been averted."
Beyond debt conversions, Dudley argued that another alternative to tougher capital requirements would be an expansion of the range of exposures included under risk-based-capital requirements.
"An emphasis on improved risk capture may be superior to simply raising the capital requirements across the board," he said. "There are two reasons for this. First, it may better tie capital to the risks being undertaken. … Second, it may reduce the risk of regulatory arbitrage."
Dudley has run the New York Fed since January and in that time has offered few specific thoughts on the banking sector. But he hit some of the industry's top issues during Tuesday's speech.
He said regulators should consider under certain circumstances stepping in and killing dividend payments and share buybacks in an effort to avoid capital depletion at a troubled bank. That authority could extend, he said, to oversight of compensation.
"There is an opportunity to rethink capital preservation policies to ensure that banks' incentives are consistent with the supervisory objectives of a safe and sound banking system," he said.
Dudley expressed broad support for the Obama administration's regulatory reform proposal and, in particular, its plan to rein in over-the-counter derivatives.
Finally, he used the opportunity to send a clear message to foreign banks operating in the United States: "These institutions should not expect a return to 'business as usual.' "
"We are committed to implementing the reforms that will prevent a recurrence of the recent financial crisis," he said. "In particular, we will have substantial concern if these firms' compensation practices are contrary to the text or spirit of the international agreements that are in the process of being hammered out. For example, multiyear guaranteed bonus payments would raise a red flag for us."
