New Capital Bond Could Tackle an Old Problem

Capital maintenance bonds, if approved during the legislative battle over banking reform, could play a major role in ameliorating the problems of banks and thrifts.

A capital maintenance bond would be treated as indebtedness for purposes of interest deduction. One primary feature would distinguish a capital maintenance bond from other forms of indebtedness on which interest is deductible: Interest payments could be withheld if the issuing bank's capital fell within a specified percentage of the minimum regulatory required capital.

In effect, the bond could serve as a pressure-relief valve if the issuing bank were to encounter capital problems.

Sound Footing of Capital-Based Policy

When the legislative battle is over and the roll of victors is called, the advocates of risk-based capital standards will step forward. Although the fate of much of the banking bill remains uncertain, the triumph of increased capital-based supervision is secured.

In theory, capital-based supervision is sound policy. Bank owners are less likely to make risky loans if they are gambling with their own money.

At the same time, the government's financial exposure is reduced. Nevertheless, in practice it could be a dismal failure.

Its success is premised on banks being able to attract capital. This points up its basic flaw. When a bank is most in need of capital under risk-based capital standards, it is least able to attract it.

Cold Winds Blowing in Domestic Markets

This problem is heightened in today's financial environment. Even banking giants such as BankAmerica and Citicorp have found the domestic capital markets so unfriendly that they resorted to foreign markets for infusion of fresh capital.

To most healthy banks, this option is not open. What then is a bank that is experiencing problems to do?

If a buyer can be found, the bank might be sold. But why buy a bank that may soon be in resolution and available at a fire sale price and with government subsidies?

The bank could issue stock. The market for watered-down stock of troubled banks is thin. Even the hint of such as issue will send the existing stock into a tailspin, making a successful offering most problematic.

If a bank issues traditional debt, it will be at a high interest rate, which will aggravate the problem. To pay the higher interest, the bank will have to engage in riskier loans which, in turn, will increase its capital requirements. It will be on a treadmill, unable to get off.

Little Sustenance in Pending Bill

The features of the initial Treasury proposal that were intended to address the problem are unlikely to become law. The Treasury attempted to make banks more attractive investments by allowing them to be owned by commercial entities. Banks were also given new powers.

These very features have run into formidable -- and probably fatal -- opposition from key members of Congress. Even if adopted, there is doubt that they would be anything more than a one-time fix.

Banks invest in the efforts of others whose efforts may fail because of circumstances beyond anyone's ability to foresee. Therefore, even well-managed banks need the ability to ride out downturns.

Solution: The Capital Maintenance Bond

To attract investors, the capital maintenance bond -- similar to existing debt instruments -- would carry features such as convertibility, exchangeability, or stock warrants.

Flexible treatment of unpaid interest might also be allowed. For example, unpaid interest might be cumulative, paid in kind, or paid in equity -- depending on terms of the indenture. These features, combined with the ability to postpone interest payments, make the bond an attractive alternative to the traditional subordinate debt offered by banks and thrifts.

One strength of the instrument is that it should not result in any revenue loss to the government. It does not create a new deduction. In fact, it sets forth conditions under which a deduction might not be taken.

It replaces current reliance on existing forms of subordinated debt with a new form. Since it would be considered Tier 2 capital, it is unlikely that it would be a substitute for stock. For purposes of financial analysis, it would also be treated as debt.

Consequently, the debt-equity ratios for the industry would be maintained, from the investment community's perspective. From both a tax and financial viewpoint the desired capital structure would be unaffected.

Capitol Hill Perspective

From a legislative perspective, strong arguments can be made for such an instrument. First, if banks are not given the tools to respond to a capital crisis, the inevitable result will be more banks in receivership -- with resultant costs to the Treasury.

Risk-based capital standards are a way to prevent banks from falling into trouble. However, they cannot rescue a bank that is in trouble. Capital maintenance bonds might help a bank extricate itself from a threatening situation.

To the extent that capital maintenance bonds reduce the likelihood of further takeovers, they will be a most welcome addition to the banking bill.

A Safer, More Fashionable Mix

Capital maintenance bonds would permit banks and thrifts to fashion a capital mix that is safer, from an investment and regulatory perspective. The bonds would not be a substitute for common or preferred stock.

Common stock would remain the most attractive form of equity participation. Preferred stock would still be issued to attract corporate investment.

Capital maintenance bonds would appeal to different investment goals. For example, pension funds and other tax-exempt entities would find them attractive because they would allow some participation in appreciation while assuring a steady stream of income from profitable banks.

Mr. Karl J. Sandstrom teaches public policy at American University and is an aide to Rep. Al Swift, D-Wash., a member of the House Energy and Commerce Committee.

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