WASHINGTON — A regulatory drive to force large, systemically risky banks to issue "contingent capital," a new type of instrument that allows institutions to quickly convert debt to equity under stressful circumstances, is gaining momentum.
Federal Reserve Board Chairman Ben Bernanke became the latest policymaker to discuss such a plan at a hearing Thursday, in a sign the idea, which was considered radical as recently as last year, has become increasingly mainstream.
In theory, such a debt instrument would allow a bank to quickly raise capital if a crisis occurs, lowering the risk that the government would have to bail it out. During the hearing, Bernanke said regulators are still working on capital standards that would be "calibrated to the systemic importance of the firm."
"Options under consideration in this area include requiring systemically important institutions to hold aggregate levels of capital above current regulatory norms or to maintain a greater share of capital in the form of common equity or instruments with similar loss-absorbing attributes, such as 'contingent' capital that converts to common equity when necessary to mitigate systemic risk."
Bernanke follows Treasury Secretary Tim Geithner, who mentioned the idea during a recent visit to Capitol Hill, and included it as part of the administration's release on proposed new international capital standards last month.
"Requiring banking firms to issue these sorts of contingent capital instruments to market participants could substantially reduce the procyclical effects of regulatory capital requirements and expedite the private sector recapitalization of banking firms during a severe economic downturn," Treasury said in its white paper ahead of the G20 finance ministers' meeting.
The idea has also been mentioned by other Fed officials, including William Dudley, the president of the Federal Reserve Bank of New York, and Gary Stern, the former president of the Minneapolis Fed.
Observers said regulators are certain to make contingent capital part of new capital rules.
"The plan is going to be part of the rewrite of capital rules in the Basel II accords," said Karen Shaw Petrou, managing director of Federal Financial Analytics. "You'll see a plan out by year-end. There is a determination to find a way of putting contingent capital into the Tier 1 capital base going forward. That's why everyone's talking about it."
Despite its growing popularity, however, regulators are still struggling with how to implement the idea. There are several different models, but sources close to the Treasury and the Fed said regulators have not decided which option to use.
Among the different methods is one pushed by Mark Flannery, a finance professor at the University of Florida who is currently a resident scholar at the New York Fed, who argues banks should issue debt that can convert to equity if the market value of their capital fell past a certain threshold.
Another version of the idea, devised by the Squam Lake Working Group on Financial Regulation, would have the conversion triggered by a systemic crisis and a decline in the book value—instead of the market value—of banks' capital.
A third idea, presented at a symposium at the New York Fed in late August by two economists from the central bank, would define the trigger by using an econometric model that would examine a number of variables to forecast systemic risk.
Observers see pros and cons to each of the ideas. A market-value trigger, for instance, would allow banks to respond to a severe drop in their share prices—an event that could wipe out common equity capital overnight. But Jeremy Stein, an economics professor at Harvard University who recently spent time at Treasury helping the administration with its financial rescue efforts, said having a market-value trigger could be dangerous, too.
"The tension here is on the one hand, you want a trigger that kind of reacts to reality as quickly as possible," Stein said. "The danger is when you do things with market value, there are these sort of death-spiral effects that people worry about. If people start worrying a lot about the stock price falling, there's sort of a self-fulfilling dynamic that can kick in. Maybe people start trying to manipulate the thing by shorting the stock price."
And it's not clear that investors would want to buy banks' contingent capital.
"The very time that a fixed income investor would least want to own common equity they could be forced to own common equity," said Jaret Seiberg, an analyst with Concept Capital. "The question is, can you get fixed income investors to take that risk? And the answer is, for the right price."
Seiberg said the premium banks would have to pay to get investors to want to buy their convertible debt would be too high. "If you were forcing banks to sell a large amount of that debt, they would have to pay a very high premium," he said, "and the only way banks could make money on that is that they would have to take a lot more risk, which is exactly what the government is trying to avoid."
But Raghuram Rajan, an economist at the University of Chicago's Booth School of Business and a member of the Squam Lake group, said that criticism was overblown.
"People sort of tend to question the idea that you would buy this stuff that goes down in value in bad times," he said, "but there's a lot of stuff out there that goes down in value during bad times."
Rajan pointed to credit-default swaps, which can become worthless if a company on which a CDS contract is written goes bankrupt, as one example of the risky instruments investors have been willing to buy.
Rajan also dismissed concerns that if banks owing debt suddenly wanted to force their debt to be converted to equity, they could try to manipulate their stock prices to force the conversion.
"This is precisely why you require the systemic trigger," Rajan said. "If somebody tried to drive down the equity prices just because they wanted their debt converted into equity, the debt would not get converted."
Flannery published his first paper on contingent capital in 2002 and has watched the idea shoot to popularity in just the past nine months. He said he believes contingent capital instruments will be the key to combating "too-big-to-fail."
"This is the only way I see to regain control of these large firms," he said.