The recently completed stress tests provide estimated capital deficiencies for 19 large U.S. institutions. Much of this "capital gap" was quickly filled by the issuance of standard equity or debt instruments.

The market's willingness to purchase bank shares and uninsured debt bodes well for the current state of the financial system. At the same time, traditional capital instruments cannot fully address public policy concerns about bank stability.

Bankers and bank investors find it more profitable to operate with leverage. But this leverage creates the threat of financial instability.

A new type of capital instrument could permit reasonable levels of bank leverage while stabilizing financial institutions. These securities have been labeled "contingent capital certificates." They would be less expensive for bankers in normal times but would protect customers (and taxpayers) if a bank suffered unexpected losses.

Equity capital protects an institution's depositors and other customers from credit and trading losses. Though the Basel accord recognizes some bond liabilities as Tier 2 capital, bank supervisors have been unwilling to impose losses on bank debtholders. Instead, governments have issued costly guarantees or purchased large amounts of bank equity.

Protecting debtholders has a vital benefit for public policy. Bank debt absorbs losses only if the bank enters some sort of bankruptcy procedure, which obliterates the confidence upon which modern banking firms rely so heavily. Counterparties cannot be sure how or when they would be repaid after a bank fails, particularly if it operates in multiple countries. The financial markets therefore pull back from a weak bank, probably hastening its demise.

Because the standard type of bank debt cannot be permitted to suffer losses, regulators support large, troubled banks at taxpayers' expense. The long-run costs of this "too big to fail" policy include severe impediments to the market's future ability to limit risk-taking.

It would be helpful if banks raised equity as losses began to accumulate. However, that is exactly when outside investors are most skeptical and least willing to purchase equity. A far better alternative is to arrange for equity issuance during calmer times.

Contingent capital certificates are sold as debt liabilities that offer periodic, tax-deductible interest payments. Unlike conventional debt obligations, however, the certificates would be converted into new shares if the issuing bank's capital ratio fell too low. If losses absorbed enough of the bank's initial equity, some debt would convert to equity. The resultant leverage reduction would make default less likely.

CCCs would differ from conventional convertible bonds in two important ways. First, the debt would convert at the current market price for shares (not at some absolute, pre-specified price). Second, conversion would occur automatically if the issuer's capital ratio fell too low. Conversion would be not optional.

The certificates avert potential insolvency by moving the bankruptcy point as it approaches. A firm whose equity cushion became inadequate would have its outstanding debt obligations reduced and its equity raised automatically. This recapitalization would occur only under adverse conditions, and no new investors need to contribute money to the firm when it is under stress. Contingent equity capital is provided when — and only when — the bank's solvency comes into question. From the bondholders' perspective, these bonds are quite safe. Repayment would occur either in cash ($1,000 per bond) or in an equivalent value of equity (50 shares if the bank's share price were $20 on the conversion date, or 100 shares if the share price were $10).

The capital ratio triggering a conversion should be based on the current market value of an institution's equity, because accounting measures tend to lag a deteriorating firm's true condition. We could measure the share price on a specific day, or we could average the price over enough days to offset the possibility that short-sellers might seek to depress the price to acquire more shares.

Why would bankers wish to issue these bonds? Historically, supervisors have been slow to require troubled firms to raise capital. Forbearance has provided the banks an option to continue operating with high leverage, which benefits shareholders. By contrast, a weak bank dilutes its initial shareholders' claims by selling new equity. However, the same high bank leverage adds to taxpayers' potential obligations.

Bankers might forego this option by issuing CCCs if it lowers the overall expected cost of capital. Confronted with a choice between, say, 8% Tier 1 capital or 6% Tier 1 capital and 3% CCCs, many banks would prefer the tax deductibility of interest on the bonds.

Contingent capital certificates would lead shareholders to consider the downside potential of their investment activities. If all goes well, the bonds are retired with cash payments. But if the bank's fortunes deteriorated, the bonds would convert into equity shares, diluting the claims of existing shareholders.

By providing new equity just when the bank needs it, contingent capital certificates would improve risk-taking incentives and insulate taxpayers from the cost of "bailing out" a firm that regulators wish to protect.

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