Contingent Capital: Valuation and Risk Implications Under Alternative Conversion Mechanisms

Several proposals for enhancing the stability of the financial system include requirements that banks hold some form of contingent capital, meaning equity that becomes available to a bank in the event of a crisis or financial distress. Specific proposals vary in their choice of conversion trigger and conversion mechanism, and have inspired extensive scrutiny regarding their effectivity in avoiding costly public rescues and bail-outs and potential adverse effects on market dynamics. While allowing banks to leverage and gain a higher return on their equity capital during the upturns in financial markets, contingent capital provides an automatic mechanism to reduce debt and raise the loss bearing capital cushion during the downturns and market crashes; therefore, making it possible to achieve stability and robustness in the financial sector, without reducing efficiency and competitiveness of the banking system with higher regulatory capital requirements. However, many researchers have raised concerns regarding unintended consequences and implications of such instruments for market dynamics. Death spirals in the stock price near the conversion, possibility of profitable stock or book manipulations by either the investors or the issuer, the marketability and demand for such hybrid instruments, contagion and systemic risks arising from the hedging strategies of the investors and higher risk taking incentives for issuers are among such concerns. Though substantial, many of such issues are addressed through a prudent design of the trigger and conversion mechanism. In the following chapters, we develop multiple models for pricing and analysis of contingent capital under different conversion mechanisms. In Chapter 2 we analyze the case of contingent capital with a capital-ratio trigger and partial and on-going conversion. The capital ratio we use is based on accounting or book value to approximate the regulatory ratios that determine capital requirements for banks. The conversion process is partial and on-going in the sense that each time a bank's capital ratio reaches the minimum threshold, just enough debt is converted to equity to meet the capital requirement, so long as the contingent capital has not been depleted. In Chapter 3 we simplify the design to all-at-once conversion however we perform the analysis through a much richer model which incorporates tail risk in terms of jumps, endogenous optimal default policy and debt rollover. We also investigate the case of bail-in debt, where at default the original shareholders are wiped out and the converted investors take control of the firm. In the case of contingent convertibles the conversion trigger is assumed as a contractual term specified by market value of assets. For bail-in debt the trigger is where the original shareholders optimally default. We study incentives of shareholders to change the capital structure and how CoCo's affect risk incentives. Several researchers have advocated use of a market based trigger which is forward looking, continuously updated and readily available, while some others have raised concerns regarding unintended consequences of a market based trigger. In Chapter 4 we investigate one of these issues, namely the existence and uniqueness of equilibrium when the conversion trigger is based on the stock price

Contingent convertible bonds with the default risk premium

Contingent convertible bonds (CoCos) are hybrid instruments characterized by both debt and equity. CoCos are automatically converted into equity or written down when a predefined trigger event occurs. The present study quantifies the issuing bank's default risk that only manifests in the post-conversion period for pricing CoCos depending on a loss-absorbing method. This work aims to reflect the distinct features of equity-conversion CoCos - in contrast to a write-down CoCos - in a valuation framework. Accordingly, we propose a model to compute the ratio of common equity Tier 1 (CET1), which is composed of core capital and risky assets, by employing a geometric Brownian motion and a random variable. Then, we formulate the post-conversion risk premium by measuring the probability with which the bank's CET1 ratio breaches a regulatory default threshold after conversion. Finally, we empirically examine a positive value of the post-conversion risk premium embedded in the market prices of equity-conversion CoCos

Countercyclical contingent capital (CCC): possible use and ideal design

Contingent capital – any debt instrument that converts into equity when a predefined event occurs – has received increasing attention as a viable tool for allowing banks to raise capital when needed at relatively more affordable prices than common equity. While the debate has focused on contingent capital for systemically important financial institutions, this paper concentrates on its possible use for covering capital needs arising from the implementation of countercyclical buffers. We propose the introduction of countercyclical contingent capital (CCC) based on a double trigger. The interaction of the two triggers would determine a quasi-default status. Conversion would be required when the financial system is simultaneously facing aggregate problems and the individual bank – while still in a going concern status – shows weaknesses. Building on this proposal, the paper tests how different double triggers would have worked in the past and discusses the optimal design of the conversion mechanism and prudential treatment.Basel 2, capital buffer, procyclicality, contingent capital, financial crisis, reforms

Strengthening Bank Regulation: OSFI's Contingent Capital Plan

Bank failures around the world during the recent financial crisis put taxpayers on the hook for trillions of dollars in government backstopping. In future, requiring banks to issue contingent capital, which would convert from debt to equity when banks run into trouble, is one way to help avoid that happening again, and limit taxpayer costs if it does, according to this paper. The author makes the case for contingent capital, critiques the current federal proposal, and makes recommendations for design that would help stave off disaster for banks, not hasten their demise.Financial Services, bank failures, contingent capital, Office of the Superintendent of Financial Institutions (OSFT)

Controlling Financial Chaos: The Power and Limits of Law

This Essay examines how law can help to control financial chaos. To that end, regulation should strive to not only maximize economic efficiency within the financial system but also protect the financial system itself. Any regulatory framework for achieving these goals, however, will be imperfect and have tradeoffs. Increasing financial complexity has created information failures that even disclosure cannot remedy, whereas law-imposed standardization would have its own flaws. Bounded human rationality limits the effectiveness of even otherwise ideal laws. Furthermore, the increasing dispersion of financial risk is undermining monitoring incentives. We also do not yet fully understand how systemic risk is triggered and spread. Because regulation therefore cannot prevent systemic shocks, regulation should also operate to reduce systemic consequences by stabilizing parts of the financial system afflicted by those shocks

Contingent liquidity

After the crisis, bank regulators are considering mitigating liquidity risk by introducing quantity limits on liquidity and maturity mismatch. We argue that aggregate liquidity risk can be reduced with little deadweight loss by encouraging banks, through adequate regulatory relief, to satisfy part of their financing needs with a new class of securities. These would include a Roll-Over Option Facility (ROOF) that allows the issuer, for a price, to keep the funds if at maturity a readily observable variable correlated with systemic liquidity risk (e.g. the LIBOR-OIS spread) is above a trigger threshold. At roll-over the yield would reflect the current price of liquidity and credit risk, making ROOFs attractive to investors. The instrument could attenuate a liquidity crisis by reducing banks’ need to roll debt over or sell off assets, and diminish the probability of runs, if markets are convinced that banks can secure sufficient liquidity when needed thanks to the widespread use of this contingent claim.funding, liquidity, contingent claim, financial crisis

Does "skin in the game" reduce risk taking? Leverage, liability and the long-run consequences of new deal financial reforms

We examine how the Banking Acts of the 1933 and 1935 and related New Deal legislation influenced risk taking in the financial sector of the U.S. economy. Our analysis focuses on contingent liability of bank owners for losses incurred by their firms and how the elimination of this liability influenced leverage and lending by commercial banks. Using a new panel data set that compares balance sheets of state and national banks, we find contingent liability reduced risk taking, particularly when coupled with rules requiring banks to join the Federal Deposit Insurance Corporation. Leverage ratios are higher in states with limited liability for bank owners. Banks in states with contingent liability converted each dollar of capital into fewer loans, and thus could sustain larger loan losses (as a fraction of their portfolio) than banks in limited liability states. The New Deal replaced a regime of contingent liability with stricter balance sheet regulation and increased capital requirements, shifting the onus of risk management from banks to state and federal regulators. By separating investment banks from commercial banks, the Glass-Steagall Act left investment banks to manage their own leverage, a feature of financial regulation that, in part, depended on their partnership structur

Labour's record on financial regulation

In 1997 the new Labour government launched major initiatives in the area of financial regulation, setting up the Financial Services Authority as a comprehensive regulatory body, supported by the legislative framework of the Financial Services and Markets Act 2000. We evaluate the Labour government’s record on financial regulation in terms of its achievements and failures, especially in dealing with the global financial crisis that started in 2007. While we identify some clear flaws in regulatory design and enforcement, our evaluation highlights some inherent difficulties of financial regulation

The Evolving Market for Catastrophic Event Risk

This paper discusses the recent changes in the market for catastrophe risk. These risks have traditionally been distributed through the insurance and reinsurance systems. However, because insurance companies tend to share relatively small amounts of their cat exposures and because insurance companies' capital is threatened by large event, these risks are now being shared partly through the capital markets. In looking to likely future developments, the paper enumerates five key ingredients that successfully structured cat instruments are likely to share: retentions should be substantial; layers of protection should not be too high; dollar amounts of risk transfer should not be too small; loss triggers should be beyond cendent control; and loss triggers should be symmetrically transparent.