This paper was part of the conference "Beyond Pillar 3 in International Banking Regulation: Disclosure and Market Discipline of Financial Firms," cosponsored by the Federal Reserve Bank of New York and the Jerome A. Chazen Institute of International Business at Columbia Business School, October 2-3, 2003.Bank supervision ; Bank capital ; Banking law

Jeremy C. Stein

English

Research Papers in Economics

FRBNY Economic Policy Review / September 2004 27
n his very interesting paper, Jean-Charles Rochet argues
 that instead of spending so much time on refining Pillar 1 
(risk-based capital), the Basel Committee should seriously 
think about Pillars 2 (supervisory action) and 3 (market 
discipline).  I certainly agree with the broad theme of Rochet’s 
paper, which I would interpret as saying that one can get too 
lost in the details of implementing risk-based capital standards 
and that it is useful to step back and ask, what fundamental 
economic problem are we trying to solve, and how can we best 
deploy all the tools at our disposal together? These tools include 
not only capital requirements, but also market-based 
information as well as supervision and early intervention.
Rather than going through the details of Rochet’s model, 
I will try to illustrate some of his ideas using an alternative—
and much homelier—model. My model is also designed to 
highlight one critical variable not emphasized in Rochet’s 
analysis, namely, the cost to banks of holding equity capital.  
I want to demonstrate that the cost of bank equity has an 
important impact on how one thinks about the optimality of 
using other policy tools, such as risk-based (as opposed to flat) 
capital requirements. I also want to suggest that, in addition to 
focusing on the three pillars, policymakers might want to 
devote more attention to thinking about ways to reduce the 
cost of equity for banks.
The model proceeds as follows. Imagine that bank i can 
invest in a loan of type i at time 0. With a probability 1/2, the 
loan yields a gross return of (1 +  ) + 2  at time 2, and with 
a probability 1/2, the loan yields (1 –  ) at time 2. Thus, the 
loan has an expected return of  , and a “volatility” of  . Let 
, so that riskier loans have higher expected returns to 
the bank that makes them.
As an alternative to bank lending, the loan can also be made 
in the bond market, where the market discount rate is zero. 
However, in this case, the time-2 payoff on the loan is only 
(1 +  ) in good state, instead of (1 +  ) − 2 . In other words, 
bond market borrowing is always zero net present value, while 
the bank can create an expected surplus of   by virtue of its 
monitoring efforts. Note that since  , the relative 
appeal of bank lending compared with bond market lending is 
greater for riskier borrowers—one can think of these 
borrowers as firms for whom monitoring is most valuable.
To create a role for capital regulation, I assume that there are 
externalities associated with banks getting into trouble. A 
simple way to do so is to assume that bank managers do not 
attach any private costs to bank defaults, but that each bank 
default has a social cost of X. Finally, I assume that banks have 
two ways of raising funds. They can borrow, in which case they 
have to offer their investors an expected return of zero. 
Alternatively, they can finance themselves with equity, but 
equity has a cost of k. For the time being, this added cost 
represents an unspecified deviation from the Modigliani-
Miller capital structure irrelevance benchmark; I will discuss its 
vi Ri
vi
Ri vi
Ri bvi =
vi vi Ri
Ri
Ri bvi =
Jeremy C. Stein
The views expressed are those of the author and do not necessarily reflect the 
position of the Federal Reserve Bank of New York or the Federal Reserve 
System.
Commentary
Jeremy C. Stein is a professor of economics at Harvard University and 
a research associate at the National Bureau of Economic Research.
I28 Commentary
possible origins shortly. And as will become clear momentarily, 
it is precisely this cost of bank equity that makes the regulatory 
problem a nontrivial one. 
Let us first ask what happens in a world with no regulation 
of any sort. Absent regulation, every bank holds zero equity 
capital—that is, debt finance is strictly preferred because it is 
viewed as cheaper—and makes all loans.  The good news in this 
scenario is that all gains from intermediation are realized. The 
bad news is that society bears an expected default cost of X/2 
per loan.
Now consider some possible regulatory approaches. First, 
one might try a regime of “flat,” or non-risk-based, capital 
requirements. This corresponds to forcing banks to hold some 
fixed amount of equity v against all loans, irrespective of their 
risk. The benefit of this approach is that it eliminates the 
possibility of default for the less risky loans, those for which 
. The downside, however, is that the bank’s cost of capital 
for all loans is now vk. This results in disintermediation—loans 
leaving the banking sector for the bond market—and hence a 
loss of the monitoring-related surplus if  . In other 
words, flat capital requirements distort cross-sectional pricing 
and discourage banks from making safe loans where they might 
otherwise create value.
These types of problems make clear the appeal of risk-based 
capital requirements. In this context, risk-based requirements 
amount to forcing a bank to hold   against loan type i. The 
obvious advantage is that this eliminates all defaults, and can 
do so with less distortion of pricing and hence less disinter-
mediation because the capital charge for low-risk loans can be 
reduced. At the same time, going from flat to risk-based capital 
requirements is not without its costs. As Rochet emphasizes, 
these costs arise from the real-world complexities associated 
with implementing a risk-based system, along with its potential 
vulnerabilities to lobbying and political pressure.
Taking these political-economy considerations into 
account, which regime—flat or risk-based—is better? Observe 
that the answer will depend crucially on the cost of bank 
equity k. For high values of k, the distortions in loan pricing 
associated with a flat-capital regime are severe, so it is better to 
go with risk-based capital despite the political-economy costs. 
In contrast, for low values of k, it makes sense to stick with the 
simpler and less politically vulnerable flat-capital 
requirement.1 
Said a bit differently, the complex risk-based capital 
approach envisioned in the Basel II proposals can make sense 
only if one believes that k is relatively high—that is, that there 
is a significant violation of the Modigliani-Miller conditions 
that makes bank equity costly. This observation leads to two 
questions. First, what are the primitive frictions that make bank 
equity so expensive? And second, are there any steps that 
vi v <
Ri bvi = vk <
vi
policymakers can take to help reduce the cost of bank equity, 
thereby mitigating the distortions associated with capital 
regulation?
With respect to the first question, it is easy enough to 
enumerate the usual suspects that are thought to make equity 
finance more expensive than debt finance: 1) tax disadvantages; 
2) free-cash-flow-type agency problems, whereby investors 
discount the value of a bank when management has too much 
slack and might be tempted to make bad investments; 
3) asymmetric information, which can make raising new equity 
difficult; and 4) market inefficiencies, which can lead to (real or 
perceived) transient undervaluations, and again discourage 
new equity issues.
Of course, it is harder to get a good handle on the relative 
importance of each of these frictions for banks. But this may be 
a very useful area for further study because if we had a better 
understanding of exactly why bank equity is thought to be so 
costly, we might be able to take steps to bring the cost down. 
And again, with a lower cost of bank equity, capital regulation 
can be made more efficient, and potentially simpler.
Let me offer a couple of examples. First, and most directly, 
if it is the case that taxes play an important role in pushing up 
the cost of bank equity, it follows that one might want to 
increase scope for tax-favored instruments to count toward 
capital requirements. I will not try to get into the specifics of 
how this could be implemented, but it is worth noting that the 
tax angle provides an alternative motivation—distinct from 
market discipline—for the types of subordinated debt 
proposals that Rochet discusses.
My second example is motivated by the free-cash-flow 
agency problem. If the primitive friction is that investors do not 
like a bank having a lot of capital just sitting around on the 
balance sheet, why not employ some sort of conditional capital 
arrangement that only channels the equity to the bank in those 
states where it is needed to avert default? Specifically, suppose 
a bank has 100 in loans today; these loans will be worth either 
90 or 110 next period, with a probability 1/2 of either outcome. 
One way for the bank to avoid default would be to finance itself 
with 90 of debt and 10 of equity. But this approach leaves the 
bank with 20 of free cash in the good state. If investors worry 
that this excess slack in good times will lead to waste, they will 
discount the bank’s stock.
An alternative—in the spirit of a recent proposal by Mark 
Flannery—would be for the bank to raise 90 in debt, 5 in 
equity, and 5 with a “reverse convertible debenture.” The 
reverse convertible would be structured as follows. It would 
have a face value of 10, and in the good state, it would remain 
as a 10 debt claim, so the bank’s total debt obligation would be 
100. In the bad state, it would convert into a prespecified 
number of shares, so the bank’s total debt obligation would FRBNY Economic Policy Review / September 2004 29
remain at 90. (Note that in this extremely simple example, any 
shares would turn out to be worthless in the bad state.)
From a regulator’s perspective, the bank should be viewed as 
just as well capitalized as before, since it is still guaranteed not 
to default in either state. Thus, the reverse convertible should 
“count” as regulatory capital. At the same time, the free-cash-
flow problem is attenuated, because after paying off its debt, 
the bank now has less slack in the good state (10, rather than 
20).2 This is just a specific example of a general corporate risk 
management principle: capital structure and derivatives should 
be used to match net inflows with investment opportunities on 
a state-by-state basis, so that to the extent possible, firms never 
have too little or too much cash on hand at any point in time 
(see Froot, Scharfstein, and Stein [1993]).
Of course, this reverse convertible idea raises a host of 
practical questions concerning, for example, the specifics of 
security design, which are beyond the scope of this brief 
comment.3 However, my goal is not to make the case for a 
particular new financial instrument, but simply to suggest that 
further creative thinking along these lines is likely to be valuable.Endnotes
30 Commentary
1. As Rochet points out, for any given value of k, one can improve the 
terms of the trade-off by relying on market-based signals and prompt 
corrective action. In the context of the model, suppose that at some 
interim time 1, one can observe a market signal that suggests that the 
bad state is coming. Moreover, if the bank is liquidated promptly, 
instead of waiting until time 2, one can recover ( ), where  . 
This has the benefit that capital charges can be lowered in either the 
flat or risk-based regime.
1 hvi – h 1 <
2. If accounting concerns, such as a desire to have a high return on 
equity, also drive bank managers’ reluctance to carry too much equity 
on the balance sheet, the reverse convertible may also be helpful on 
that dimension, to the extent that return on equity is now calculated 
based on balance-sheet equity of 5, rather than 10.
3. See Flannery (2002) for a detailed discussion of many of these 
issues.
References
Flannery, M. J. 2002. “No Pain, No Gain? Effecting Market Discipline 
via Reverse Convertible Debentures.” Unpublished paper, 
University of Florida.
Froot, K. A., D. S. Scharfstein, and J. C. Stein. 1993. “Risk Management: 
Coordinating Corporate Investment and Financing Policies.” 
Journal of Finance 48, no. 5 (December): 1629-58.
The views expressed are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York 
or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty, express or implied, as to the 
accuracy, timeliness, completeness, merchantability, or fitness for any particular purpose of any information contained in 
documents produced and provided by the Federal Reserve Bank of New York in any form or manner whatsoever.

No Pain, No Gain? Effecting Market Discipline via Reverse Convertible Debentures.” Unpublished paper,

Risk Management: Coordinating Corporate Investment and Financing Policies.”

Commentary on "Rebalancing the three pillars of Basel II."

http://www.newyorkfed.org/research/epr/04v10n2/0409stei.pdf

Commentary on "Rebalancing the three pillars of Basel II."

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