Contingent capital: the trigger problem

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Date: Winter 2012
From: Economic Quarterly(Vol. 98, Issue 1)
Publisher: Federal Reserve Bank of Richmond
Document Type: Article
Length: 6,297 words
Lexile Measure: 1420L

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Contingent capital is long-term debt that automatically converts to equity when a trigger is breached. It is a new and innovative security that many people are proposing as part of a reform in bank capital regulations. (1) The security is most associated with Flannery (2005), but with the recent financial crisis many others, including Flannery (2009); Huertas (2009); Albul, Jaffee, and Tchistyi (2010); Plosser (2010); Squam Lake Group (2010); Calomiris and Herring (2011); McDonald (2011); Pennacchi (2011); and Pennacchi, Vermaelen, and Wolff (2011), have also advocated its adoption. (2) Furthermore, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 mandated a study of contingent capital, while the Independent Commission on Banking's report (2011) on banking in the United Kingdom recommended that bank capital structure include loss-absorbing debt like contingent capital.

Contingent capital has four appealing properties. First, it increases a bank's capital when a bank is weak, which is precisely when it is hardest for a bank to issue new equity. In doing so, contingent capital reduces the "debt overhang" problem, which is the inability of a bank to raise funds to finance new loans because their return partially accrues to existing debtholders. During the recent financial crisis, many U.S. banks were forced to raise new equity. If they had had contingent capital securities, this process would have been much easier. Second, contingent capital automatically restructures part of a bank's capital structure, reducing the chance it fails and is put in resolution or bankruptcy. (3) Many people think that the abrupt nature of Lehman's bankruptcy was very disruptive to financial markets, so a pre-bankruptcy reorganization of a financial firm may be valuable. Third, it is a way to force regulators to act, at least when the trigger is tied to an observable variable, like the price of a bank's equity. Fourth, it "punishes" equityholders by diluting existing equityholders. Some proposals argue that the threat of this dilution will give a bank an incentive to take less risk (e.g., Calomiris and Herring 2011).

All four of these properties have varying degrees of merit, but the purpose of this article is not to analyze these benefits. (4) Instead, it is to discuss a cost of implementing contingent capital. All contingent capital proposals rely on a trigger to implement conversion. Many of the proposals advocate the use of a market-price trigger (e.g., Flannery 2005, 2009), but some of them rely on accounting numbers (e.g., Huertas 2009), and others also include a role for regulators. For example, Squam Lake Group (2010) advocates as a trigger the use of accounting numbers at the firm level plus a regulatory declaration that there is a systemic crisis.

This article argues that the trigger is the weak point of contingent capital and, more specifically, a trigger based on a market price, be it a fixed trigger or a signal for a regulator to act, suffers from an inability to price contingent capital. This inability will be more precisely defined later, but the problem arises because asset...

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Gale Document Number: GALE|A322029045