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Contingent Capital, Systemically Important Banks, and the Public

Journal 36: Global Finance and Regulation

In recent years, regulators worldwide have indicated that they will be calling for better capitalization of banks in order to enhance the stability of the financial system. In particular, it has been proposed that the issue of the so-called “too big to fail” (TBTF) or synonymously, systemically important banks (SIBs), should be alleviated through an increase in minimum equity capital requirements. The Basel Committee on Banking Supervision has already included this new demand in Basel III [BCBS (2011a)], the new global regulatory standards on bank capital adequacy and liquidity. Compared to previous standards, Basel III’s minimum requirements for bank liquidity and minimum equity capital are significantly higher. Various governments and regulators, including Switzerland [State Secretariat (2010)], have also suggested so-called contingent capital or contingent convertibles (CoCos) as an alternative to additional hard equity capital. Predictably, regardless of their actual form, such attempts have not found much favor within the banking industry. Most banks argue that additional equity capital is expensive and restrains both their competitive position and their contribution to general economic prosperity. Meanwhile, regulators and academic contributors, following classical asset-pricing concepts, emphasize that while such measures reduce the banks’ earnings and return on equity, they also reduce the risk for shareholders. In addition, they say, the banks’ business and lending activities are not negatively affected.

To date, various academic contributions have focused on the impact of the use of CoCo bonds on the issuer’s capital structure decisions. Raviv (2004) was one of the first to investigate the impact of contingent capital on bank stability and market discipline. Influenced by the recent financial crises and regulatory developments, the vast majority of more recent contributions have focused on the pricing and implementation of CoCo bonds. Flannery (2009) evaluates the potential of CoCo bonds to resolve or alleviate the TBTF issue. He points out that they could greatly reduce default risk and thus the expected rescue costs for the government, but he also highlights several potential difficulties with their practical implementation. McDonald (2010) takes up the issues of market manipulation and the value transfer between issuer and investor. He presents a CoCo design that relies on a dual price trigger and thus prevents such problems. The contributions of Sundaresan and Wang (2010) and De Spiegeleer and Schoutens (2011) focus more on the question of how to price contingent capital. From another angle, Albul et al. (2010) and Pennacchi (2010) analyze the impact of the use of CoCo bonds on the issuing bank’s capital structure considerations. They conclude that, on the one hand, the use of contingent capital mitigates the possible default cost for the issuing firm and, on the other, may increase its tax expenses.

The present contribution ties in with the analysis of private and social costs incurred by implicit government guarantees, as discussed from the qualitative point of view by Admati et al. (2011). Relying on the aforementioned existing literature on capital structure considerations, this article extends their qualitative discussion of the impact of higher equity capital requirements using quantitative analysis. In order to incorporate the dimension of risk and the impact of changes in the risk structure, the assumption of risk-averse market participants is added to the classical capital structure models. Given a corresponding utility function, all stakeholders rely on the measurement of expected utility. Furthermore, this article analyzes for the first time the impact of an increase in equity capital requirements, and in particular the issuance of CoCo bonds, on the government’s expected income and its risk structure. Relying on a comprehensible analytical model, the present contribution differentiates the government’s expected tax income from the expected rescue costs for SIBs. It is shown that, even under risk aversion, a traditional capital increase is undesirable for the shareholders. However, due to a possible reduction in the default cost, the issuance of contingent capital can lead to a Pareto improvement in both the issuer’s and the government’s riskadjusted income. In practice, though, market inefficiencies caused by low CoCo market liquidity, insufficient transparency, and non-optimal taxation and/or regulation may impede such a result.