“Why and How to Design a Contingent Convertible Debt Requirement” Charles W. Calomiris and Richard J. Herring Problem: Protected banks don’t voluntarily target sufficiently low default risk. When problems arise, too-‐big-‐to-‐fail bailouts can occur. Solution: Prudential regulation must specify and enforce requirements that credibly limit bank default risk. This requires proper initial budgeting of capital relative to asset risk, and prompt replacement of lost capital when losses on loans or investments occur. Complication: Loss recognition is a matter of regulatory accounting. Neither banks nor regulators like to recognize losses in a timely way (“evergreening” by banks and “forebearing” by regulators), nor do they adopt approaches for measuring risk that produce proper initial budgeting of capital relative to risk. Example of Inadequate Capital Budgeting: Citibank in April 2006 has MVE/(MVE+Debt) of 13%, Goldman 8%. But Citi fails, not Goldman, because Citi’s risks were higher. On average, intervened institutions in 2008 had higher RBC ratios in 2007 than others. Example of Inadequate Recognition of Loss: Citibank in December 2008 at time of its intervention had a Risk-‐Based Capital ratio of 11.8% and Tier 1 equity ratio of 7%, but its MVE/(MVE+Debt) was about 1%. Capital Structure Proposal: Minimum capital requirements will consist of two equal parts: a 10% equity requirement, and a 10% contingent capital certificate (CoCo) requirement. CoCos convert to equity if MVE/(MVE+Debt) falls to 9% (a high trigger, reached long before insolvency, and thus at a time that voluntary equity offerings are feasible). If the CoCos convert, the conversion is highly dilutive to stockholders (because CoCos are large, and because the conversion ratio is set to be dilutive). As they approach the trigger (say, around the 10.5% ratio), managers will voluntarily issue equity into the market to prevent triggering conversion of the CoCos. To allow reaction time, use 90-‐day moving average for MVE/(MVE+Debt) used in the trigger. Results: Banks will target a high average MVE/(MVE+Debt) – probably above 12%. Losses that reduce capital, as perceived by the market, will be timely replaced, long before insolvency becomes a concern, so too-‐big-‐to-‐fail bailouts will be avoided. Knowing that virtually all their downside risk is borne by the stockholders, and that even the voluntary preemptive issues of equity in the wake of loss are likely to be dilutive and viewed as a managerial mistake, managers will be incentivized to manage risk better ex ante. CoCos will trade like senior debt, and so will be tax deductible and not very expensive to issue, which economizes on the costs of satisfying regulatory requirement, which implies that the imposition of the capital requirement will cause much less of a credit crunch than a 20% equity-‐only requirement. “Getting the Right Mix of Capital and Cash Requirements in Prudential Regulation” Charles W. Calomiris Cash reserve requirements are useful as a broadly conceived prudential tool, not just as a narrowly focused means of limiting the risks associated with illiquidity. Indeed, illiquidity risk is neither a necessary nor a sufficient condition for establishing bank liquidity requirements. The primary means of mitigating the systemic costs of bank illiquidity risk is the creation of an effective lender of last resort. When considering the optimal tradeoff between capital ratios and cash ratios as prudential requirements, five “frictions” are identified that favor the use of one or the other: (1) the adverse-‐selection costs of raising equity (which favors the use of cash); (2) the opportunity cost of forgone abnormal profits (or “quasi rents”) from lending (which favors the use of capital); (3) the limited verifiability of loan outcomes (which favors the use of cash); (4) the moral hazard that results from costly or postponed loss recognition, given the incentive for risk shifting in bad states (which favors the use of cash); and (5) the prospect of changes in the risk environment (which favors cash since it creates greater option value for maintaining targeted default risk with lower adjustment costs in the face of changing loan risk or illiquidity risk). When viewed from the perspective of achieving the central prudential goal of controlling default risk at a minimum social cost, capital requirements have some limitations that favor liquidity requirements, and vice versa. Given that marginal costs are generally increasing along any one cost margin, the optimal policy will combine liquidity and capital requirements. Table 1 Risk Shifting Examples: Cash Limits Risk-Taking Panel A: Bank A’s Balance Sheet Assets Liabilities and Net Worth Time 0 100 loans 85 deposits 15 equity ________________________________________ Time 1 if Bad State 90 loans 85 deposits 5 equity Panel B: Bank B’s Balance Sheet Assets Liabilities and Net Worth Time 0 40 loans 85 deposits 60 cash 15 equity ________________________________________ Time 1 if Bad State 36 loans 85 deposits 60 cash 11 equity Definitions: Loans/(R+T) is loans and discounts divided by reserves plus Treasury securities. Ass.Risk is defined as the implied standard deviation of returns to assets held by banks. Equity/Ass. is the ratio of the market value of equity to the market value of assets. p is the actuarily fair default risk premium on deposits derived from the Black-Scholes model.