Automatic Recapitalization Alternatives

Abstract

The recent experiences of U.S. financial institutions highlight the shortcomings of the capital regulatory regime that has evolved over the preceding three decades. That regime focuses on capital requirements and prompt corrective action (PCA) - escalating supervisory restrictions as a financial firm’s capital position deteriorates relative to established triggers. The shortcomings of that regime include that it exacerbates cycles in financial services activity and the macroeconomy and fails to protect the financial system or the economy from spillover effects related to the distress of financial firms.Regulators are seeking ways to reduce the procyclical effect of the current capital regulatory regime and the spillovers associated with financial firm distress. This paper examines one set of proposed solutions: ex post mechanisms that would automatically recapitalize systemically important financial institutions during periods of distress. Such mechanisms include contingent capital notes (CCNs) and capital insurance. The Treasury Department’s recent white paper, Financial Regulatory Reform: A New Foundation, mentions those options specifically and calls for an “analysis of the costs, benefits, and feasibility of allowing banks and BHCs [bank holding companies] to satisfy a portion of their regulatory capital requirements through the issuance of contingent capital instruments … or through the purchase of tail insurance against macroeconomic risks.”