Bail-Ins Versus Bail-Outs: Using Contingent Capital to Mitigate Systemic Risk

Abstract

Because the quickest, simplest way for a financial institution to increase its profitability is to increase its leverage, an enduring tension will exist between regulators and systemically significant financial institutions over the issues of risk and leverage. Many have suggested that the 2008 financial crisis was caused because financial institutions were induced to increase leverage because of flawed systems of executive compensation. Still, there is growing evidence that shareholders acquiesced in these compensation formulas to cause managers to accept higher risk and leverage. Shareholder pressure then is a factor that could induce the failure of a systemically significant financial institution. What then can be done to prevent future such failures? The Dodd-Frank Act invests heavily in preventive control and regulatory oversight, but this paper argues that the political economy of financial regulation ensures that there will be an eventual relaxation of regulatory oversight (“the regulatory sine curve”). Moreover, the Dodd-Frank Act significantly reduces the ability of financial regulators to effect a bail-out of a distressed financial institution and largely compels them to subject such an institution to a forced receivership and liquidation under the auspices of the FDIC. Believing that there is a superior and feasible alternative to forcing a strained, but not insolvent, financial institution into a liquidation, this paper recommends a system of “contingent capital” under which, at predefined points, a significant percentage of a major financial institution’s debt securities would convert into an equity security. However, unlike earlier proposals for contingent capital, the conversion would be to a senior, non-convertible preferred stock with cumulative dividends and voting rights. The intent of this provision is to create a class of voting shareholders who would be rationally risk averse and would resist common shareholder pressure for increased leverage and risk-taking, but who would obtain voting rights only at the late stage when the financial institution enters the “vicinity of insolvency.” This paper discusses (i) the possible design of such a security, (ii) the recent experience in Europe with issuances of similar securities, (iii) tax and other obstacles, (iv) the possibility of international convergence on a system of contingent capital, and (v) the existing authority of the Federal Reserve Board to implement such a requirement. It submits that contingent capital is an idea whose time is coming, but whose optimal design remains debatable.