Capital Access Bonds: Contingent Capital with an Option to Convert

Abstract

This paper argues that there is a Coasean Bargain available to banks, Long-term Investors, and Bank Regulators around a particular form of 'Contingent Capital'. By purchasing rights to issue equity in crisis events at a pre-specified price from Long-term Investors, banks can ensure that they will have sufficient regulatory capital available when they need it most: in a crisis. By selling these rights (effectively, a form of crisis insurance) long-term investors can monetize their counter-cyclical investments strategies in banks and, thus, obtain an adequate return as long-term investors. Bank Regulators, in turn, gain as they can thereby implement a more efficient form of equity-capital regulation. Banks have a special need to maintain their equity-capital base in the event of a crisis. Sovereign Wealth Funds and other long-term investors have proved to be the only available counterparties for banks in crisis times. This is why we argue that these investors must be able to monetize the countercyclical asset-management strategies they are trying to implement by obtaining a higher return on their cash reserves. The form of contingent capital we propose (Capital Access Bond) reflects a balance between investors’ preferences, issuers’ constraints, and regulators' objectives.