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.
Highlights
The financial crisis of 2007-2008 has painfully revealed a major weak link in the financial system: excess leverage at many of the major financial institutions
Due to the particular shareholder structure of the bank, the Senior Contingent Notes (SCN) Rabobank issued on the 12th of March 2010 have the specific feature that instead of transforming into shares, they face a 75% write-down and the remaining 25% are paid out in cash in the event the bank‘s Equity Ratio falls below 7%
VII] CONCLUSION We believe the economic case for a contingent capital solution to foster greater stability of the banking system is compelling
Summary
The financial crisis of 2007-2008 has painfully revealed a major weak link in the financial system: excess leverage at many of the major financial institutions. Under our contingent capital mechanism banks would purchase a (collateralized) option to issue new equity at a pre-specified strike price8.
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