Why and How to Design a Contingent Convertible Debt Requirement

Abstract

We develop a proposal for a contingent capital (CoCo) requirement. A proper CoCo requirement, alongside common equity, would be more effective as a prudential tool and less costly than a pure common equity requirement. CoCos can create strong incentives for the prompt recapitalization of banks after significant losses of equity but before the bank has run out of options to access the equity market. That dynamic incentive feature of a properly designed CoCo requirement would encourage effective risk governance by banks, provide a more effective solution to the “too-big-to-fail” problem, reduce forbearance risk (supervisory reluctance to recognize losses), and address uncertainty about the appropriate amount of capital banks need to hold, and the changes in that amount over time. If a CoCo requirement had been in place in 2007, the disruptive failures of large financial institutions, and the systemic meltdown after September 2008, could have been avoided. To be maximally effective, (a) a large amount of CoCos (relative to common equity) should be required, (b) CoCo conversion should be based on a market value trigger, defined using a moving average of a “quasi market value of equity ratio” (QMVER), (c) all CoCos should convert if conversion is triggered, and (d) the conversion ratio should be dilutive of preexisting equity holders.