Stabilizing Large Financial Institutions with Contingent Capital Certificates

Abstract

The 2008–2009 financial crisis clearly indicated that government regulators are reluctant to let a large financial institution fail. In order to minimize the transfer of future losses to taxpayers or to solvent banks, we need a system for assuring that large institutions continuously maintain sufficient capital. For a variety of reasons, supervisors find it difficult to require institutions to sell new shares after they have suffered losses. This paper describes and evaluates a proposed security that converts from debt to equity automatically when the issuer’s equity ratio falls too low. “Contingent capital certificates” (CCCs) can greatly reduce the probability that a large financial firm will suffer losses in excess of its common equity, and will provide market discipline by forcing shareholders to internalize more of their assets’ poor outcomes. The proposed reliance on equity’s market value to trigger conversion creates some problems, which must be compared to the shortcomings of our current application of capital adequacy standards.