Front Matter Page

Monetary and Capital Markets Department

Authorized for distribution by José Viñals

Contents

  • Executive Summary

  • I. Introduction

  • II. Economic Rationale of Contingent Capital

  • III. Operational Aspects of Contingent Capital

  • IV. Contingent Capital Proposals

    • A. Basel Committee Point of Nonviability Proposal

    • B. Contingent Capital As Additional Loss-Absorbing Capital Buffer for SIFI

  • V. Concluding Remarks

  • Figures

  • 1. Issuance of Tier 1, Tier 2, and Lower Tier Capital in Europe

  • 2. Outstanding Bank Debt and Equity in Europe and the United States

  • 3. Indicative Investors’ Yield Targets and Select Capital Instruments Yields

  • Boxes

  • 1. A Schematic Exposition of Use of Contingent Capital Instruments

  • 2. The Swiss Contingent Capital Proposal

  • 3. “Bail-In” Proposals: A Statutory Approach to Debt Restructuring

  • Appendixes

  • I. Models of Bail-Out and Bank Risk Taking

  • II. Summary of Contingent Capital Trigger Conditions

  • III. How Does Contingent Capital Compare with Hybrid and Subordinated Debt

  • Appendix Tables

  • 1. Summary of Contingent Capital Trigger Conditions

  • 2. Summary Table of Contingent Capital Conversion Options

  • 3. Comparison of Characteristics of Contingent Capital and Basel III Tier 1 and Tier 2 Loss-Absorbing

  • References

Executive Summary

Contingent capital instruments have gained increasing support as a potential option to reduce the need for public bail-outs.2 These instruments are dated bonds with principal and scheduled coupon payments that can be automatically converted into equity (i.e., contingent-convertible bonds or CoCos) or written down when a predetermined trigger event occurs, enabling a fresh injection of capital into a distressed bank. Several regulators (Canada, Netherlands, United Kingdom, and the United States) have shown interest in adding contingent capital to their supervisory toolkits to improve crisis management, while Switzerland’s contingent capital proposal is expected to be adopted into law by early 2012. Contingent capital proposals are also currently under discussion within the Basel Committee, the Financial Stability Board (FSB), and the European Union.

This note reviews the debate on the merits and limits of contingent capital by analyzing its economic rationale and its potential role in crisis prevention (by making banks more resilient to shocks and less likely to fail) and bank resolution (by making the failing banks more resolvable in a worst-case scenario). The main conclusions are as follows:

  • Contingent capital instruments could be considered as part of a comprehensive and consistent crisis-management framework. While these instruments could be useful additions to the crisis-management toolkit, they are unlikely to be effective as stand-alone tools. They should be implemented within a comprehensive framework, including strengthened supervision, an enhanced capital base, revamped disclosure that better informs markets, and an effective resolution regime. Their design should also avoid adding procyclicality during crisis times and complexity to the capital structure. Contingent capital should only be viewed as a complement to, not a substitute for, equity.

  • Policies that support contingent capital should be squarely geared toward reducing the risk and cost of systemic crises. These objectives can be well served by instruments that (i) enable automatic conversion of debt into equity when market access is difficult; and (ii) disincentivize excessive risk taking by financial institutions.

  • Contingent capital instruments could be used to meet more stringent capital buffers, including additional loss-absorbing capital requirements for SIFIs. Making SIFIs less likely to fail and increasing the possibility of burden sharing of a failure with the private sector would help improve market discipline. The design of conversion triggers and conversion rates will be crucial to ensure the effectiveness of contingent capital instruments.

  • Contingent capital instruments are untested and need careful scrutiny in order to avoid potentially adverse effects on market dynamics. In particular, market perception of a bank’s financial condition could be adversely impacted as bank capital approaches the conversion trigger. Circuit breakers could be considered in debt contracts in order to avoid potential “death spirals” (very sharp and continuous decline in share prices). Supervisors need to be vigilant in monitoring the design and issuance of contingent capital instruments, the implied transfer of risks within the financial system and potential build-up of systemic risks, including liquidity risks.

Contingent Capital: Economic Rationale and Design Features
Author: Ceyla Pazarbasioglu, Ms. Jianping Zhou, Mrs. Vanessa Le Lesle, and Michael Moore