How to Design a Contingent Convertible Debt Requirement That Helps Solve Our Too‐Big‐to‐Fail Problem*
| Author | Charles W. Calomiris,Richard J. Herring |
| DOI | http://doi.org/10.1111/jacf.12015 |
| Date | 01 June 2013 |
| Published date | 01 June 2013 |
VOLUME 25 | NUMBER 2 | SPRING 2013
In This Issue: CEO Pay and Capital Markets
CEO Pay and Corporate Governance in the U.S.:
Perceptions, Facts, and Challenges
8Steven N. Kaplan, University of Chicago Booth School
of Business
How “Competitive Pay” Undermines Pay for Performance
(and What Companies Can Do to Avoid That)
26 Stephen F. O’Byrne, Shareholder Value Advisors, and
Mark Gressle, Gressle and McGinley
How to Design a Contingent Convertible Debt Requirement
That Helps Solve Our Too-Big-to-Fail Problem
39 Charles W. Calomiris, Columbia University, and
Richard J. Herring, University of Pennsylvania
Syndicated Leveraged Loans During and After the Crisis
and the Role of the Shadow Banking System
63 Christopher L. Culp, Compass Lexecon and
The University of Chicago Booth School of Business
The Future of International Liquidity and the Role of China 86 Alan M. Taylor, University of Virginia, NBER, and CEPR
Private Equity and Investment in Innovation:
Evidence from Patents
95 Josh Lerner, Harvard Business School,
Morten Sorensen, Columbia University, and
Per Stromberg, Stockholm School of Economics
Two-Sided Matching: How Corporate Issuers and
Their Underwriters Choose Each Other
103 Chitru S. Fernando, University of Oklahoma,
Vladimir A. Gatchev, University of Central Florida, and
Paul A. Spindt, Tulane University
Discounted Cash Flow Valuation for Small Cap M&A Integration 116 Norman Hoffman, Dominion Enterprises, LLC and
College of William & Mary
Journal of Applied Corporate Finance • Volume 25 Number 2 Spring 2013 39
How to Design a Contingent Convertible Debt Requirement
That Helps Solve Our Too-Big-to-Fail Problem*
* This article is based on a paper originally published as “Why and How to Design a
Contingent Convertible Debt Requirement,” Chapter 5 in Rocky Times: New Perspectives
on Financial Stability, edited by Yasuyuki Fuchita, Richard J. Herring and Robert E. Litan,
Washington: Brookings/NICMR Press, 2012. For helpful comments, the authors wish to
thank, without implicating, Don Chew, Wilson Ervin, Mark Flannery, Charles Goodhart,
Andrew Haldane, Tom Huertas, George Pennacchi, Kenneth Scott, Matthew Willison, and
Peter Zimmerman. We are also grateful to the participants in the Brookings-Nomura-Whar-
ton Conference on Financial Markets for comments on an earlier draft.
1. By “equity capital” we refer here and elsewhere in this article to the economic
value of equity (which we later proxy with a moving average of the market value of eq-
uity) rather than the book value of equity.
2. See Coffee (2010) for the view that these apparent failures in corporate governance
may in fact be the consequence of pressure from institutional shareholders for managers
to take greater exposures to risk. To the extent that this view has merit, our proposal
addresses it by creating substantial dilution risk for shareholders, including the CEO, who
is also at risk of losing both his equity interest and his institution-specic human capital.
3. See Ellul and Yerramilli (2010).
A
by Charles W. Calomiris, Columbia University, and Richard J. Herring,
University of Pennsylvania
lthough debates still ra ge over the causes of the
nancial crisis of 20 07-09, one thing is clear:
several of the world’s largest na ncial institu-
tions—including Fannie Mae, Freddie Mac,
Citigroup, UBS, AIG, Bear Stear ns, Lehman Brothers, a nd
Merrill Lynch—had a massed huge and concentrated credit
and liquidity risks stem ming from subprime mortgages and
other risky investments, but they ma intained equity capi-
tal that was too sma ll to absorb the losses that resulted from
those investments. In other words, relative to their r isks, their
equity capital proved inadequate to insu late these rms—and
many others—from insolvency w hen the risks materialized.
1
Internal bank risk m anagement and external prudential reg u-
lation and supervision failed precisely because they did not
compute risk correctly and require the appropriate amount
of equity relative to risk. e regu latory failure wa s not that
equity capital requirements were too low per se. Af ter all, as of
mid-2006, the ratio of the market va lue of Citigroup’s equity
to the market value of its assets w as nearly twice that of Gold-
man Sachs; but it was Citigroup, not Goldman Sachs, whose
losses produced insolvency. e dierence occurred becau se
Citigroup’s risk exposures, including the o-balanc e sheet
risks associated w ith its implicit obligation to clean up prob-
lems in its special purpose entities and special investment
vehicles, were disproportionately larger tha n Goldman’s.
Examples of failures to c onstrain risk with in a rm’s
capacity to bear loss are not hard to nd. Chief executive
ocers and boards appea red to lack either an eective frame-
work or the willingness to apply the appropriate tools to
measure risk correctly or to constrain aggreg ate risk-taking
within prudent limits.
2
One recent study reported that bank s
that provided risk managers w ith greater compensation and
standing with in their organiz ations not only experienced
smaller crisis-related losses, but had lower stock price volati lity
prior to the crisis. is nding sug gests that top management
decisions not to prioritize and empower risk management
were an important contributor to the crisis.3
is defect can t ake many forms withi n a bank’s risk
management system. It ca n show up as overreliance on risk
decisions taken at a low level in many product li nes and
trading desks, without consideration of how such exposures
might interact under various macroeconomic conditions.
Or it can take the form of a tendency to follow the herd in
an attempt to grow revenues and market share rather than
questioning the adequacy of c apital to absorb risks inher-
ent in particula r strategies. Other source s of vulnerability
include reluctance to question fundamental assumptions
about basis risks and hedges, general disrega rd for the risk
inherent in the centuries-old cha llenge of funding long-term
assets with short-term liabilitie s, and neglect of liquidity
risk more generally. And coming on top of all these com mon
risk management fai lings are a handful of others: the well-
known tendency of people inside large orga nizations to
override limits when they conict with revenue goals; the
diculty of tra cking aggregate exposure s over complex legal
structures a nd product silos in any reasonable amount of
time; and the failure to “risk-adjust” the price of internal
transfers of funds a nd compensation more generally.
As a fairly direct consequence of these kinds of errors of
risk management, the bonuses and c ompensation that many
nancial rm s granted were real, but the prots used to justify
those payments were not. Not only did stockholders suer as
a result of these errors, but taxpayers were ultim ately obliged
to bail out insolvent large institutions or face the pos sibility
of signicant spillover costs to t he rest of the nancial system.
Examples of these problems can be found in the
bankruptcy of L ehman Brothers, the losses sustai ned by UBS
and AIG, the collapse of Northern Rock, t he forced merger
of Bear Stearns, and t he collapses of Indy-Mac, Washington
Mutual, and Wachovia as well as the st ring of losses reported
by Citibank, Merrill Lynch, and Ba nk of America. Studies
of all of these experience s have questioned whether anyone,
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