On the Design of Contingent Capital with a Market Trigger

• Published date: 01 April 2015
• Author: ZHENYU WANG,SURESH SUNDARESAN
• DOI: http://doi.org/10.1111/jofi.12134
• Date: 01 April 2015

THE JOURNAL OF FINANCE •VOL. LXX, NO. 2 •APRIL 2015

On the Design of Contingent Capital with

a Market Trigger

SURESH SUNDARESAN and ZHENYU WANG∗

ABSTRACT

Contingent capital (CC), which aims to internalize the costs of too-big-to-fail in the

capital structure of large banks, has been under intense debate by policy makers and

academics. We show that CC with a market trigger,in which direct stakeholders are

unable to choose optimal conversion policies, does not lead to a unique competitive

equilibrium unless value transfer at conversion is not expected ex ante. The “no value

transfer” restriction precludes penalizing bank managers for taking excessive risk.

Multiplicity or absence of equilibrium introduces the potential for price uncertainty,

market manipulation, inefficient capital allocation, and frequent conversion errors.

ONE OF THE LESSONS learned from the financial crisis of 2007 to 2009 is

that the capital structure and financial insolvency procedures of banks and

financial institutions need a major overhaul. The bailout of Bear Stearns and

AIG, the public assistance to Citigroup and Bank of America, and the freeze

of the financial system after Lehman Brothers’ bankruptcy have demonstrated

the need to revisit financial insolvency procedures. In particular, the extensive

amount of implicit guarantees, outright infusion of taxpayer money, and other

benefits extended to large financial institutions have come under scrutiny.

Recognizing these lessons, the U.S. Congress passed the Dodd-Frank Act1

and the Basel Committee moved to strengthen bank regulation with Basel

∗Sundaresan is with Columbia University, Graduate School of Business. Wang is with Indiana

University, Kelley School of Business. We are grateful for the comments from the seminar and

conference participants in the NY Fed Workshop on Contingent Capital, BIS, ECB, ToulouseEco-

nomics Group, Columbia Business, Law,and Engineering Schools, Wisconsin (Madison), Richmond

Fed, Indiana (Bloomington), Exeter, SAIF, Seattle, Drexel, Baruch, the Moody’s Conference, FIRS

conference, IFMR, UBC Summer Conference, and FMC2 Bank Resolution Mechanism Conference.

We especially thank Anat Admati, Pierre Collin-Dufresne, Doug Diamond, Mark Flannery, Ken

Garbade, Paul Glasserman, Larry Glosten, Charles Goodheart, Christopher Hennessy,Bev Hirtle,

Ravi Jagannathan, WeipingLi, Jamie McAndrews, Bob McDonald, Stewert Myers, George Pennac-

chi, Ned Prescott, Adriano Rampini, Marc Saidenberg, Joao Santos, Ernst Schaumburg, Chester

Spatt, Kevin Stiroh, James Vickery,Cam Harvey (Editor), the anonymous Associate Editor, and the

anonymous referees for helpful remarks. Julia Dennett and Kevin Pan provided excellent research

assistance.

1The Dodd-Frank Act is the Wall Street Reform and Consumer Protection Act (Pub.L. 111-203,

H.R. 4173), a federal statute in the United States signed into law on July 21, 2010 by President

Barack Obama.

DOI: 10.1111/jofi.12134

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882 The Journal of Finance R

III.2A central issue in the debate on these new regulations is the design of

a prudential capital structure that ensures enough loss-absorbing capital in

large financial institutions and removes the need of a public bailout.3

In the pursuit of a prudential capital structure of banks, there has been con-

siderable interest in contingent capital (CC), a debt security that converts into

equity in periods of distress when a bank has low capitalization but can still be

recapitalized as a going concern.4Some academic researchers and regulatory

agencies have argued that such a security may mitigate the “too-big-to-fail”

problem and reduce the systemic risk in the financial industry, for several

reasons. First, CC may overcome the reluctance of raising equity in a good

state because it does not dilute earnings when it functions as debt (HM Trea-

sury (2009)). Second, timely conversion of sufficiently large CC may restore the

level of loss-absorbing equity in a bad state, overcoming the difficulty of raising

equity caused by debt overhang, recapitalizing the highly levered bank as a

going concern, and reducing financial distress (Squam Lake Working Group

(2009)). Third, it has been argued that the potential for a “punitively dilutive”

conversion of contingent debt sets the right incentives for managers to avoid

excessive risk-taking, and encourages them to maintain higher capital ratios

(Himmelberg and Tsyplakov (2012)).5Based on these arguments, some aca-

demics and industry lobbyists have urged governments to let banks use CC as

regulatory capital. Against this backdrop, Section 115(c) of the Dodd-Frank Act

mandates that U.S. regulators must study, with a two-year deadline, whether

requiring banks to issue CC reduces the systemic risk caused by large financial

institutions and what the proper design of CC contracts should be.

In the debate on the proper design of CC, the trigger for conversion from

debt to equity is perhaps the most important and controversial. Many trig-

ger designs have been discussed in the literature, including triggers deter-

mined by accounting ratios (Squam Lake Group (2010)), regulatory discretion

(Dickson, 2010), and bank management’s option (Glasserman and Wang(2011)

and Bolton and Samama (2011)). There are concerns about each of these

triggers. Accounting triggers tend to be backward looking and are prone to

2Basel III is a set of new capital and liquidity standards set by the Basel Committee. For a

summary of its features, see Bank for International Settlements (2011).

3For example, Kashyap, Rajan, and Stein (2008) propose that banks buy “systemic risk insur-

ance” and secure the payouts on insurance. Admati and Pfleiderer (2010) argue for increasing the

liability of owners (equity holders) and suggest that such a structure will mitigate the conflicts of

interests between equity and debt holders and may help reduce the need for bailouts. Admati et al.

(2010) suggest a significant increase in equity capital.

4It is necessary to distinguish CC from bail-in debt, another convertible security proposed by

Credit Suisse (The Economist, 2010, From bail-out to bail-in, January 28.). Unlike CC, a bail-in

debt converts into equity when the bank enters into resolution as a gone concern. Since pre-existing

equity holders’ stake is wiped out at resolution, the analysis in our paper does not apply to bail-in

debt.

5Currently,economic theory does not offer a coherent theoretical framework on just how punitive

the conversion should be to curtail the incentive for excessive risk-taking, but scholars, regulators,

and practitioners refer to punitive conversion as a desirable feature for CC to be used as a tool to

manage both the agency problem and the capital structure.

With a Market Trigger 883

manipulation by managers.6Regulatory discretion potentially suffers from

insufficient information, ineffective monitoring, and political pressures. And,

giving the option to convert to bank managers may result in delayed conver-

sion or no conversion, especially if the conversion is dilutive and the managers

anticipate a bailout.

Because of these concerns, many academics and regulators have turned

attention to triggers placed on market prices, which are our focus.7Placing

a mandatory-conversion trigger on an observable market value of a publicly

traded security is thought to ensure that conversion will be based on criteria

that is informative, objective, timely, difficult to manipulate, and independent

of regulators’ intervention, avoiding the problems associated with other types

of triggers. For this purpose, the price of the security serving as a trigger should

be a timely indicator of the expected financial difficulties of the bank that issues

CC, and thus the security should be junior to CC as a claim on the firm. Since

CC becomes common equity after conversion, the only financial claim that is

junior to CC is common equity. This makes common equity the natural choice

for the market trigger.

We show that a CC with a market equity trigger does not in general lead

to a unique competitive equilibrium in the prices of the issuing bank’s equity

and CC. Multiplicity or absence of equilibrium arises because the stakeholders

are not given the option to choose a conversion policy in their best interests.

This problem exists even if banks can issue new equity to avoid conversion.

The equilibrium problem is more pronounced when a bank’s asset value has

jumps and when bankruptcy is costly. We consider jumps in asset values and

bankruptcy costs in our analysis because they are the reality of the banking

industry.

We prove that, for a unique competitive equilibrium to exist, a mandatory

conversion must not transfer value between equity holders and CC investors.

This necessary condition for a unique equilibrium leads to two problems. First,

this condition prevents punishing equity holders at conversion. This is prob-

lematic because punitive conversion is viewed by regulators and academics

as a desirable feature to generate the incentives for bank managers to avoid

excessive risk-taking. Second, the necessary condition implies that CC cannot

be practically designed so that the market has a unique equilibrium because

the conversion ratio in the contract has to be a function of the market value of

the contract. In particular,a CC contract with a constant conversion trigger and

6The use of Repo 105 by Lehman Brothers and the special purpose vehicles by Enron are two

visible cases of such manipulation, with disastrous consequences. In the month of bankruptcy,

Lehman Brothers’ tier-one capital ratio was 10.1%. In the month immediately before Bear Stearns

was bailed out, its capital ratio was estimated to be 13.5%. These capital ratios were even above

the new capital requirement in Basel III.

7Flannery (2002,2009) is an early advocate of CC with a market trigger for mandatory conver-

sion.