BANKS, REGULATION, AND THE CASE OF

CONTINGENT CAPITAL

Jrgen Richter
April 2012

Abstract
The recent experiences of financial institutions highlight the shortcomings of the current
capital regulatory regime. The shortcomings of that regime include that it fails to protect the
economy from spillover effects related to the distress of financial firms. In the aftermath of the
latest crisis, regulators are seeking ways to reduce such spillovers to protect taxpayers. This
study examines after explaining the economic reasons for banks and the basics of bank
regulation one specific issue of the proposed solutions: contingent capital in the form of
debt that converts to equity when a bank faces financial distress. The work analyzes the
potential of contingent capital structures in order to enhance financial stability and avoid
costly government rescues. Therefore all relevant papers about contingent capital since 2002
are taken into account. To verify the academic view, market participant comments are also
considered. Although the case of contingent capital remains a heterogeneous one and
regulators so far have not stated their exact requirements on contingent capital structures, I
come to the conclusion that CoCo-bonds bear the potential to play its part in a strengthened
financial system.

Of all the beings that have existence

only in the minds of men, nothing is
more fantastical and nice than credit;
it is never to be forced; it hangs upon
opinion; it depends upon our passions
of hope and fear; it comes many times
unsought-for, and often goes away
without reason; and once lost, it is
hardly to be quite recovered.
[Charles Davenant]

Although life is not easy in the world of K,

it is easier in K than in u, and easier in u
than in U. Hence, one gains by moving
leftward through KuU toward knowledge,
that is, form U to u to K. The question, then,
is how to do it: How to invest in knowledge?
Not surprisingly given our taxonomy of
knowledge as measurement and knowledge
as theory, two routes emerge: better
measurement and better theory. The two
are mutually reinforcing, moreover, as
better measurement provides grist for the
theory mill, and better theory stimulates
improved measurement.
[Francis Diebold, Neil Doherty, and Richard Herring]

ii

ACKNOWLEDGEMENTS
Several factors have contributed to this works development. First and foremost the people
who directly supported me: Teresa Weiss who did a great editorial job and who helped
eliminate most of my errors. Anton Stelzmller supported me greatly with a constant
inquisitorial discussion on the functioning of the banking industry hopefully we can keep this
discussions going on and on. Guido Schfer, my academic supervisor, had always an open
door policy and helped to find a proper structure for the subject and gave important feedback
on every single chapter many thanks in advanced for continuing the work with me on my
dissertation thesis. Also mentioned should be Christian Spanberger, Johannes Stelzhammer,
and Tom Rohrer for proofreading. Furthermore all friends and colleagues should be thanked
which helped with uncountable issues but whose specific input I am not able to specifically
associate with single subjects anymore. Thank you all for your help without this work would
not be the same. Another important factor was the great infrastructure from the Vienna
University of Economics and Business which made the research and the writing for this work
possible in the first place.
I apologize in advance for the many errors that surely remain. They are my, and only
my, responsibility. Despite such errors, I hope that the works content will help expand the
readers understanding of the banking industry, financial regulation and contingent capital. I
always do appreciate critical remarks; therefore, please write to jrgnrichter@gmail.com.

Vienna, 2012

iii

Content
ACKNOWLEDGEMENTS ...................................................................................................................... III
ACRONYMS .......................................................................................................................................................... VI
TABLES ................................................................................................................................................................. IX
1. INTRODUCTION .......................................................................................................................... 1
2. THE BANKING BUSINESS ...................................................................................................... 3
2.1 BANKS AND THEIR ROLE IN THE FINANCIAL SYSTEM .......................................................... 3
2.1.1 MATCHING BORROWERS AND LENDERS ....................................................................................... 4
2.1.2 TRANSACTION COSTS .......................................................................................................................... 7
2.1.3 LIQUIDITY INSURANCE ....................................................................................................................... 10
2.1.4 ASYMMETRY OF INFORMATION ...................................................................................................... 11
2.1.5 OPERATION OF THE PAYMENTS MECHANISM .......................................................................... 15
2.1.6 DIRECT BORROWING FROM THE CAPITAL MARKET ............................................................... 16
3. BANK REGULATION ...............................................................................................................17
3.1 THE JUSTIFICATION FOR BANK REGULATION ......................................................................18
3.1.1 THE SOURCES AND CONSEQUENCES OF RUNS, PANICS, AND CRISES ........................ 19
3.1.2 A MARKET FOR LEMONS .................................................................................................................. 21
3.2 THE GOVERNMENT SAFETY NET.............................................................................................22
3.2.1 PRUDENTIAL REGULATION AND SUPERVISION: INSTRUMENTS AND AIMS .................... 24
3.2.2 DEPOSITORY INSTITUTIONS AND FORMS OF DEPOSITOR PROTECTION........................ 26
3.2.3 THE GOVERNMENT AS LENDER OF LAST RESORT................................................................. 28
3.2.4 PROBLEMS CREATED BY THE GOVERNMENT SAFETY NET ................................................ 28
3.3 REGULATION AND SUPERVISION .............................................................................................29
3.3.1 RESTRICTIONS ON COMPETITION ................................................................................................. 31
3.3.2 RESTRICTED ASSET HOLDINGS AND MINIMUM CAPITAL REQUIREMENTS .................... 32
3.3.3 DISCLOSURE REQUIREMENTS ....................................................................................................... 33
3.3.4 SUPERVISION AND EXAMINATION ................................................................................................. 34
3.4 REGULATORY RESPONSE TO THE FINANCIAL CRISIS OF 2007-09..................................34
4. THE BASEL COMMITTEE ......................................................................................................36
4.1 THE REFORM AGENDA ..............................................................................................................36
4.2 HISTORY AND ORGANIZATION OF THE BASEL COMMITTEE...............................................37
4.3 A PRIMER ON BASEL III.............................................................................................................39

iv

5. CONTINGENT CAPITAL .........................................................................................................44

5.1 DEFINITIONS, FORMS AND FUNCTION OF CONTINGENT CAPITAL ....................................45
5.2 THE TRIGGER ..............................................................................................................................51
5.3 PRICING OF CONTINGENT CAPITAL ........................................................................................55
5.4 ECONOMIC RATIONALE OF CONTINGENT CAPITAL .............................................................57
5.5 WHY CONTINGENT CAPITAL INSTEAD OF EQUITY? ............................................................59
5.6 ANOTHER REGULATORY APPROACH: BAIL-INS ..................................................................62
5.7 LEGAL, ACCOUNTING, AND TAX ISSUES ...............................................................................64
5.8 WHERE ARE WE NOW? ............................................................................................................65
6. CONCLUSION.............................................................................................................................67
APPENDIX 1: CONTINGENT CAPITAL LITERATURE OVERVIEW ...................................................... 70
APPENDIX 2: SELECTED FEATURES OF OUTSTANDING LOSS-ABSORBING SECURITIES .... 79
BIBLIOGRAPHY .............................................................................................................................80

ACRONYMS
AIRB

Advanced Internal Ratings-Based Approach

ALM

Asset Liability Management

BAKred

Federal Banking Supervisory Office

BCN

Buffer Capital Notes

BIS

Bank for International Settlements

BCBS

Basel Committee on Banking Supervision (or the Basel Committee)

BCCS

Buffer Convertible Capital Securities

bn

Billion

bp

Basis Point (1bp = 0.01%)

CAB

Capital Access Bond

CAMELS

US supervisory rating of a banks overall condition

CAPM

Capital Asset Pricing Model

CC

Contingent Capital

CCB

Contingent Convertible Bond

CCC

Contingent Capital Certificates

CCR

Counterparty Credit Risk

CDO

Collateralized Debt Obligation

CDS

Credit Default Swap

CET1

Common Equity Tier 1

CHIPS

Clearing House Interbank Payments System

CLO

Collateralized Loan Obligation

CMS

Constant Maturity Swap

CoCo

Contingent Convertible Capital Bond

CRC

Contingent Reverse Convertible

CRD

Capital Requirements Directive

CT1

Core Tier-1 Capital

CSFI

Centre for the Study of Financial Innovation

CVA

Credit Valuation Adjustment

DM

Deutsche Mark

e.g.

For example (from Latin exempli gratia)

EBA

European Banking Authority

EPC

Event-driven Process Chain

EPE

Expected Positive Exposures

ECB

European Central Bank

ECN

Enhanced Capital Notes

EMU

European Monetary Union

EUR

Euro

FASB

Financial Accounting Standards Board

Fedwire

Federal Reserve Wire Network

vi

FDIC

Federal Deposit Insurance Corporation

FINMA

Swiss Financial Market Supervisory Authority

FIRB

Foundation Internal Ratings Based Approach

FMA

Financial Market Authority

FSA

Financial Services Authority

FSB

Financial Stability Board

FSF

Financial Stability Forum

FSOC

Financial Stability Oversight Council

FSPP

Financial Services Practitioners Panel

FX

Foreign Exchange

G-SIBs

Global Systemically Important Banks

G-SIFIs

Global Systemically Important Financial Institutions

G20

Group of Twenty Finance Ministers and Central Bank Governors

GBP

Pound Sterling

GDP

Gross Domestic Product

IADI

International Association of Deposit Insurers

IASB

International Accounting Standards Board

IFRS

International Financial Reporting Standards

IMF

International Monetary Fund

IR

Interest Rate

LCFI

Large, Complex, Cross Border Financial Institution

LFI

Large Financial Institution

LLR

Lender of Last Resort

LYON

Liquid Yield Option Note

LT2

Lower Tier 2

LTV

Loan to Value, usually Loan to Value Ratio

MAG

Macroeconomic Assessment Group (established by the Financial Stability

Board and the Basel Committee on Banking Supervision)

MCB

Mandatory Convertible Bond

MM

Modigliani-Miller

NA

Not Applicable

mn

Million

MPT

Modern Portfolio Theory

NPL

Nonperforming Loan

NPV

Net Present Value

NOPAT

Net Operating Profit after Tax

OeNB

Oesterreichische Nationalbank

OTS

Office of Thrift Supervision

PwC

PricewaterhouseCoopers, a Global Professional Services Firm

RCD

Reverse Convertible Debenture

vii

REPO

Repurchase Agreement

ROA

Return on Assets

ROE

Return on Equity

ROIC

Return on Invested Capital

RWA

Risk Weighted Assets

SA

Standardized Approach

SIFI

Systemically Important Financial Institution or Systemically Important

Financial Intermediaries

SWF

Sovereign Wealth Fund

TBTF

Too Big To Fail

tn

Trillion

USD

US-Dollar

GAAP

U.S. Generally Accepted Accounting Principles

UST

U.S. Treasury Note

UT2

Upper Tier 2

WACC

Weighted Average Cost of Capital

WIPO

World Intellectual Property Organization

yr

Year

viii

TABLES
Table 1: Implications of banks target returns on equity..................................................................... 3
Table 2: The regulatory reform agenda post-lehman ........................................................................ 37
Table 3: Basel IIi and the impanct on european banking .................................................................. 42
Table 4: Pre- and Post-Crisis Contingency Planning ........................................................................ 43
Table 5: Contingent Convertible Capital in a Nutshell ....................................................................... 46
Table 6: Instruments Providing Common Equity in Distress ............................................................ 51
Table 7: Types of Triggers ................................................................................................................... 52
Table 8: After the trigger-event ............................................................................................................ 54

ix

1. Introduction
The recent financial crisis has highlighted, inter alia, that not only the absolute amount of a banks
equity position, but also the quality of the capital it holds available to absorb losses, is important. In
response to this, the Basel Committee on Banking Supervision (BCBS or the Basel Committee) has
tightened up its requirements of the quality and quantity of core capital, promoted the build-up of
capital buffers that can be drawn down in periods of severe market conditions, improved the risk
coverage of the capital framework and introduced a non-risk based supplementary measure.
Hybrid forms of capital were meant to combine the cost-efficiency of debt with the support that
equity offers to banks in times of crisis. Yet they ultimately proved to be less well constructed than
originally thought. When extra capital was needed to protect depositors and other creditors, these
hybrid instruments did not provide it without the bank first defaulting (The Economist, 2009). Due to
the fact that hybrid capital did not support banks in the way they were originally thought of, only very
few of the old hybrid capital instruments are to be recognized as regulatory capital (Zhres, 2011).
1

With regulators pressing for higher loss absorbency for hybrid forms of capital , here, the case of
contingent capital applies.
The new BCBS measures are designed to have subordinated creditors participate in the cost
of recapitalization, just like providers of equity capital, to prevent socially not desired outcomes (e.g.
that investors in subordinated debt were held liable only in the event of a gone concern) (Zhres,
2011). The moral hazard problem to which such flawed risk-responsibility connection gave rise is now
being addressed by involving subordinated creditors at an early stage. It is intended to reflect the risks
entailed in subordinated bonds adequately in their pricing and to close the door on investors benefiting
from the assumption of risk taking by the government. Only then will creditors have more appropriate
incentives to price, monitor, and limit the risk-taking of the firms to which they lend (Bernanke, 2010).
Bernanke told the U.S. Congress: The right response is to put extra cost, extra supervision on these
[financial] firms that will give them an incentive to eliminate unnecessary size, to eliminate
unnecessary activities and to reduce their risk-taking. (Wessel, 2011)
Driven by the conclusions of the latest financial crisis, two fundamental approaches have
evolved to improve bondholder liability. The first is a hybrid capital instrument in the form of fixed
income securities serving as an equity buffer in times of financial distress and known as contingent
convertibles (CoCo-bonds); the second tool would be a so called bond creditor bail-in. The two ideas
differ fundamentally: CoCos are market-based fixed income instruments, while bail-ins rest on the
principle of discretionary intervention. Together they share the goal to strengthen the stability of the
financial system (Zhres, 2011).
CoCo-bonds look like the perfect post-crisis panacea. Swiss regulators (FINMA) backed them
as an ordinary equity supplement (Schweizerische Eidgenossenschaft, 2010). Credit Suisse
2

successfully sold USD 2bn of Tier 2 Buffer Capital Notes (BCN) in February 2011. But the Basel
Committee on Banking Supervision is not convinced: it wants the worlds 30 too-big-to-fail lenders or
G-SIFIs/G-SIBs to use only common equity to meet its proposed core equity tier one capital surcharge
1

Hybrid capital has certain properties of debt but is treated as equity as far as depositors are concerned (subordinated to
depositors). Prior to the financial crisis many banks issued hybrid capital as a cost-effective means of meeting their Tier 1 and
Tier 2 capital requirements.
2
USD 2bn 7.875 per cent Tier 2 Buffer Capital Notes due 2041.

of between 1 per cent and 3.5 per cent (BCBS, 2011). Common Equity Tier 1 is the highest quality
component of a banks capital as it is capable of fully absorbing losses whilst the bank remains a
going concern. For the financial institution, Common Equity Tier 1 is the most costly form of capital to
raise.
The case of contingent capital is to support banks with sufficient capital to comply with
regulatory capital requirements. Therefore, this form of structured credit instruments has to provide the
originally intended function of hybrid capital to protect depositors, other creditors and in the end the
taxpayers. The aim of this study is to evaluate the possibilities of contingent capital instruments to
strengthen the financial system. The regarding research questions are:

A) Is contingent capital a useful regulatory tool to strengthen the financial system?

B) If question A is to answer positively how will the specific CoCo-bond features have to be
designed to ensure that A is given?

To reach an appropriate conclusion, all the issued academic research on contingent capital will be
reviewed. To support the findings, expert comments from market participants, broker research,
newspapers and magazine articles will also be considered. Finally, the empirical findings will be
compared to the contingent capital securities issued so far.
A good state of the art textbook on money, banking, and financial markets is usually based on
a few core principles (see, for example, Ceccetti (2008)). Knowledge of these principles is the basis
for learning how the financial system is organized. To better understand the case of contingent capital,
we will adopt a similar approach. Applying a proper structure to this study, we will first explain how the
banking business works and which economic functions it provides. In the following chapter, a
framework for bank regulation is explained in detail, with a primer on the new Basel III rules closing
the focus on regulation. Finally, after we are aware of all the issues modern banking has to deal with,
we will review the features of contingent capital to evaluate their possible contribution for a
strengthened financial system.

2. The Banking Business

Banking plays the major role in channelling funds to borrowers with productive investment
opportunities. Therefore, the provided activities are important in ensuring that the financial system and
the economy run smoothly. In this section, we will examine the role of financial institutions within the
economy in detail and set the preconditions for the necessary knowledge of the following chapters on
bank regulation, the Basel Accord and contingent capital.

2.1 BANKS AND THEIR ROLE IN THE FINANCIAL SYSTEM

Financial institutions come in various forms and offer an extensive product range. Although around for
centuries, the banking landscape has changed dramatically over the last decades; and with it, our
world: in the 1980s, deal making shifted to a new focus on trading. Firms such as Merrill Lynch or
Drexel Burnham Lambert who became prominent as investment banks earned an increasing amount
of their profits from trading for their own account. Trading with the firms money, proprietary trading
(also dubbed as "prop trading"), occurs when a firm trades stocks, bonds, currencies, commodities,
derivatives, or any other financial instruments to make a profit for itself. This search for yield

became one of the most important drivers for the industry and bank CEOs competed globally with
their yearly ROE-targets. See Table 1 for an analysis of the meaning of banks target returns on
equity.
TABLE 1: IMPLICATIONS OF BANKS TARGET RETURNS ON EQUITY

What banks target returns on equity tell us

According to a company statement from September 2011, Lloyds bank announced a target return on equity of 14.5 per cent.
Another famous example would be Deutsche Bank, where CEO Josef Ackermann targeted a more demanding return on
equity of 25 per cent, something the bank achieved in 2005. Bank managers like to argue that this is the necessary level of
return on equity they need to earn, in order to gain funding from the markets. Usually, the variable compensation part of
executive employees is linked to achieving such objectives. But is it really useful to target such objectives? Regarding to
Martin Wolf, chief economist of the Financial Times, the brief answer is: no.
Consider the following: someone is offering you an investment with a promised real return of 15 per cent (referring to the
Lloyds target return on equity). You might instantly reply (as a person who is aware of the correlation between risk/reward and
recalling a current risk free yield of close to zero): What is the catch? If you come to the conclusion that you were being
offered a reliable real return at such an exalted level, you would buy as much as your finances allow. So what is the catch?
The obvious answer has to be that the real return in question must be extremely risky and has the chance of a total wipe-out.
Obviously, these cannot be sustainable safe returns in economies growing at a rate of about 2 per cent a year, for such a
well-established industry as the banking industry is. At a 15 per cent real return, the value of cumulative retained earnings
would double in five years and increase 16-fold in 20 years. As a consequence, bank equity would be the most desired real
asset in the world.
If you were really confident that banks could earn 15 per cent real returns, no one would ask for distributions, since the returns
would be so much higher than anywhere else. Therefore, the example of compound growth of bank equity, under
reinvestment of profits, is not unreasonable if the returns were themselves plausible. But they are clearly not. If these really
were plausible returns, there would also be no problem for banks obtaining much more capital; they would just have to
prevent distributions for a few years. We can therefore summarize that these returns must represent the result of extreme
risk-taking. Just how big that risk must be emerged during the latest crisis, when real returns became significantly negative
and several institutions failed.
Turner et al. (2010) made exactly this point regarding to the UK banking sector: trends in return on equity are divided into two
periods. Until around 1970, return on equity in banking was around 7 per cent with a low variance in other words, returns to
the financial sector were in line with the economy as a whole. But the 1970s mark a regime shift, with return on equity in
banking roughly trebling to over 20 per cent. During much of the latter period, banks internationally were engaged in a highly
3

Actually, the term search for yield lately the reference to the industrys excessive risk taking refers to a more technical
issue within the asset management industry: investors may underestimate risk if their investment managers take risks that are
not evident, or are purposely concealed. For example, some investment managers promise to pay a relatively high nominal rate
on a long-term contract. However, when expected inflation falls, as it did in the U.S. for nearly two decades after 1982, nominal
interest rates fall too. In these circumstances, the investment manager may for a time try to continue making high nominal
interest payments by taking greater risks: a so-called search for yield (Cecchetti, 2011).

competitive return on equity race.

There are other reasons why banks might earn 15 per cent returns on equity (besides the fact that these highly leveraged
balance sheets are risky and pose a real threat to society): one is that they can earn monopoly profits, the other is that they
are subsidised, mainly because taxpayers provide a safety net. Both are related. Without entry barriers, subsidies would be
arbitraged away. So when banks tell us that they target an ambitious high return on equity figure, they are saying that their
businesses are very risky and/or protected against competition and/or well subsidised and probably a bit of all three.
The question we need to ask ourselves is: can we afford to have financial institutions that are both so large and so essential
and yet run such enormous risks? Wolf suggests the answer is (again): no. Make them safer. It really is not going to hurt.
Source: Wolf (2011)

Today, the importance of the banking industry is obvious and goes hand in hand with other
developments: debt to GDP ratios increased somewhat dramatically, worldwide trading volumes
4

exploded , and financial products have become highly complex since Wall Street embraced financial
5

th

engineering . Stephen Cecchetti, advisor to the BIS, puts it as follows: For most of the 20 century,
defining money and banks was straightforward. Money was currency or a checking account balance;
banks were institutions that took deposits and made loans. Then the invention of computers and the
resulting revolution in information technology changed everything. [] The changes have been so
sweeping that if a banker of the 1960s or 1970s were transported to the present day, he or she would
hardly recognize our current financial system. The way we use money, financial instruments, financial
markets, and financial institutions is completely different from the way our grandparents generation
used them. (Cecchetti, 2008, p. vii)
Until the recent crisis, this increased surge in financial products and their complexity were
believed to enhance stability as well as efficiency. That assumption was, to put it mildly, not correct.
Financial innovation has allowed market participants to share risk more effectively than before. At the
6

same time, the financial industry has introduced a large number of highly complex securities , which
investors and risk managers have to deal with.
In summary, complexity matters (Brunnermeier & Oehmke, 2009, p. 4) in financial markets.
Investors, and therefore also regulators, need to find ways to deal with it. In 2011, three years after the
near collapse of the global financial system, former U.S. Federal Reserve chief Alan Greenspan sees
the possibilities for regulators limited (Greenspan, 2011): The problem is that regulators, and for that
matter everyone else, can never get more than a glimpse at the internal workings of the simplest of
modern financial systems. Todays competitive markets, whether we seek to recognise it or not, are
driven by an international version of Adam Smiths invisible hand that is unredeemable opaque.
So what should financial market regulation try to achieve to stop the on-going uncertainty? We
will deal with this and other questions in later sections. First, to start with, we have to think about why
we need financial intermediaries (if ever) and what functions they have within an economy.

2.1.1 MATCHING BORROWERS AND LENDERS

Worldwide total merchandise (exports, USD in current prices) grew by 4,707 per cent from 1970 to 2010 (World Trade
Organization, 2011).
5
Financial engineering is a multidisciplinary field related to the creation of new financial instruments and strategies, typically
exotic options and specialized interest rate or debt derivatives. Today, all full service institutional finance firms employ financial
engineering professionals in their banking and finance operations. JPMorgan Chase & Co. was one of the first firms to create a
large derivatives business, which employs computational finance (Tett, 2010, p. 3 f.).
6
One interpretation is that complexity emerged from financial institutions desire to sidestep regulation (Brunnermeier &
Oehmke, 2009).

What does the financial system do, and how does it deliver economic value added? This section will
provide us with the economic rationale about why banks exist.
There are different ways of categorizing activities within the financial system for the purpose
7

of this work, referring to Adair Turner , we will distinct between following four activities (Turner, et al.,
2010):

Provisions of payment services;

Provisions of pure insurance services, which enables economic entities to lay off exposure to
risks by pooling their exposure with others;

Creation of markets in spot or futures instruments in, for instance, commodities;

Financial intermediation between surplus units (borrowers) and deficit units (lenders), or
generally speaking an intermediation, which plays a crucial role in capital allocation within the
economy.

Of course, different banking products and activities span these four categories, but the conceptual
separation remains valuable. The last category (financial intermediation) deserves special attention:
8

linking surplus units/lenders with deficit units/borrowers. The claims between borrowers and lenders
can take the form of debt, equity or a combination of the two (hybrid), and appears with a variety of
different maturities. One function of financial institutions is simply to help match surplus and deficit
units. This straightforward matchmaking function is only a small part of the financial service industry.
The more interesting part, the core of what the financial system does, is to intermediate non-matching
borrowers and lenders of funds, enabling the pattern of lenders assets to differ from the pattern of
borrowers liabilities.

Jonathan Adair Turner is a British businessman, academic and chairman of both the Financial Services Authority and the
Committee on Climate Change in the U.K.
8
Here the problems arose in the latest financial crisis and most past financial crisis (for an historical overview see, for example,
Reinhart and Rogoffs work on financial crises over the last eight centuries (Reinhart & Rogoff, 2009)).

This intermediation of non-matching assets and liabilities provides four functions (Turner, et al., 2010):

Risk transformation: through the pooling of risks, with each depositor of a bank having an
indirect claim on all obligations owed to the bank rather than a claim on a specific loan;

Maturity transformation (through balance sheet intermediation): an inherent feature of a banks

business is maturity transformation. This is accomplished through lending at longer average
maturities compared to the maturities of a banks borrowings. The risk herein lies in the
9

management of the equity cushion, but also in the holding of a reserve of highly liquid assets .
Normally, liquidity insurance is achieved through the interbank market but also by the central
bank (in providing the lender-of-last-resort function). Through this process, savers are enabled
to hold short-time deposits, while borrowers can take out long-term debt;

Maturity transformation (via provision of market liquidity): gives the holder of a long-term asset
10

the option of selling his asset anytime he wants to in a liquid market ;

Risk return transformation: banks offer a mix of debt and equity investment options for savers,
which arise naturally from the liabilities of the borrowers. A banks balance sheet takes a set of
debt liabilities from final users and tranches them. This credit tranching refers to creating a
multi-layered capital structure that includes senior and subordinated tranches (classes)
(Nomura, 2004). Essentially, depositors and senior debt holders possess a (debt) claim of
lower risk than the average pooled quality of the asset side of the banks balance sheet. But
this comes with a lower return, while equity holders have a higher risk with an assumed higher
return on their investment.

Now we are able to analyse, how banks add value to the economy. Based on the four transformation
functions above, banks can provide value added to the economy in three different ways (Turner, et al.,
2010):

Pooling: the intermediary allocates capital to specific projects. The pooling process is
important, since a more efficient allocation of capital will tend to produce higher income
levels;

11

Asset/Liability maturity mix: a maturity mix of assets and liabilities provides assurance of
access to liquid assets in the face of either fluctuating consumption or (unanticipated) income
shocks. Therefore it enables individual economic units a smoothing of consumption across
their life cycle. In summary, it can deliver welfare benefits independent of any impact on
aggregate savings rates, investment levels, the efficiency of capital allocation, or economic
growth;

The Basel III rulebook addresses this issue with the Liquidity Coverage Ratio (LCR). The 30-day liquidity coverage ratio is
designed to ensure short-term resilience to liquidity disruptions.
10
This form of liquidity provision comes with uncertainty compared to maturity transformation on the balance sheet, where the
depositors are enabled to enjoy both liquidity and capital certainty. But it is still recognized as a form of maturity transformation,
giving the fund provider a different set of assets options that is inherent in the maturity of the liabilities faced by fund users
(Turner, et al., 2010).
11
A significant amount of capital allocation occurs de facto within firms, which make decisions about the use of retained
earnings. But still, intermediaries play an important role when it comes to capital allocation (Turner, et al., 2010).

Transformation: all above stated functions inherent to the intermediation of non-matching

assets and liabilities together enable individual household sector savers to hold an asset-mix
(as defined by risk, return and liquidity), which is different from the liability-mix owed by
business users of funds. This transformation may produce a higher savings rate, more
investments and, temporarily, higher growth (Levine, Loayza, & Beck, 2000).

These above stated functions increase the range of options for investments in different
risk/return/maturity combinations beyond the possibilities, which would exist if investors had only the
opportunity of direct investments in untransformed liabilities of businesses or households, or in pools
of these untransformed liabilities. It may be useful to note that the wave of credit securitization, which
played an important part in the recent crisis, was not in its economic function entirely new, but rather a
stepping up of the four financial system transformations described by Turner, et al. (2010).
As illustrated above, financial intermediaries can engage in asset transformation as regards
size/maturity/risk to accommodate the utility preferences of lenders and borrowers (first explained by
Gurley and Shaw (1960)). We have to consider if this explanation for the existence of banks is
complete.
One question is obvious: why are firms themselves not committed to direct borrowing (cutting
out the middleman)? Prima facie, the shorter transaction chain involved in direct lending-borrowing
would be less costly than the longer chain involved in indirect lending-borrowing. This leads to the
(theoretically correct) conclusion that, in a world with perfect knowledge, transaction costs and
indivisibilities would not exist and therefore financial intermediaries would be of no use. Of course,
these conditions are usually not present in the real world. Any business venture is subject to
uncertainty and consequently risky. Both project finance and lending are not perfectly divisible, and
transaction costs most certainly exist. To consider the reasons why borrowers and lenders prefer the
services of financial intermediaries we have to think of the following (Matthews & Thompson, 2008):

One reason for the dominance of financial intermediation over direct lending-borrowing refers
to transaction costs; Benston and Smith (1976) argue that the raison d tre for this industry
is the existence of transaction costs;

Other reasons include liquidity insurance (Diamond & Dybvig, 2000), information-sharing
coalitions (Leland & Pyle, 1977) and delegated monitoring (Diamond, 1984 and 1996).

We will discuss these topics in the following sections.

2.1.2 TRANSACTION COSTS

As a first stage in the analysis of the role of costs in an explanation of financial intermediation, we
need to examine the nature of costs involved in transferring funds form surplus to deficit units. The
following broad categories of cost can be discerned (Matthews and Thompson, 2008):

Search costs: these involve economic units searching out agents willing to take an opposite
position, e.g. a borrower seeking out one or more lenders who is willing to provide the
required amount. Additionally, beside the search for a counterparty, it would also be
7

necessary for the agents to obtain information about the opposite party to the transaction and
then negotiate and finalize relevant contract(s);

Verification costs: these arise from the need of the surplus unit to evaluate the proposal for
which the funds are required;

Monitoring costs: once a loan is made, the lender will wish to monitor the progress of the
deficit unit and ensure that the funds are used in accordance with the purpose agreed;

12

Enforcement costs: such costs will be incurred by the surplus unit should the deficit unit
violate any of the contractually agreed conditions.

The role of costs can be examined more formally. In the absence of a bank, the cost-return structure
of the two parties involved is depicted below, denoting the rate of interest as R, the various costs
incurred by the borrower as T B and those incurred by the saver as TS (Matthews & Thompson, 2008):
Return to the saver (RS) = R - TS
Cost to the borrower (RB) = R + TB
Then the spread is equal to: RB RS = TB + TS
The spread provides a profit opportunity, which can be exploited by the introduction of an
intermediary, a bank. The bank books transaction costs denoted by C. For simplicity, we will assume
that this cost is borne solely by the borrower. Following the introduction of a bank, the cost-return
structure of the two parties will be amended to (the prime indicates the costs after the introduction of a
bank):
Return to the saver (RS) = R TS
Cost to the borrower (RB) = R + TB + C
Then the spread is equal to: RB RS = TB + TS + C
The introduction of a bank will lower the cost of the financial transaction provided the borrowers and
savers cost fall by more than the amount of the charge raised by the intermediary, i.e. provided
(TB + TS) (TB + TS) > C
We can now consider the reasons for the assumption that the fall in the total costs incurred by
borrowers and lenders will be greater than the charge levied by a bank. As far as search costs are
concerned, banks are nowadays located within every city and the growth of Information Technology
has permitted direct access to financial institutions. Access can be easily accomplished. The
contractual arrangements are carried through standard forms of contract, which again lowers
transaction costs. Costs are also lowered for borrowers through size and maturity transformation.
12

A moral hazard problem could arise here: the borrower may be tempted to use the funds for purposes other than those
specified in the loan contract (Matthews & Thompson, 2008). To cover these risks the lender may demand an insurance
(Zimmermann, Henke, & Broer, 2009).

Consider the scale of costs likely to be incurred negotiating a series of small loans and their
subsequent renegotiation as and when each individual loan matures. In fact, economies of scale are
likely to be present, particularly in the banking industry. Costs of monitoring n loans carried out by q
investors are likely to be far more than the costs if monitoring were carried out by a single financial
intermediary.
In addition to economies of scale, scope economies are also likely to be present.

13

Economies

of scope arise from diversification of the corresponding asset portfolio including loans. Clearly, given
the geographical dispersion of agents and the resulting transport costs, some economies can arise
from the concentration of lending and deposit acceptance facilities. Pyle (1971) argues that economies
of scope can be explained within a portfolio framework. Deposits earn a negative return; loans and
advances earn a positive return. If these two returns were positively correlated (which would be
expected), then the financial intermediary would for optimization purposes hold a short position in
the first category and a long position in the second. In other words, the financial intermediary will issue
deposits and make loans.
It is therefore fairly certain that the introduction of financial intermediaries lowers the cost of
transferring funds from deficit to surplus units. Nevertheless, reasons for caution are appropriate
(Matthews & Thompson, 2008):

Economies of scale seem to be exhausted relatively early. The increased value of banks can
arise from two potential sources: increased efficiency and, of course, increased market power.
The first source is beneficial to society and originates from economies of scale (and also due
to economies of scope). As most banks offer a wide range of services, further large-scope
economies are not very likely;

There seems to be a quite general agreement that there is little potential for economies of
scope see, for example, Clark (1988) and Mester (1987);

Large firms with excellent credit ratings find it cheaper to obtain direct finance through equity,
bonds or money markets. This would be a case for disintermediation.

There is clear evidence that banks do generally lower the aggregate cost of financial intermediation;
but this appears to be an incomplete story of why financial intermediation occurs. It seems to suggest
that the level of transaction costs is exogenous without examination as to why these costs vary
between direct and indirect borrowing/lending. Further analysis is required to investigate the nature of
these costs.

13

Economic efficiency can be defined as the firms combining its inputs in a manner such that its costs are at a minimum: it is
therefore a combination of pure technical and allocative efficiencies (Matthews & Thompson, 2008).

2.1.3 LIQUIDITY INSURANCE

In the absence of perfect information, consumers are unsure when they will require funds to finance
consumption. Therefore consumers will desire a pool of liquidity to offset the adverse effects of shocks
to the economy. Provided these shocks to individual consumers are not perfectly correlated, modern
portfolio theory (MPT) suggests that the total liquid reserves needed by a bank will be less than the
aggregation of the reserves required by individual consumers acting independently. This is the basis
of the argument put forward by Diamond and Dybvig (1983) to explain the existence of financial
intermediaries. The existence of banks obviously enables consumers to alter the pattern of their
consumption in response to unexpected events compared with the pattern that would have existed in
a base scenario (Matthews & Thompson, 2008). The value of this service justifies a fee to be raised by
the intermediary.
Diamond and Dybvig illustrate the case of liquidity insurance in form of a three-period model.
Decisions are made in period 0 to run over the next two periods. Technology is assumed to require
two periods to be productive. As a result, every interruption of the process to finance consumption
leads to a lower return. Consumers are split into two categories: those who consume early in period 1
and those who consume late at the end of period 2. Early consumption imposes a cost in the form of
lower output and consumption in period 2.
Diamond and Dybvig point out that business investment often requires expenditures in the
present to obtain returns in the future. Therefore, when deficit units need to borrow to finance their
investments, they wish to do so on the understanding that the surplus unit will not demand
repayment(s) until some agreed upon time in the future, in other words they prefer loans with a long
maturity (low liquidity). The same principle applies to individuals seeking financing to purchase largeticket consumer goods. On the other hand, individual savers may have unpredictable need for cash,
due to unforeseen expenditures or broader shocks to the economy. Therefore they demand liquid
accounts, which permit them immediate access to their deposits (they value short maturity deposit
accounts). Regarding to the introduced model, the existence of a bank offering fixed money claims
overcomes this problem by pooling resources and making larger payments to early consumers and
smaller payments to later consumers than would be the case in the absence of a financial
intermediary. For this reason the financial intermediary acts as an insurance agent.
Diamond and Dybvig's crucial point about how banking works is that under ordinary
circumstances, savers' unpredictable needs for cash are unlikely to occur at the same time. Thus a
bank can make loans over a long horizon, while keeping only relatively small amounts of cash on hand
to pay any depositors that wish to make withdrawals. It should also be noted that the key point is that
the existence of uncertainty provides the underlying rationale for the model (Matthews & Thompson,
2008). There is also the critical assumption that the division of agents between the two classes of
consumers is certain. Finally, the explanation is not independent of transaction costs as the role of the
bank does depend on possessing a cost advantage, otherwise individuals would introduce their own
contracts, which would be able to produce a similar outcome.

10

2.1.4 ASYMMETRY OF I NFORMATION

A large literature (see, for example, Bhattacharya and Thakor (1993), or van Damme (1994) for an
overview) has identified asymmetric information as the decisive element of credit markets. The basic
rationale underlying the asymmetry of information argument is that the borrower is likely to have more
information about the project that is the subject of a loan than the lender. In any case, the borrower
should be aware of the degree of risk attached to the project (Matthews & Thompson, 2008). These
asymmetries lead to a credit rationing equilibrium (see, for example, Stiglitz and Weiss, 1981), and
may invalidate other competitive market results (Ariccia, 1998). But lenders are able to resolve part of
these informational problems over time. In the process of lending, financial intermediaries gather
valuable proprietary information about borrowers creditworthiness. Banks gather market power by
acquiring some degree of informational monopoly about their clients (Greenbaum, Kanatas, &
Venezia, 1989). In essence, it is simply all about the cost of figuring out whether a borrower is
trustworthy.
Special attention should be drawn upon moral hazard and adverse selection. The phrase
moral hazard originated when economists who were studying the insurance business noted that an
insurance policy changes the behaviour of the insured person (Cecchetti, 2008). In our context, moral
hazard is the risk that the borrower may engage in activities that reduces the probability of the loan
being repaid. Prior to the credit line granted, the borrower may well have inflated the probable
profitability of the project either by exaggerating the profit if the venture is successful or by minimizing
the chance of failure. It goes without saying that it is difficult for the lender to assess the true situation.
After a loan is negotiated, moral hazard may occur because the borrower acts not as agreed upon. On
the other hand, adverse selection may occur because the lender is not sure of the precise
circumstances surrounding the loan and associated project. Given this lack of information, the lender
may select the wrong projects to finance. Apparently, the result of the existence of asymmetric
information between borrower and lender reduces the efficiency of the transfer of funds from surplus
to deficit units (Matthews & Thompson, 2008). What can the introduction of an intermediary do to
circumvent these problems? Three answers are given in the literature (Matthews & Thompson, 2008):

Banks are subject to economies of scale in their borrowing/lending activities so that they can
be considered as information-sharing coalitions;

Banks monitor the projects that they finance, i.e. they operate as delegated monitors of
borrowers;

Banks provide a mechanism for commitment to a long-term relationship.

In all these cases a bank may overcome the pitfalls of moral hazard and adverse selection. The next
subsections will explain the above-mentioned answers against the asymmetry of information problems
in greater detail.

11

2.1.4.1 I NFORMATION -S HARING C OALITIONS

As we have mentioned above, the assumption is made that the borrower knows more about the
underlying risk of a project than the lender. Insofar, the lender will have the desire to collect
information to get more insight about the risk-reward structure of the projects he finances. The
difficulty for the lender is that information is costly to obtain and is in its nature a public good (nonrivalry, non-excludability). Any purchaser of information is enabled to resell or share the obtained
information with other economic units so that the original firm may not be able to recoup the value of
the information obtained. A second difficulty for the lender is that the quality of the information is hard
to evaluate, so that the distinction between good and bad information is not readily apparent
(Matthews & Thompson, 2008). Leyland and Pyle (1977) argue that, because of these problems, the
price of information will reflect its average quality, so that firms that are going for high-quality
information will lose money. Importantly, Leland and Pyle point out, that these difficulties can be
resolved through the introduction of an intermediary that uses information to buy and hold assets in its
portfolio. Thus, information becomes a private good because it is implemented in the underlying
portfolios and, hence, not transferable. This provides an incentive for the gathering of information.
Furthermore, Leyland and Pyle (1977) emphasize that one way a borrower can provide information
about its projects is to offer collateral, and so a coalition of borrowers can do better than any individual
borrower. Formally demonstrated: assume N individual borrowers each have identical projects,
2

yielding the same expected return (R). The given variance of each individual return is given by . The
coalition of borrowers do not alter the expected return of each single project, but because of
2

diversification the variance is now /N. Regarding to Leyland and Pyle (1977) their analysis about
information asymmetries, financial structure and financial intermediation also offers an explanation for
the liability structure of a banks balance sheet (for an in debt analysis of the banks liability structure
see, for example Bradley and Shibut, 2006). They propose that the optimal capital structure for banks
with riskier returns will be one with lower debt levels; given a bank with a reduced risk level, the
structure of liabilities observed with high debt in the form of deposits is quite logical (Matthews &
Thompson, 2008, p. 43).

2.1.4.2 B ANKS AND D ELEGATED M ONITORING

Generally speaking, the term monitoring refers to the collection of information about a firm, its
investment projects and its behaviour before and after the loan application is made. Schumpeter
assigned such a monitoring-task to banks (Schumpeter, 1939, p. 116): [] the banker must not only
know what the transaction is which he is asked to finance and how it is likely to turn out but he must
also know the customer, his business and even his private habits, and get, by frequently talking things
over with him, a clear picture of the situation.

12

Examples, to name a few, of such monitoring-tasks are:

Screening the application of loans to sort out the good from the bad to reduce the probability
of financing too risky loans;

Examining the creditworthiness of the counterparty;

Implementing control mechanisms to keep track of the borrowers behaviour if he sticks to the
terms of the contract; etc.

A bank has a special advantage in the monitoring process as it will often be operating the clients
current account and will therefore have private information concerning the clients flows of income and
expenditure. This factor is very important in the case of small- and medium-sized companies and
arises from the fact that banks are the main operators in the payments mechanism.
A bank will require a firm to produce a business plan before granting a loan. Given the number
of such plans examined, a bank will have developed special expertise in assessing such plans and will
therefore get more competent in judging the plausibility of a plan over time. Further controls exist in
the form of credit scorings whereby a clients creditworthiness is assessed by certain rules (for
example, the best-known and most widely used credit score model in the U.S. is the FICO score
(named after the Fair Isaac Corporation, a provider of analytics and decision management
technology).

14

The FICO score is calculated statistically, with information from personal credit files.

Other, more public information is available in respect of firms. Rating agencies exist that provide credit
ratings for firms and also sovereign debt, where country ratings are a necessary by-product (rating
agencies are not being paid for country ratings, but are a factor to evaluate for firms based in the
regarding jurisdiction). The most well-known rating agencies are Standard & Poor, Moodys and Fitch.
This information becomes available to the general public via reports in the media. Finally, monitoring is
also relevant after a loan has been granted. Banks will set conditions in the loan contract that can be
verified over time. For a firm these typically will include the adherence to certain accounting ratios and
a restraint over further borrowing while the loan is outstanding. The bank is able to check that such
conditions are being adhered to. In addition, collateral security will often be required. Failure to adhere
to the terms of the agreement will cause the loan to be cancelled and the collateral forfeited (Matthews
& Thompson, 2008).
The information obtained from borrowers is also confidential, which is not the case when
funds are obtained from the capital market. In the latter situation, a firm raising funds must provide a
not inconsiderable amount of detail to all prospective investors. There is a second advantage to firms
raising bank loans. The fact that a firm has been able to borrow from a bank and meet its obligations
regarding repayment provides a seal of approval as far as the capital market is concerned. It shows
that the firm has been satisfactorily screened and absolves the capital market form repeating the
process. The role of banks, in particular, provides a means for the problems associated with
asymmetric information to be ameliorated. For monitoring to be beneficial, it is necessary to show that
14

Credit scores are widely used because they are inexpensive and largely reliable, but are not without any problems. One
problematic issue, for example, is the piggyback problem. Because a significant portion of the U.S. FICO score is determined by
the ratio of credit used to credit available on credit card accounts, one way to increase the score is to increase the credit limits
on one's credit card accounts (Foust & Pressman, 2008).

13

the benefits of monitoring outweigh the costs involved in gathering the information. As noted in Section
2.1.2 (Transaction Costs), banks have a comparative advantage in the process of monitoring the
behaviour of borrowers both before and after the loan is granted. This gives the lenders an incentive to
delegate the monitoring to a third party, thus avoiding duplication of effort.
Any bankruptcy cost or default will be spread over a large number of depositors, making the
average cost per depositor quite small. This contrasts with the situation where each lender is
concerned with few loans. In such cases the failure of one borrower to service the loan according to
the agreement would have a major impact on the lender (Matthews & Thompson, 2008).
Diamond (1984, 1996) presents a more formal model of intermediation reducing the costs of
outside finance under conditions of imperfect information. Diamond considers three types of
contracting arrangement between lenders and borrowers:

No monitoring,

Direct monitoring by investors and

Delegated monitoring via an intermediary.

In the case of no monitoring, the only recourse to the lender in the case of a failure by the borrower to
honour his/her obligations is through some form of bankruptcy proceedings. This is an all or nothing
approach and is clearly expensive and inefficient. Direct monitoring can be extremely costly. The
example given by Diamond (1996) assumes there are m lenders per borrower and a single borrower.
If K is the cost of monitoring, then the total cost of monitoring without a bank is mK. The introduction of
a bank changes the situation. Assume a delegation cost of D per borrower. Then the cost after
delegation will be (K+D) as against (mK) without a bank. (If there were N rather than a single
borrower, then the two costs without and with a bank would be nmK and (K+nD) respectively. This
leaves the analysis intact.) It is readily apparent that (K+D) will be less than mK, so that the
introduction of a bank has lowered the cost of intermediation (Matthews & Thompson, 2008).
The analysis so far assumes that the monitoring cost per loan remains the same, but, as
noted earlier, the monitoring cost per transaction would be expected to fall because of the existence of
economies of scale and scope. There is still the problem for the lenders/depositors of monitoring the
behaviour of the bank, as the depositors will not be able to observe the information gleaned by the
bank about the borrowers. They can, however, observe the behaviour of the bank, so that it could be
argued that the process has merely led to a transfer of the monitoring of the behaviour of the borrower
to that of the bank. Furthermore it is assumed that the bank maintains a well-diversified portfolio so
that the return to the investors in the bank, i.e. the ultimate lenders, is almost riskless (but not
completely so given the fact that banks do fail) and therefore not subject to the problems associated
with asymmetric information. The depositors also have the sanction of withdrawing deposits as a
means of disciplining the bank. Furthermore, in addition to the diversification of its portfolio, depositors
receive further protection because of the supervision of banks carried out by a regulatory authority, the
precise nature of which depends on the institutions of the country concerned. Consequently, the bank
is able to issue fixed-interest debt and make loans to customers with conditions significantly different
from those offered to the depositors (Matthews & Thompson, 2008).
14

2.1.4.3 M ECHANISM FOR C OMMITMENT

Another reason for the existence of banks given asymmetric information is that they provide a
mechanism for commitment (Matthews & Thompson, 2008). Contracts cannot be drawn up and
agreed upon in a manner that specifies all possible outcomes; this means that there is an absence of
complete contracts.
Mayer (1988) suggests that a close relationship with borrowers may provide an alternative
means of commitment. It is argued that German and Japanese banks do have a close relationship
with their clients and often are represented on the firms governing bodies. Banks are therefore
enabled to stay well informed about investment prospects and the future outlook for the firm. Despite
of foreclosure, remedial actions can help in case of the firm experiencing problems. This close
relationship to the clients may help to ease the problems of moral hazard and adverse selection.
Supporting Mayers arguments, Hoshi et al. (1991) provides evidence that firms with close banking
ties perform more efficiently than firms without such ties.

2.1.5 OPERATION OF THE P AYMENTS MECHANISM

The operation of a payments mechanism provides banks with an advantage over competing financial
intermediaries. Money provides different functions to the economy: "Money," Scitovsky (1969, p. 1)
said, "is a difficult concept to define, partly because it fulfils not one but three functions, each of them
providing a criterion of moneyness [] those of a unit of account, a medium of exchange, and a store
of value." The two main purposes money serves in the economy are the medium of exchange and the
store of value function. Bank deposits are unique because they serve both purposes at the same time
- they are a package of services. The difference between a bank deposit and other assets serving as a
store of value is that bank deposits also provide the medium of exchange function. Usually, payments
are effected by a bookkeeping entry moving a balance between accounts without the necessity to
transfer actual cash amounts. We can say that it is always necessary for us to keep money balances,
i.e. a bank deposit, to conduct transactions. The deposits are important for banks because they can
use them to purchase interest-earning assets. Banks also protect this advantage. For example they
provide a free or nearly free service of transferring funds. Nevertheless, such services are expensive
to provide and that is why banks are trying to reduce costs by branch closure and greater operational
efficiency (Matthews & Thompson, 2008). We keep in mind that the payments mechanism by banks
gives them a great advantage over competitors in the role of financial intermediaries.

15

2.1.6 DIRECT BORROWING FROM THE CAPITAL MARKET

Even when it comes to direct borrowing by deficit units, banks have an important role to play - they
provide functions regarding to guarantees (Matthews & Thompson, 2008):

Loan commitments by way of note issuance facilities: these facilities consist of promises to
provide the credit in case the total issue will not be completely taken up in the market;

Debt guarantees: one obvious example of this is the guarantee of bills of exchange on behalf
of its customers;

Security underwriting: banks act as advisors on the issue of new securities and also they will
take up any quantity of the issue not taken up in the market.

It goes without saying that for all these activities the bank earns fee income rather than interest. This is
commonly known as off balance sheet business because it does not appear on the balance sheet
unless the guarantee has to be exercised. To evaluate the activities outside traditional financial
intermediation we can compare two figures for the banks income calculation: first, net interest income
(gap between interest paid out on deposits and interest received from lending) and second, fee or
commission income. We instantly can get an impression of the importance of the activities outside
traditional financial intermediation (Matthews & Thompson, 2008).
We have now shown the economic rationale for the existence of banks. In summary we
should keep in mind that financial institutions perform five functions (Cecchetti, 2008): (1) pooling the
resources of all the small savers; (2) providing safekeeping and accounting functions, as well as
access to the payments system; (3) supplying liquidity by converting savers balances directly into a
means of payment whenever needed; (4) providing ways to diversify risk; and (5) collecting and
processing information in ways that reduce information costs.
Now we are aware of the economic reasons for the existence of banking. In Summary, closing
the chapter on banking business, we are now able to explain the (standard textbook) economic
reasons for intermediation and classify financial institutions within an economy. For critical remarks on
the standard textbook view see, for example, Graeber (2011). Having heard of the unquestionable
importance of the banking sector, the next chapter will put its focus on bank regulation.

16

3. Bank Regulation
Banking crises are not a recent phenomenon; the history of banking over the last centuries is replete
with periods of turmoil and failure. Many of the earliest crises were driven by currency debasements
that occurred when the monarch of a country reduced the gold or silver content of the coin

15

of the

realm to finance budget shortfalls often prompted by wars (Cecchetti, 2008).

More timely, the last thirty years have seen an impressive number of worldwide banking and
financial crises. Caprio and Klingebiel (1997) identify 112 systemic banking crises in 93 countries and
51 borderline crises in 46 countries since the late 1970s.

16

The recent crises, which now appear to happen in shorter intervals than before, have renewed
interest of economic research about two questions (Rochet, 2008): the causes of fragility of banks and
the possible ways to remedy this fragility, and, as a result to this instability, the justifications and
organization of public intervention. As Rochet (2008) points out, public intervention can take several
forms:

Emergency liquidity assistance by the central bank acting as a lender of last resort (LLR);

Organization of deposit insurance funds for protecting the depositors of failed banks;

Minimum solvency requirements and other regulations imposed by banking authorities;

Supervisory systems, supposed to monitor the activities of banks and to close the banks that
do not satisfy these regulations.

The crisis of 2007-09 has been the result of the interaction of economic factors and financial
innovation (for an analysis see, for example, Brunnermeiers study Deciphering the Liquidity and
Credit Crunch 20072008, 2009). Wide global imbalances characterized the years before the crisis
the International Monetary Fund (IMF) has written at length about the problem of global imbalances
since the early 2000s

17

(see, for example, Dunaway, 2009). The financial sector went through a period

of far-reaching changes caused by innovation and the development of credit risk transfer mechanisms.
Thinking of the latest financial turmoil, the need for a more sophisticated regulatory framework seems
unquestionable.
As the BCBS (2006, p. 6) points out, an effective system of banking supervision needs to be
based on a number of external elements, or preconditions. [] These preconditions, although mostly
outside the direct jurisdiction of the supervisors, have a direct impact on the effectiveness of
supervision in practice. Where shortcomings exist, supervisors should make the government aware of
these and their actual or potential negative repercussions for the supervisory objectives. Supervisors
should also react, as part of their normal business with the aim to mitigate the effects of such
15

It is cheap to produce a coin or a banknote; the difference between what it costs the government to issue money and an
economic unit to produce it is known as seignorage, after the right of the medieval lord, or seigneur, to coin money and keep for
himself some of the precious metal from which it was made (Eichengreen, 2011). In German, seignorage was therefore aptly
denoted as Mnzgewinn or Schlagschatz.
16
Many books have been written about the history of international financial crises, perhaps most famous Kindelbergers (1989)
book Manias, Panics and Crashes and more recently Reinhart and Rogoffs (2009) book This Time is Different. Fergusons
(2010) history of the foundations of currency and finance Der Aufstieg des Geldes: Die Whrung der Geschichte is also worth
to be mentioned at this point.
17
See world Economic outlook, International Monetary Fund, various issues.

17

shortcomings on the efficiency of regulation and supervision of banks. These external elements
include:

Sound and sustainable macroeconomic policies;

A well-developed public infrastructure;

Effective market discipline; and

Mechanisms for providing an appropriate level of systemic protection (or public safety net).

Continuing, Chapter 3 will address the topics of the justification for bank regulation, the governments
safety net, bank regulation and supervision, and, finally a brief look on the regulatory response to the
financial crisis of 2007-09.

3.1 THE JUSTIFICATION FOR BANK REGULATION

The strongest need for regulation arises in cases where physical danger is involved; obviously, bank
regulation does not fall into this category. Due to the absence of an immediate threat, it seems
appropriate to explain the need for bank regulation. For a detailed analysis of this topic regarding
specifically to the latest crisis, Bullard, Neely and Wheelock (2009), for example, explain in Systemic
Risk and the Financial Crisis: A Primer why the failures of financial firms are more likely to pose
systemic risks than the failures of nonfinancial firms.
We could think of bank regulation as an application of a general theory of public regulation to
the specific problems of the banking industry. But in fact, as Freixas and Rochet (2008) argue, this
would be misleading. It is worth devoting some effort to understand why bank regulation raises some
questions that are not addressed within the general theory of public regulation. Although some
instruments and models of the theory of regulation can be adapted to cope with issues in bank
regulation, there are exceptions. The discussion here in Section 3.1 examines the justification for
regulation, considering first the general argument relating regulation and market failure, and then
analysing what is specific to banks as seen in Freixas and Rochet (2008).
The case for regulation hinges on the argument from Ronald Coase

18

that unregulated, private

actions create outcomes whereby marginal social costs are greater than marginal private costs. The
marginal social costs occur because bank failure has a far greater effect which is obvious when we
think of the topics we discussed in Chapter 2 (The Banking Business) throughout the economy than
the failure of other businesses. In comparison, the marginal private costs are borne by the
stakeholders of the company, and these are likely to be of a smaller magnitude than the marginal
social costs.

18

Ronald Harry Coase is a British-born, American-based economist. Coase is best known for two articles: The Nature of the
Firm (1937), which introduces the concept of transaction costs to explain the nature and limits of firms, and The Problem of
Social Cost (1960), which suggests that well-defined property rights could overcome the problems of externalities.

18

It should be kept in mind that regulation involves real resource costs, which arise from two sources
(Matthews & Thompson, 2008):

Direct regulatory costs;

Compliance costs, occurred at the regulated entities.

These costs are not trivial and have been characterized by Goodhart (1995, p. 2 f.) as representing
19

the monstrous and expensive regiment of regulators . Therefore we can see why, in general, public
regulation is justified by market failures. In terms of financial intermediation, contemporary banking
theory offers a series of explanations for the emergence of banks. But still, it is quite possible that
financial institutions do not completely solve the associated market failures or may even create new
market failures (Freixas & Rochet, 2008).
Banks emerge because they provide liquidity insurance solving the market failure owing to the
absence of contingent markets (e.g. markets, in which contracts will only be exercised under certain
circumstances). Still, regarding to Freixas and Rochet (2008), they create a new market failure
because a bank run equilibrium

20

exists, therefore requiring regulation.

The subsequent discussion establishes the existence of two market failures that make bank
regulation necessary: the fragility of banks is owed to their illiquid assets and liquid liabilities, and the
fact that depositors are not in the position to monitor the management of their bank.

3.1.1 THE SOURCES AND CONSEQUENCES OF RUNS, P ANICS, AND CRISES

By their very nature, financial systems are fragile and vulnerable to crisis - as illustrated by
Kindelberger (1989) or Reinhart and Rogoff (2009). Unfortunately, when a countrys financial system
collapses, its economy goes with it (Calvo & Mendoza, 2000).
Considering the fact that there is empirical evidence (see, for example, Taylor 2008) that
government actions and interventions caused, prolonged, and worsened the latest financial crisis, it is
obvious that the lack of coordination can be costly (Gai, Hayes, & Shin, 2001, p. 7). Gai, Hayes &
Shin (2001, p. 7) continue that [] in the event of a sovereign default, disorder in the workout process
can lead to the premature scrapping of longer-term investment projects and a protracted exclusion
from international capital markets. Much of the policy debate has therefore focused on reducing the
costs of crisis. Keeping banks open and operating is therefore an essential to maintaining our way of
life. Because a functioning financial system benefits everyone, authorities are deeply involved in the
way banks and other financial intermediaries function. Referring to Cecchetti (2008), it is therefore
hard to exaggerate the importance of this government oversight in ensuring financial stability. Banks
fragility arises from the fact that they provide liquidity to depositors. (Cecchetti, 2008, p. 331) As we

19

Goodhart uses the phrase as an intentional misquote from a famous polemic of John Knox (1558) against Mary, Queen of
Scots named The First Blast of the Trumpet Against the Monstrous Regiment of Women. The book was written against the
female sovereigns of his day, particularly Mary of Guise, Dowager Queen of Scotland and regent to her daughter Mary, Queen
of Scots, and Queen Mary I of England. Knox, a staunch Protestant Reformer, opposed the Catholic queens on religious
grounds, and used them as examples to argue against female rule over men generally (but not about women in all roles or
respects).
20
In a bank run equilibrium, the pure demand deposit contract is worse than direct ownership of assets (Diamond & Dybvig,
2000).

19

all know, banks allow their depositors to withdraw their balances on demand. If a bank cannot meet
this promise because of insufficient liquid assets, it will fail.
It is important to mention that banks not only guarantee their depositors immediate cash on
demand, but they promise to satisfy depositors withdrawal requests on a first-come, first served basis
- this has some important implications. We shall consider the following scenario: depositors who read
in the newspaper that their bank defaulted on one of its loans will lose confidence in the banks ability
to make its payments. Hence, they think that the banks assets may no longer cover its liabilities.
Thinking of the banks first-come, first-served policy, depositors may rush to the bank to convert their
balances to cash before other customers arrive (Cecchetti, 2008).
As a bank run progresses, it turns into a self-fulfilling prophecy: as more and more people
withdraw their deposits, the likelihood of default increases, therefore encourages further withdrawals.
Clearly, this can destabilize a bank to the point where it faces bankruptcy (Diamond, 2007). The British
21

bank Northern Rock , which needed state intervention to avoid a breakdown in September 2007, may
be named as a recent example (for more details on this see the report by the Treasury Committee
ordered by the House of Commons and published on January 26, 2008).
What matters during a bank run is not whether a bank is solvent, but whether it is liquid:
solvency means that the value of the banks assets exceeds the value of its liabilities (the bank has a
positive net worth); on the contrary, liquidity means that the bank has sufficient reserves and
immediately marketable assets to meet depositors demand for withdrawals. Rumours, true or not, that
a bank is insolvent can lead to a run that renders a bank illiquid (Cecchetti, 2008).
When a bank fails, depositors may lose some or all of their deposits, and also their data e.g.
information about borrowers creditworthiness may disappear. The primary concern is that a single
banks failure might cause a small-scale bank run that could turn into a system wide bank panic. This
phenomenon of spreading panic on the part of depositors is called contagion

22

(Cecchetti, 2008).

But we have to be aware of the trade-off that comes with a tight regulatory approach and that
is why government officials have to think about an optimal regulation and not about a regulatory
framework where single failures are minimized. But fortunately, there is empirical evidence that helps.
Barth, Capiro, & Levine (2001) evaluated the efficacy of specific regulatory and supervisory policies
from an database of 107 countries and assessed two competing theories of government regulation: (1)
the helping-hand approach (governments regulate to correct market failures) and the (2) grabbinghand approach (governments regulate to support political constituencies). Their findings were that the
grabbing-hand theory predicts that countries with powerful supervisors, limits on bank activities, high
levels of government ownership of banks, and entry-restrictions will tend to have a higher level of
corruption without the desired improvement in bank perfromance and/or stability. Their conclusion is
that governments that focus more on the empowerment of private-sector control of bank behaviour are
more likely to promote bank performance and stability than governments which take an interventionist
stance to regulation and supervision. On the contrary, the grabbing-hand view suggests that
21

On November 17, 2011 Virgin Money, Sir Richard Bransons banking arm, announced to buy Northern Rock for GBP 747mn.
The lender will be rebranded as Virgin Money. Speaking for the UK Treasury, George Osborne, chancellor of the exchequer,
said (Financial Times, 2011): The sale of Northern Rock to Virgin Money is an important first step in getting the British taxpayer
out of the business of owning banks. It represents value for money; will increase choice on the high street for customers; and
safeguards jobs in the north-east.
22
For a detailed explanation of the term contagion, more specific bank contagion, and the interdependencies to systemic risk
see, for example, Bandt and Hartmann (2000).

20

regulatory and supervisory practices that demand detailed disclosures from banks, empower the
private-sector corporate control of banks, and support incentives for private agents to exert corporate
control work best to reach a high level of banking performance and stability. Barth, Capiro, & Levine`s
(2001) research results are questioning strategies that place excessive reliance on direct, government
oversight of and restrictions on banks; therefore, authorities should be aware of the tradeoff from a too
strict regulatory approach. Officials should be aware of such findings. Next up: the notorious Market
for Lemons.

3.1.2 A MARKET FOR LEMONS

Information asymmetries are the reason that a run on a single bank can turn into a bank panic that
threatens the entire financial system. Now we have to consider Akerlofs famous market for lemons
problem: if there is no way to differ a good used car from a bad one, there will only be lemons on the
market. And, regarding to Cecchetti (2008), what is true for cars is even truer for banks. Most of us

23

are clearly not in a position to assess the quality of a banks balance sheet (not to mention the offbalance sheet activities). Hence, depositors are in the same position as uninformed buyers in the used
car market: they cant tell the difference between a good bank and a bad bank. So when rumours
spread that a certain bank is in trouble, depositors everywhere begin to worry about their own banks
financial condition. Concern about even one bank can create a panic that causes profitable banks
throughout the region to fail, leading to a complete collapse of the banking system (Cecchetti, 2008).
As we have shown, banking panics and financial crises can easily result from false rumours,
they can naturally also occur for more concrete reasons. Since a banks assets are a combination of
loans and securities (plus physical assets and reserves), anything that affects entitled loan
repayments or reduces the market value of securities on a banks banking or trading book has the
potential to imperil the banks finances. Recessions, or at least a weak economy, have a negative
impact on a banks balance sheet. When business activity slows, all economic units have a harder
24

time paying their debts. As a result, default rates rise , bank assets lose value, and bank capital
suffers a slump. With less available capital, banks are forced to contract their balance sheets, handing
out fewer loans. This decline in loans, is followed by less business investment the downturn
intensifies. If the economic situation gets really bad, banking institutions begin to fail (Cecchetti, 2008).
25

Financial disruptions can also occur during a deflationary economic environment , where the
borrowers net worth falls. Companies borrow a fixed number of currency units to invest in real assets,
whose values fall with deflation. So a drop in prices reduces companies net worth but not their loan
payments. This decline in firms net worth aggravates the adverse selection and moral hazard
problems caused by information asymmetries, and therefore making loans more difficult to obtain. If
the firms cannot get new financing, business investment will fall like during a recession, reducing
23

Even for professional financial analysts it is nearly impossible to evaluate the financial strength of banks (Mayo, 2011).
This issue can be monitored over a banks financial statement, where it is referred to as nonperforming loans (NPLs), which
are defined as follows (IMF, 2005, p. 4): A loan is nonperforming when payments of interest and/or principal are past due by 90
days or more, or interest payments equal to 90 days or more have been capitalized, refinanced, or delayed by agreement, or
payments are less than 90 days overdue, but there are other good reasonssuch as a debtor filing for bankruptcyto doubt
that payments will be made in full. After a loan is classified as nonperforming, it (and, possibly, replacement loan(s)) should
remain classified as such until written off or payments of interest and/or principal are received. Institutions holding
nonperforming loans in their portfolios may choose to sell them in order to get rid of risky assets and clean up their balance
sheets. Sales of nonperforming loans must be carefully considered by the management since they can have numerous financial
implications, including affecting the company's profit and loss, and its tax situations.
25
For an analysis of the disruptive effect of deflation on the financial system see, for example, Bernanke and James (1991).
24

21

overall economic activity and raising the number of defaults on loans. As more and more borrowers
default, banks balance sheets deteriorate, compounding information problems and intensifying the
economic stress (Cecchetti, 2008).
At the end of this section, and for a better illustration of the above stated threats for the
financial industry, we will state the economic effects, which caused the financial crisis from 2007-09.
Following Brunnermeiers (2009) arguments, four economic mechanisms amplified the latest U.S.
mortgage crisis into a severe financial crisis:

The borrowers balance sheet: banks equity capital erodes through falling asset
prices, forcing the institutions to sell positions at fire sale prices;

The lending channel: problems within the lending sector lead to less lending; this may
also be true if the creditworthiness of borrowers does not change. An uncertain
outlook on a banks future funding needs is enough to limit lending activity. Banks end
up hoarding funds, and as a consequence the lending market grinds to a halt;

Bank runs: runs can cause, as we already discussed above, a sudden erosion of bank
capital;

Counterparty risk: through the high grade of interconnectedness (financial institutions

have to be lenders and borrowers at the same time as Brunnermeier points out), an
increase in counterparty risk can cause network gridlock. In such a gridlock situation,
each individual institution is unwilling to sign netting agreements: each institution has
to shore up funds to insure against each others counterparty credit risk. Obviously,
the result is even more pressure on the funding side.

Having heard of all the bad things which can happen within the financial sector and therefore why it is
justified to regulate banks, we will now discuss the government safety net, which should enhance the
stability of the financial sector.

3.2 THE GOVERNMENT S AFETY NET

There are three reasons for the government to get involved in the financial system (Cecchetti, 2008):

To protect investors;

To protect bank customers from monopolistic exploitation; and

To safeguard the stability of the financial system.

First, the government is obligated to protect small investors. While market forces are supposed to
discipline the industry, in practice only the force of law can ensure a banks integrity (we already
mentioned above Greenspans misjudgement of the invisible hand). Small investors rely on the
government to protect them from mismanagement and malfeasance. Second, the growing tendency

22

for small firms to merge into larger corporations reduces competition

26

, which could lead to

monopolies. Because monopolies are inefficient, the government intervenes or should intervene to
prevent such firms from becoming too large and to ensure that even large banks still face competition.
Also relevant in this context is the TBTF problem where the government faces five problems (Mschel,
2011):

Stability of the financial system: the stability of the financial system and the potential threat
from the banking institutions to the real economy is an important focus of the government. The
mid-size investment bank Lehman Brothers elevated the financial crisis from North America to
a global level;

Competition: banks, labelled systemic important, create major distortions of competition

because of their implicitly given guarantee by the taxpayers (they enjoy, for example, a clear
advantage in terms of refinancing);

Misallocation: the latent state responsibility causes wrong incentives and therefore
misallocation of resources. This is true for the owners, management, employees, creditors and
shareholders. The implicit state guarantee leads to carefree handling of risk;

Wrong incentives for politics: bailout programs, as we have witnessed in the latest financial
crisis of 2007-09, may lead to enormous financing costs. Combined with fiscal stabilisation
measures, huge public deficits and threatening debt to GDP ratios may be the consequences.
The financial capacity of a country could be affected for many years to come;

Complicated management of rescues: the complex structure of interconnected banks can be

so high that a desired rescue may not be possible within a limited timeframe.

Third, the combustible mix of liquidity risk and information asymmetries means that the financial
system is inherently unstable (Cecchetti, 2008, p. 333). A financial firm can collapse much more
quickly than companies form other business sectors. Financial institutions can create and destroy the
27

value of its assets in an astonishingly short period of time , and as it goes down, it threatens the
entire system.
Government officials employ a combination of strategies to protect other economic units and
ensure the stability of the financial system. Most important, authorities provide the safety net to insure
depositors. Government institutions operate as a lender of last resort and provide deposit insurance
(Cecchetti, 2008).
26

As an example for such a negative environment for customers we can name, for example, the so called Lombard Club: The
Lombard Club was a European banking cartel broken up by the European Commission in 2002. The Commission found that
eight Austrian banks met monthly to organize widespread price fixing across Austria. It was organized before Austria joined the
European Union. The Commission imposed fines totaling EUR 124,26mn (European Commission, 2002).
27
The real issue behind creating this high degree of risk is linked to derivatives (see, for example, Gibsons study on the
underlying risk of synthetic CDOs, 2004). As Cecchetti (2008) puts it: [] Like dynamite, when used properly derivatives are
extremely beneficial, allowing the transfer of risk to those who can best bear it. But in the wrong hands, derivatives can bring
down even the largest, most respected institutions. The failure of Barings Bank in 1995 is an example. One of the oldest and
best-known banks in England, Barings collapsed in just two months after a single trader wiped out the banks capital with losses
of more than USD 1bn on futures positions worth over USD 17bn. Bets like that can be made only using derivatives. And,
because they can be made in ways that are extremely difficult for government regulators to detect, these high-risk actions have
the potential to put the entire financial system at risk.

23

A state of the art financial safety net usually includes prudential regulation and supervision, a lender of
last resort and deposit insurance. Following this recommended infrastructure for a government safety
net, the next section will examine three topics. First we will outline a framework for prudential
regulation and supervision. After that our focus switches to the protection of depositors and finally, the
function of the lender of last resort will be examined. The last topic within Section 3.2 will provide a
brief statement on the problems, which are derived from a government safety net.

3.2.1 PRUDENTIAL REGULATION AND SUPERVISION: INSTRUMENTS AND AIMS

Prudential supervision involves government regulation and monitoring of the banking system to ensure
its safety and soundness (Mishkin, 2000). The aim of this section is to outline a framework of
instruments that regulators can use in their activity of prudential regulation and supervision. Such a
framework should be applicable to a variety of geographical and historical contexts and should aid
cross-country and temporal comparisons concerning regulation activity. (Giordano, 2009, p. 243)
All governments provide some form of a safety net for the banking system. Whether they do
so explicitly or implicitly important is that they have to implement mechanics to limit moral hazard
and adverse selection that the safety net creates. Prudential supervision is thus needed to ensure the
smooth functioning of the banking system (Mishkin, 2000).
The framework presented here is based on Giordanos (2009) Banca dItalia paper and can be
seen as an extension and reorganization of Whites (2009) categorization, which is built on Mishkins
(2000) work.
Both Mishkin (2000) and White (2009) argue that banks play a key role in financial markets.
Therefore, bank regulation is justified, since it mitigates the depositors informational problem.
Mishkin (2000, p. 8) states nine basic forms of prudential supervision: (1) restrictions on asset
holdings and activities; (2) separation of the banking and other financial service industries such as
securities, insurance, or real estate; (3) restrictions on competition; (4) capital requirements; (5) riskbased deposit insurance premiums; (6) disclosure requirements; (7) bank chartering; (8) bank
examination; and (9) a supervisory versus a regulatory approach.
White (2009, p. 17) also identifies nine forms of policy interventions to deal with asymmetric
information problems: (1) controls on entry; (2) capital requirements; (3) limits on economies of scale;
(4) limits on economies of scope and diversification; (5) limits on pricing; (6) liability insurance; (7)
disclosure requirements; (8) bank examination; and (9) bank supervision and enforcement.
Before classifying the instruments, an important consideration must be made: this concerns
the institutional setting in which the regulation is embedded; both, perimeter of regulation and the
nature of the regulators must be defined. This implies identifying the objects of regulation, which
Giordano (2009) calls the regulated entities. It seems also appropriate to break up each general class
of entities even further so that regulation can differ according to the specific type of financial firm
encountered (commercial banks, investment banks, cooperative banks, etc.). Also important is the
indication of who actually detains prudential regulation and supervision responsibility. The regulator
may be the central bank or government agencies or a combination of several institutions (Giordano,
2009).

24

Therefore regarding to Giordano (2009), the analysis of the temporal evolution of regulation can be
approached considering twelve possible regulatory instruments:

Restrictions on entry and on dimensions: include bank chartering, controls on entry of foreign
28

banks, restrictions on branching, restrictions on mergers, etc.;

Regulation on ownership and control: it is important to define who can own the regulated
29

entities. These may be completely state-owned , which implies that regulation loses some of
its scope and already enjoy extensive control over the choice of projects to be financed and
the risks to be undertaken. On the opposite, regulated entities could be entirely in private
hands. When ownership is mixed, the share of state property is a major factor. There may also
be limits on the percentage of shares owned by certain classes of shareholders and may
extend to related party groups;

Restrictions and directions on activities and asset holdings: regulation may explicitly allow or
forbid regulated entities to undertake certain activities besides their core business, or to hold
specific assets. Furthermore, risk diversification may be promoted by regulation. Finally,
restrictions on off-balance-sheet activities or generally any kind of risky business can be
undertaken;

Price regulation: this includes the implementation of floors or ceilings on the fees charged on
loans or on deposits;

30

Capital and liability requirements: capital requirements take forms as leverage ratios, capital
ratios, risk-adjusted ratios, etc. Provisions, which address specific classes of risk, may also be
required. Other factors are the percentage of assets to be held within the bank or the central
bank and the existence, or lack of, limits on dividend payments to shareholders. Furthermore,
there may also be specific requirements concerning subordinated debt.

31

Finally, as Giordano

(2009, p. 246 f.) mentions, the imposition of a multiple liability, according to which, in case of
bankruptcy, the shareholders are called upon to supplement the pool of assets available to
creditors, has an impact on the actual capital held by financial institutions;

Deposit insurance: deposit insurance, government- or privately-funded, may or may not be

obligatory;

Regulation on compensation and insurance schemes for managers and directors: by

specifying mandatory rules concerning compensation plans, regulation can also impact the
remuneration of the management;

28

Be aware of the effects of these instruments: restrictions on competition and limits on economies of scale, which may imply
significant disadvantages to consumers. However, these effects must be kept separate from the actual policy instruments and
do not enter the classification at this stage (Giordano, 2009).
29
See, for example, La Porta, Lopez-de-Silanes and Shleifer (2000) for an in-depth study on the large and pervasive
government ownership of banks around the world.
30
Again, this would be a restriction on competition.
31
As, for example, stressed in Calomiris (1999) or Calomiris and Powell (2001), subordinated debt holders have strong
incentives to monitor bank managers, since their debt is paid off only after more senior claims have been satisfied. We can
therefore see this as one form of market discipline.

25

Accounting standards: different accounting standards (historical cost, mark-to-market, etc.)

can be prescribed to evaluate assets. A periodic reassessment of the value of assets may
also be required. Formal, unequivocal definitions of certain balance sheet items could be
stated. Measures to limit the potential for accounting arbitrage may also be conceived;

Disclosure to authorities and on-site examinations: disclosure requirements define what

information must be revealed to authorities. Disclosure may be general and refer to all risks or
may be targeted and refer to specific exposures. On-site examinations may also be required;

Disclosure to the public: certain information may be obligatorily included in reports to the
public. Regulatory authorities can demand a specific content, form and frequency of these
information flows. And as we know, supervisors can require financial firms to obtain certified
audits and/or ratings from renowned agencies;

32

Regulation on organization, risk management and corporate governance: supervisors often

intervene with respect to the corporate structure of financial firms. From an ex ante view,
managers may be compelled to possess specific professional skills or they could be forbidden
to take other positions, incompatible with their primary role. Ex post, managements practices
(for instance risk-taking) may be assessed. Finally, to stem disruptive effects on financial
markets, living wills and wind-down plans, in case a firm is facing bankruptcy, may be imposed
33

upon institutions;

Enforcement of the regulation: authorities must also implement disciplinary sanctions when
needed. The regulatory toolbox includes: obligatory summoning of the corporate bodies;
cease-and-desist orders; override of management decisions by supervisors; suspension of
dividends, bonuses and fees; forced changes of the regulated entities organizational
structure; suspension/removal of directors and officials; revocation of charters; declaration of
insolvency and forced dismantlement; etc.

As previously mentioned, the framework outlined above only refers to the instruments regulators
possess and use in their activities of prudential regulation and supervision.

34

Clearly, policies grouped

under the same heading may also be used for different purposed. It is also noteworthy that some aims
are actually in contrast with others.

3.2.2 DEPOSITORY INSTITUTIONS AND FORMS OF DEPOSITOR PROTECTION

Depository institutions receive special attention from government regulators. On the one hand
because they play a central role in the economy and on the other because they are exposed to a
specific set of problems. Non-depository institutions, insurance companies, investment trusts etc., do
32

Publicity requirements are an explicit way of increasing consumer protection.

The rationale behind this is to avoid situations in which the failure of a key financial firm ripples through markets the way
Lehman Brothers did in 2008. A new U.S. regulation, drafted by the FDIC and the Federal Reserve in April 2011, applies to
banks and other major financial firms with more than USD 50bn in assets globally. The plans will ensure comprehensive and
coordinated resolution planning for both the insured depository and its holding company and affiliates in the event that an
orderly liquidation is required, said FDIC chairman Gruenberg in an interview. According to the rule, initial resolution plans have
to be updated annually (Orol, 2011).
34
See, for example, Kroszner and Strahan (2001) for a description of alternative approaches to justifying regulation.
33

26

not play the same role as banks in facilitating payments and are also not exposed to runs. Banks hold
illiquid assets to back their liquid liabilities; securities firms, in contrast, hold liquid assets that can
(considering normal market conditions) be sold rapidly in the secondary markets if customers call to
redeem their investments. Moreover, banks, as Cecchetti (2008, p. 334) puts it, are linked to one
another both on their balance sheets and in their customers minds. If a bank begins to fail, it will
default on its loan payments and create financial distress within the financial system. This
interconnectedness

35

of banks is almost unique to the financial industry. While bank failures are

contagious, non-depository institutions problems are not (Cecchetti, 2008).

Policymakers have many choices how to protect depositors.

36

Some countries have implicit

protection that arises when the public, including depositors and perhaps other creditors, expect some
form of protection in the event of a bank failure. This expectation usually arises because of the
governments past behaviour or statements made by officials. Implicit protection is, by definition, never
formally specified. There are no statutory rules regarding the eligibility of bank liabilities, the level of
protection provided or the form which reimbursement will take. By its nature, implicit protection creates
uncertainty about how depositors, creditors and others will be treated when bank failures occur.
Funding is discretionary and often depends on the governments ability to access public funds.
Although a degree of uncertainty can lead some depositors to exert greater effort in monitoring banks,
it can undermine stability when banks fail (FSF, 2001).
Statutes or other legal instruments usually stipulate explicit deposit insurance systems.
Typically, there are rules governing insurance coverage limits, the types of instruments covered, the
methods for calculating depositor claims, funding arrangements and other related matters. A deposit
insurance system is preferable to implicit protection if it clarifies the authorities obligations to
depositors and limits the scope for discretionary decisions that may result in arbitrary actions. A
deposit insurance system can also provide countries with an orderly process for dealing with bank
failures (FSF, 2001).
The introduction of a deposit insurance system can be more successful when a countrys
banking system is healthy. A deposit insurance system can contribute effectively to the stability of a
countrys financial system if it is part of a well-designed safety net. To be credible, a deposit insurance
system needs to be properly designed, well implemented and understood by the public. It also needs
to be supported by strong prudential regulation and supervision, sound accounting and disclosure
regimes, and the enforcement of effective laws. A deposit insurance system can deal with a limited
number of simultaneous bank failures, but cannot be expected to deal with a systemic banking crisis
by itself (FSF, 2001).
Many national deposit insurers are members of the International Association of Deposit
Insurers (IADI), an international organization established to contribute to the stability of financial
systems by promoting international cooperation and to encourage wide international contact among
deposit insurers and other interested parties, in particular, IADI.

35

The BCBS, for example, separates a banks interconnectedness in three sub-categories: (1) intra-financial system assets, (2)
intra-financial system liabilities, and (3) the wholesale funding ratio. For more Details see BCBS (2011a, p. 7 f.).
36
For an overview on insurance schemes see, for example, Gerhardt and Lannoo (2011), where the fragmented state of
deposit insurance in Europe is the topic.

27

3.2.3 THE GOVERNMENT AS LENDER OF LAST RESORT

The best way to stop a bank failure from turning into a bank panic is to make sure that institutions can
meet their depositors withdrawal demands. In 1873 the British economist Walter Bagehot suggested
the need for a lender of last resort to perform this function (Cecchettis reference to Bagehot who
coined the phrase is not undisputed):

37

the lender of last resort function of central banks frequently is

defended by reference to Britains financial stability following Bagehots persuasion of the Bank of
England to distinctly acknowledge that it is its duty to support the market in times of panic (Bagehot,
1873, p. 61). Such an institution could make loans to prevent or end a financial panic. Specifically,
Bagehot proposed that Britains central bank should lend freely on good collateral at a high rate of
interest. By lending freely he meant providing liquidity on demand to any bank that asked for it. Good
collateral would ensure the banks solvency, and the high rate would penalize the borrowing bank for
failing to hold enough reserves or easily saleable assets to meet deposit outflows (Cecchetti, 2008).
Obviously, the existence of a lender of last resort significantly reduces, but does not eliminate,
contagion. But the mere existence of a lender of last resort will not keep the financial system from
collapsing.
In order to ensure that the financial system is working, central bank officials who approve the
loan applications must be able to distinguish an illiquid from an insolvent institution. But during a crisis,
computing the market value of a banks assets is almost impossible, since there are no market prices.
(If a bank could sell its marketable assets in the financial markets, it wouldnt need a loan from the
central bank.) A bank will go to the central bank for a direct loan only after having exhausted all
opportunities to sell its assets and borrow from other banks without collateral; therefore its illiquidity
and its need to seek a loan from the government raise the question of its solvency. Officials, anxious
to keep the crisis from deepening, are likely to be generous in evaluating the banks assets and to
grant a loan even if they suspect the bank may be insolvent. Knowing this, bank managers will tend to
take too many risks. Therefore, the central banks difficulty in distinguishing a banks insolvency from
its illiquidity creates moral hazard for bank managers. It is important for a lender of last resort to
operate in a manner that minimizes the tendency for bankers to take too much risk in their operations
(Cecchetti, 2008).

3.2.4 PROBLEMS CREATED BY THE GOVERNMENT S AFETY NET

We know that insurance changes peoples behaviour. Protected depositors have no incentive to
monitor their bankers behaviour. Knowing this, bankers take on more risk than they would normally
do, since they get the benefits while the government assumes the costs. In protecting depositors, the

37

Referring to Bagehot - as the first who uses the phrase lender of last resort - should be made with a comment: Henry
Thornton did not use or originate as sometimes referred to the phrase lender of last resort. (It seems to have been Sir
Francis Baring (1797) who first referred to the Bank of England as the dernier resort for the other British banks.) But Thornton
surely contributed to the understanding of the central role of the bank in the monetary system more than any other economist.
But very few would dispute Frank Fetters judgement that Bagehots role was more that of a populariser than creator of ideas
(Laidler, 2002). As Fetter summed the matter up, Bagehot may not have said more than Francis Baring and Henry Thornton had
sad, but he said it in a way that carried conviction to a wider audience who no longer accepted all the premises from which
Thorntons and Barings conclusions had sprung (Fetter, 1965). Undoubtly, Thornton and Bagehot did important work on the
function of central banks Charles Goodhart (2010, p. 34) praised their work as the first two great books on central banking:
[] a central purpose of the first two great books on central banking, Henry Thorntons (1802) Inquiry into the Paper Credit of
Great Britain and Walter Bagehots (1873) Lombard Street, was to outline ways to resolve such a conflict [a central banks
purpose to maintain both, price and financial stability], especially when an (external) drain of currency threatened maintenance
of the Gold Sandard at the same time as an internal drain led to a liquidity panic and contagious bank failures.

28

38

government creates moral hazard . Cecchetti (2008) stresses the point that this is not just a theory.
We can find evidence for this assertion by comparing bank balance sheets before and after the
implementation of deposit insurance. Most economic and financial historians believe that government
insurance led directly to a rise in risk (Cecchetti, 2008).
And that is not the only problem. Because government officials are obsessed with avoiding
financial crises, they pay close attention to the largest institutions. While the failure of a small
community bank is unfortunate, the prospect of a large financial conglomerate going under is a
regulators worst-case scenario. In effect, some banks are just too big to fail, hence systemically
important. The managers of these banks know that if their institutions begin to founder, the
government will find a way to bail them out. The deposit insurer will quickly find a buyer or the
government will make a loan. Depositors will be made whole, and the managers of the bank may even
keep their jobs (Cecchetti, 2008).
The governments too big to fail-policy limits the extent of the market discipline depositors can
impose on banks. Normally, a liquid firm is concerned about the riskiness of its banks assets, given
the limits of government deposit insurance. If the bank fails, the corporation could face significant
losses. Thus, the threat of withdrawal of these large balances restrains the bank from taking on too
39

much risk. But for very large banks, the deposit insurance ceiling is meaningless, because everyone
knows that authorities will not permit the bank to fail. With virtually no monitoring by depositors and no
threat that their balances will be withdrawn, bank managers can take whatever risks they like. The too
big to fail-policy compounds the problem of moral hazard, encouraging managers of large banks to
engage in extremely risky behaviour - and putting small banks at a competitive disadvantage
(Cecchetti, 2008).

3.3 REGULATION AND SUPERVISION

It is useful to keep the distinction between regulation and supervision in mind. Regulation is the set of
rules and standards that govern financial institutions. On the other hand, supervision is the process
designed to oversee financial institutions, ensuring that rules and standards are applied properly
(Barfield, 2011).
The financial market regulation has an important effect both on the behaviour of bank
managers, and on the specific characteristics of the banking industry. Contemporary banking
regulation contemplates more complex problems because the set of regulatory instruments has
become richer, and the regulators have set more ambitious macroeconomic and prudential objectives.
Traditionally, one distinguishes between the regulation of structure and the regulation of conduct. The
former establishes which firms are qualified to develop a certain type of activity; the latter concerns the
permitted behaviour of firms in their chosen activities (see, for example, Kay & Vickers 1988).

38

In the U.S. before 1991, the problem was even worse than it is today. The FDIC once charged the same insurance premium
to all banks, regardless of the riskiness of their assets. Today premiums are risk based if not perfectly so (Cecchetti, 2008).
39
Today, large depositors can engage in what is known as a silent run on a bank. Rumours that a bank is in trouble can lead to
the electronic withdrawal of individual deposits that exceed the USD 100,000 insurance ceiling. These runs are silent and
invisible (Cecchetti, 2008).

29

Freixas & Rochet (2008) classify the regulatory instruments of supervisors into six types:

Deposit interest rate ceilings;

Entry, branching, network, and merger restrictions;

Portfolio restrictions, including reserve requirements;

Deposit insurance;

Capital requirements;

Regulatory monitoring and supervision (including closure policy).

Except for entry and merger restrictions, these regulatory instruments are specific to the banking
industry. The absence of other, classical instruments could be explained by the constraints that limit
regulatory actions: Laffont & Tirole (1986) distinguish (1) informational constraints, which limit
regulation because the relevant information is held by the firm; (2) transactional constraints, which limit
the possibility of writing contingent contracts; and (3) administrative and political constraints, which
impose limits on the scope of regulation as well as on the available instruments.
Bank regulation appears to involve diverse issues, all of them worth devoting effort to, but
obviously so heterogeneous that no model can encompass the main issues (Freixas & Rochet, 2008).
It is important to view this area as being in full evolution, where many issues remain unsolved (see, for
example, Bhattacharya, Boot, and Thakor (1998) for an assessment of the topic).

40

Government officials employ three strategies to ensure that the risks created by the safety net
are contained (Cecchetti, 2008):

Government regulation establishes a set of specific rules for bank managers to follow;

Government supervision provides general oversight of financial institutions;

Formal examination of banks books by specialists provides detailed information on the firms
operation.

As we look at each of these, keep in mind that the goal of government regulation is not to remove all
the risk that investors face. Financial intermediaries themselves facilitate the transfer and allocation of
risk, improving economic efficiency in the process. Regulating risk out of existence would eliminate
one of the purposes of financial institutions (Cecchetti, 2008).
Wary of asking taxpayers to pick up the bill for bank insolvencies, officials created regulatory
requirements that are designed to minimize public costs of such failures. The first screen, put in place
to make sure the people who own and run banks are not criminals, is for a new bank to obtain a
charter. Once a bank has been chartered and has opened for business, a complex web of detailed
40

Bhattacharya, Boot, and Thakor (1998) refer to five main unsolved issues: (1) are demand deposits important for investors
welfare?; (2) is the safety net of deposit insurance necessary?; (3) what should be the goal of financial regulation?; (4) what
role, if any, should the government play in coping with liquidity shocks?; (5) what portfolio restrictions should be imposed on
banks?

30

regulations restricts competition, specifies what assets the bank can and cannot hold, requires the
bank to hold a minimum level of capital, and makes public information about the banks balance sheet
(Cecchetti, 2008).
The best-designed regulatory structure in the world wont be worth the paper its written on
unless someone monitors banks compliance. Government supervisors monitor, inspect, and examine
banks to make sure business practices conform to the regulatory requirements (Cecchetti, 2008).
Banks are in most countries regulated and supervised by a combination of supervising
authorities.

41

The overlapping nature of this institutional setup means that more than one agency

works to safeguard the soundness of each bank. If one regulator allows an activity that another
prohibits, bank management can threaten to switch, or argue that a competitor who answers to a less
demanding regulator has an unfair advantage.

42

The consequences of such regulatory competition are

twofold: first, regulators force each other to innovate, improving the quality of the regulations they write
(positive); second, it allows bank managers to shop for the regulator, whose rules and enforcement
are the least stringent (negative) (Cecchetti, 2008).
To better structure the topic on regulation and supervision, Section 3.3 will subsequently
explain the following issues: restrictions on competition, restricted asset holdings and minimum capital
requirements, disclosure requirements, and finally supervision and examination.

3.3.1 RESTRICTIONS ON COMPETITION

One long-standing goal of financial regulators has been to prevent banks from growing too big and
powerful, because their failure might threaten the financial system and because banks would have not
enough competition. While recent legislation has changed the banking industry, restrictions on bank
size remain. Bank mergers still require governmental approval. Before granting it, officials must be
convinced on two points. Frist, the new bank must not constitute a monopoly in any geographic region.
Second, if a small community bank is to be taken over by a large regional bank, the small banks
customers must be well served by the merger (Cecchetti, 2008).
But government officials also worry that the greater the competition among banks, the more
difficulty banks will have running a profitable business. Competition reduces the prices customers
must pay and forces companies to innovate in order to survive. These effects are as true for the
deposit and loan market as they are for the retail markets. Competition raises the interest rate bankers
pay on deposits and lowers the interest rate they receive on loans; it spurs them to improve the quality
of the services they provide. Normally we think of these effects of competition as being positive, but
there is a negative side as well. Lower interest margins and reduced fee income cause bankers to look
for other ways to turn a profit. Some may be tempted to assume more risk that is, to make loans and
purchase securities that are riskier than advisable (Cecchetti, 2008).

41

In the USA, for example, following regulators oversee different types of depository institutions: (1) Federal Deposit Insurance
Corporation, (2) Office of the Comptroller of the Currency (Nationally chartered banks), (3) Federal Reserve System (Statechartered banks that are Federal Reserve members), (4) State authorities (All state-chartered banks), (5) Office of Thrift
Supervision, (6) National Credit Union (Checchetti, 2008).
42
For an illustration of the problem of regulatory arbitrage see, for example, Mayo (2011). Mayo (2011, p. 108 f.) explains how
senior regulatory officers from the OTS helped Countrywide so switch regulators in the mid-2000s: Agencies compete for banks
to gain more power, prestige, and relevance they try to make themselves appealing by offering a friendlier process and less
stringent rules. In the mid-2000s, OTS officials referred to banks as customers.

31

There are two ways to avoid this type of development. First, government officials can explicitly restrict
competition. That is the solution regulators have chosen in a number of countries; it was also one of
the purposes of branching restrictions in the U.S.

43

A second way to combat bankers tendency to take

on too much risk is to prohibit them from making certain types of loans and from purchasing particular
securities (Cecchetti, 2008).

3.3.2 RESTRICTED ASSET HOLDINGS AND MINIMUM CAPITAL REQUIREMENTS

The simplest way to prevent bankers from exploiting their safety net is to restrict banks balance
sheets. Such regulations take two forms: restrictions on the types of assets that banks can hold and
requirements for maintaining minimum levels of capital.
While banks are allowed to build big office buildings and buy corporate jets for top executives,
44

their financial assets are heavily restricted. U.S. banks, for example, cannot hold common stocks.

Regulations also restrict both the grade and quantity of bonds a bank can hold. For example, banks
are generally prohibited from purchasing bonds which are rated below investment grade, and their
holdings from any single private issuer cannot exceed 25 per cent of their capital. The size of the
loans they can make to particular borrowers is also limited (Cecchetti, 2008).
Minimum capital requirements complement these limitations on bank assets. Recall that bank
capital represents the net worth of the bank to its owners. Capital serves as both a cushion against
declines in the value of the banks assets, lowering the likelihood of the banks failure, and a way to
reduce the problem of moral hazard. Therefore, capital requirements take two basic forms. The first
requires most banks to keep their ratio of capital to assets above some minimum level, regardless of
the structure of their balance sheets. The second requires banks to hold capital in proportion to the
riskiness of their operations. The computation is extremely complicated and the rules change
frequently, but basically a bank must first compute the risk-adjusted level of its assets (RWAs) given
the likelihood of a loan or bond to default. Then a capital charge is assessed against that level. Of
course, banks face a multitude of other risks, including trading risk, operational risk, and the risk
associated with their off-balance-sheet operations. Regulators require banks to hold capital based on
assessments of those risks as well (Cecchetti, 2008).
The motivation of this section is simply to examine why capital requirements matters to
regulation. Such requirements, for example the Basel capital rules (or BIS guidelines), went into effect
in March 1989 for banks in the leading industrialized nations and are being revised since the outbreak
of the latest financial crisis. Therefore, we will first explain the role of (regulatory) capital for banks in
the next section and later (Chapter 4) we will hear about the evolution of the Basel capital rules in
detail.
43

Until the early 1970s, regulation restricted the interest rates U.S. banks could pay on deposits. Regulation Q prohibited
interest payments on demand deposits and placed a ceiling on interest payments on time and savings deposits. Its purpose was
to restrict competition in order to improve banks profitability (Cecchetti, 2008).
44
Common stock holdings were one source of the problems Japanese banks faced in the 1990s. As the Japanese stock
market collapsed, the value of Japanese bank assets declined precipitously, to the point where many banks became insolvent.
For an detailled analysis on the Japanese banking crisis during the 1990s see, for example, Nakaso (2001) or Kanaya and Woo
(2000). In this context I would also like to refer to Richard Koos book The Holy Grail of Macroeconomics: Lessons form
Japans great Recession (2008) which was often cited when proper policy tools (after the finanical crisis of 2007-09) were
discussed. Koo argues that there are actually two phases to an economy: the ordinary (called yang) phase, in which the private
sector is maximizing profits, and the post-bubble (or yin) phase, in which private sector is necessarily minimizing debt. Although
conventional economics is useful in analyzing economies in the yang phase, it is less useful in explaining phenomena such as
the liquidity trap that is typical of an economy in the yin phase. The distinction between the yin and yang phases also explains
why some policies work well in some situations but not in others.

32

Why do capital ratios matter so much for bank regulators? (We take as given the safety net of
government guarantees and regulations that protect the safety and soundness of banks.)
Regulators require capital for more or less the same reasons that other uninsured creditors of
banks demand collateral: to (1) protect themselves against the costs of financial distress, (2) agency
problems, and (3) the reduction in market discipline caused by the safety net (Berger, Herring, &
Szego, 1995).
So the reason to have banks having proper capital cushions is obvious: in the absence of
systemic risk or other significant negative externalities from bank failures, the government should
45

behave, in principle, like a private-sector uninsured creditor ; the government should price risk
through deposit insurance premiums and set capital standards and closure rules similar to covenants
contained in standard debt contracts (see, for example, Black, Miller, & Posner, 1978 or Acharya &
Dreyfus, 1989). The government does not exercise market discipline and require capital in the same
way that other uninsured creditors do.
Regulators do have some indirect means of pressuring banks to raise capital ratios, such as
cease-and-desist orders, total withdrawal of insurance coverage, bank closure, limits on asset growth
and brokered deposits, prohibition of dividend payments, etc. (Buser, Chen, & Kane, 1981).
Nonetheless, Jones & King's (1995) evidence suggests that the mandatory actions are not likely to
apply very often to the banks that are undertaking substantial risks (Berger, Herring, & Szego, 1995).
In addition, there is the possibility that these blunt actions could create additional moral hazard
incentives to take advantage of the safety net. For example, the deposit insurer could suffer increased
expected losses from raising the capital ratio at which banks are closed because some banks may
take higher risks and suffer larger losses before the insurer can detect them (see, for example, Herring
& Vankudre, 1987; or Davies & McManus, 1991). This is because the capital ratio at which moral
hazard incentives become important depends more on how far the capital ratio is from the closure
point than on the absolute level of the capital ratio. Similar increases in risk-taking could be
forthcoming in response to other costly interventions by regulators.

3.3.3 DISCLOSURE REQUIREMENTS

Banks are required to provide information to the public about their products balance sheets.
Regulations regarding disclosures to customers are intended to protect consumers; a regulatory
function which is applied to every branch of the economy. Institutions have to tell the public their
product fees in a way that allows the comparisons to other banks (Cecchetti, 2008).
Disclosure of accounting information to the public more specific to the financial markets
protects depositors in a different way. It allows both authorities and the markets to assess the quality
of a banks balance sheet. Since the information is published in a standardized format, government
officials can easily evaluate whether a bank is operating within the regulatory rules, and financial
analysts put one banks figures in context to the whole industry. With this information demanded by

45

Not all observers agree that systemic risk is an important issue (see, for example, Benston & Kaufman, 1995).

33

law, both regulators and the financial markets can reward or penalize banks regarding to the risk
46

exposure (Cecchetti, 2008).

3.3.4 SUPERVISION AND EXAMINATION

The financial market authorities enforce banking rules and regulations through an (work intensive)
oversight process called supervision. This process is conducted through a combination of monitoring
(banks are required to file detailed reports) and on-site examinations. These reports are supposed to
examine the level and sources of banks earnings, asset holdings, and liabilities. Supervisors then
process the reports using quantitative models that allow them to identify undercapitalized institutions
and to spot industry trends (Cecchetti, 2008).
Regulators also conduct on-site evaluations. Examiners arrive at a bank unannounced and
look into virtually every aspect of its business operation. At the largest institutions, examiners are more
or less on site all the time; once they get to the end of the review-process, they go back and start over
(Cecchetti, 2008).
Current practice is for supervisors to act as consultants, advising banks how to get the highest
return possible while keeping risk at an acceptable level that ensures they will stay in business
(Cecchetti, 2008); Mayo (2011) perfectly describes this issue explaining the fight for power within U.S.
regulators over the last decades.

3.4 REGULATORY RESPONSE TO THE FINANCIAL CRISIS OF 2007-09

In its broad outlines, as Goodhart (2010, p. 30) states, the current financial crisis was foreseen,
though not in its specific detail. Most of the central banks and also the BIS had been warning for
years of the underprizing of risk and unsustainable leverage-ratios by 2006-07. But only a few outside
the banking industry knew about the growth and the extent of the shadow banking

47

system and

obviously since a main rationale for this shadowy sub-system was regulatory arbitrage, the banks
were not loudly advertising such activities. (Goodhart, 2010, p. 30)
Goodhart (2010) represents the view that central banks did nothing prior to the 2007-09 crisis,
because there was next to nothing that they could have done. Therefore central banks could be best
described as having responsibility without power, which is the prerogative of a eunuch (Goodhart,
2010, p. 32). Furthermore, Goodhart (2010) asks, what could be done to give out central banks more
power? Or more figuratively: [] what needs to be done to give our central bank some balls?
(Goodhart, 2010, p. 32) For this purpose, Goodhart (2010) sees following topics immediate: (1) capital
and liquidity requirements have to be made countercyclical; (2) maximum, time-varying loan-to-value
48

ratios (LTVs) have to be reintroduced ; and (3) penalties for failure to disclose all off-balance sheet
business need to be introduced.
46

Writing disclosure rules turns out to be extremely difficult, especially for off-balance-sheet activities. For example, regulators
need to know whether a bank that buys or sells interest-rate swaps is hedging risk on its balance sheet or taking on more risk.
Since positions can change very quickly, sometimes minute by minute, regulators are challanged to figure out exactly what
should be reported and when (Cecchetti, 2008).
47
For an insightful presentation of the U.S. shadow banking system see, for example, the 2010 staff report of the Federal
Reserve Bank of New York (Pozsar, Adrian, Ashcraft, & Boesky, 2010).
48
Concerning the first two arguments, Goodhart (2010, p. 32) directly responds to his own recommendations with immediate
(generic) counterarguments whereas Goodhart argues that central banks need to respond robustly to this counterarguments: (1)
Raises the cost of borrowing in good times, and hurts the first-time buyer in the housing chain; (2) Introduced separately in an
individual country, it will just drive the business off-shore; (3) May increase the informational burden on banks; (4) By imposing

34

Goodhart (2010, p. 33), never shy of a pointed slogan, concludes that there are no such proper tools;
but as one saying of the UK wartime was Give us the tools and we will finish the job.
Clearly, this work has not the focus for reviewing all recommendation for sophisticated
financial market reforms published since the burst of the U.S. credit bubble in 2007. Commentators
still argue over some aspects but there is consensus on the key issues. The Report of the de
Larosire Group

49

on the future of European regulation and supervision, published in February 2009,

was an early contribution that succinctly identified the principal causes of the financial crisis and made
detailed recommendations for reform within the European system and on a global scale (Barfield,
2011).
Another study on the latest financial crisis, amongst various excellent analysis, worth
mentioning: Andrew Los Reading About the Financial Crisis: A 21-Book Review (2012).
Compressed on not even 40 pages, Lo reviews a set of 21 books on the 2007-09 crisis (11 written by
academics, and 10 written by journalists and one former U.S. Treasury Secretary). Lo concludes that
none of the reviewed works emerges from the others but he finds that the sheer variety of conclusions
is informative. More problematic is that economists cant even agree on all the facts [what the
underlying causes of the crisis were] (Lo, 2012, S. 31):

Did CEOs take too much risk, or were they acting as they were incentivized to act?

Was there too much leverage in the system?

Did regulators do their jobs or was forbearance a significant factor?

Was the Feds low interest-rate policy responsible for the housing bubble, or did other factors
cause housing prices to skyrocket?

50

Was liquidity the issue with respect to the run on the repo market , or was it more of a
solvency issue among a handful problem banks?

A horrific and in the end terribly frustrating state of affairs (Lo, 2012, S. 31), given that financial
economists are used to deal with precise concepts. Lo suggests: [] we need the equivalent of the
black box flight data recorder for the financial industry, otherwise we may never get to the bottom of
any serious financial accident (Lo, 2012, p. 32-33).

51

Therefore, both, the Larosire-Report and Los literature review may be a good starting point
on this topic. Continuing, we will review the most important regulatory changes in Europe: the new
Basel III rules of the Basel Committee of Banking Supervision, which we will present in the next
Chapter.
greater costs on commercial banks during expansionary phases, it will even further enhance the incentive to off-load assets
onto associated off-balance sheet entities.
49
Named after Jacques de Larosire, a French civil servant, then chairman of the High-Level Group on Financial Supervision in
the EU. The report can be accessed on the homepage of the European Commission (European Commission, 2009).
50
The repo market the market for repurchase agreements is one in which two participants agree that one will sell securities
to another and make a commitment to repurchase equivalent securities on a future specified date, or on call, at a specified
price.
51
This was precisely the motivating logic behind the Dodd Frank Acts creation oft he Office of Financial Research, but its
future is unclear given the current political stalemate that has brought a number of important legislative initiatives to a standstill.
(Lo, 2012, p. 33)

35

4. The Basel Committee

According to conventional wisdom, the Basel III Accord a set of capital adequacy standards for
international banks drawn up by a committee of G20 supervisors is essential if we are to avoid
another financial crisis. This paper will not discuss if this conclusion is right or wrong. But at this point
it should be mentioned that many market participants argue that Basel II (where one focus was the
52

problems inherent to regulatory arbitrage ) had its flaws from the beginning and indeed Basel III with
its focus on leverage and liquidity is not the solution. Instead the Basel Accord(s) are seen as an
underlying cause

53

of financial crises. For an in depth analysis one should ask why Basels creators

fell so short of their aim of improving the safety of the international banking system.
For reasons of the international importance of the Basel Committee and its specific
importance regarding to this work, we will refer to the BCBS as regulatory supervisory authority of our
interest and therefore the subsequent sections will provide an outline of the evolution from Basel I to
the recently drawn Basel III framework, which rules will now be implemented until 2019 and where the
contingent capital instruments may have their impact.

4.1 THE REFORM AGENDA

First it is important to put the new Basel rules into context. The G20s

54

main aim on banking reform is

to ensure that governments never again have to bail out the financial sector: [t]he G20 is absolutely
clear that bank dependency on taxpayer support on the scale witnessed over the last three years is
unacceptable and must not be repeated. (Barfield, 2011). (I would not take the never again for
granted, but at least they look committed to ensure, that the taxpayers bill will not be as big as it was
this time.) Importantly, the 2007-09 financial crisis did not affect all banks/all economies in the same
55

way. Several countries banks emerged more or less unscathed , and that is why the G20s common
effort is remarkable.
The cited Group of Twenty Finance Ministers and Central Bank Governors was designated
the premier forum for international economic cooperation at the Pittsburgh G20 summit in 2009,
formally superseding the G7, reflecting the shifting global balance of power. In the same year, the
Financial Stability Board (FSB) superseded the FSF (Barfield, 2011).
Since the latest crisis, a plethora of reforms have been proposed from a wide variety of
sources, not just the Basel Committee. These included the FSBs proposal on reward, the European
Commissions proposals on governance in financial institutions, bank levies proposed globally and
locally, and taxes on bankers bonuses etc. Table 2 gives an idea of the range and complexity of
reform that is being pursued. The Basel proposals are one item on this list (Barfield, 2011).

52

Which had been the motivation behind the creation of collateralized loan obligations (CLOs).
It is argued that capital-based regulation and the capital regulation approach from the BCBS cannot deal with financial crises;
instead liquidity and leverage should be the issues to focus on. It may not be possible to salvage Basel II, and the way forward
will perhaps abandon the idea of a unified international financial regulation (Moosa, 2010).
54
The Group of Twenty Finance Ministers and Central Bank Governors is a group of finance ministers and central bank
governors from 20 major economies: 19 countries plus the EU, which is represented by the President of the European Council
and by the European Central Bank. Official G20 website: http://www.g20.org
55
Asia generally, Australia, Brazil, Russia, Canada and South Africa are some notable examples. This is why the G20s unity is
remarkable, but unity it has been nonetheless (Barfield, 2011).
53

36

TABLE 2: THE REGULATORY REFORM AGENDA POST-LEHMAN

Topics of the Recent Reform Agenda

Basel II.5 and Basel III

Product market regulation

Pre-funding of deposit insurance

Pro-consumer regulation

Resolution fund

Role of credit rating agencies

Wholesale levy

Securitization markets

Provisions and other accounting changes

Fund managers to improve fund liquidity

Subsidiarization

Hedge fund regulation

Central counterparty clearing (OTC contracts)

Bank risk management and governance

Reporting (capital and liquidity) supervision/oversight

Macro-prudential

Remuneration

Supervisory approach

Narrow banking

Cross-border colleges

Glass-Steagall II/Dodd-Frank

Recovery and resolution

Source: Barfield, 2011, p. 3

Keeping all the different topics of the current regulatory overhaul in mind, the special impact of Basel
III in each country will also need to be placed in the context of the dominant local reform agenda.

In 2011 the European Commission adopted a legislative package to strengthen the regulation of the
banking sector. The proposal replaces the current Capital Requirements Directives (2006/48 and
2006/49) with a directive and a regulation and constitutes another major step towards creating a
sounder and safer financial system. The directive governs the access to deposit-taking activities while
the regulation establishes new prudential requirements (European Commission, 2012). Additionally,
Solvency II (which sets out strengthened risk management and capital adequacy requirements for
insurance firms) is being introduced with a proposed go-live date of January 1, 2013. This parallel
development may have impacts on capital markets and therefore for banks one example might be if
we think of the availability and pricing of medium term funding (Barfield, 2011).
Also we have to keep in mind that there is a rebalancing of the world economic order to the
East and the South going on and that a lot of OECD economies are running large government deficits
combined with persistent trade imbalances and mis-valued currencies. All this means that financial
market reforms are being introduced in interesting times (Barfield, 2011), and that this will not be an
easy mission.

4.2 HISTORY AND ORGANIZATION OF THE BASEL COMMITTEE

The Basel Committee, established by the central bank Governors of the G10 countries at the end of
56

1974 , meets regularly four times a year. The BCBS provides a forum for cooperation on banking
56

The Basel Committee was formed 1974 mainly in response to the liquidation of Herstatt Bank. In 1973, Herstatt became
over-indebted as the bank suffered huge losses from foreign exchange (FX) speculation - four times higher than the size of its
capital - when it first speculated on a depreciation of the USD. Only late in 1973 did the bank change its strategy and speculated
on the appreciation of the USD. But then, mid-January 1974, the direction of the dollar movement changed again. A special

37

supervisory matters and is organized in four main working groups. The goal is to enhance the
understanding of key supervisory issues and improve the quality of banking supervision on a global
basis. It seeks to do so by exchanging information on national supervisory issues, approaches and
techniques, with a view to promoting common understanding. The Committee is best known for its
standards on capital adequacy, the Core Principles for Effective Banking Supervision and the
Concordat on cross-border banking supervision. Today, the Committee's members come from
Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India,
Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia,
Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United
States. The present Chairman of the Committee is Mr Stefan Ingves, Governor of Sveriges Riksbank
(BIS, 2012).
In 1988, the Committee decided to introduce a capital measurement system commonly
referred to as the Basel Capital Accord, or Basel I. This regulatory system introduced the
implementation of a credit risk measurement framework with a minimum capital standard of 8 per cent
by end-1992 (BIS, 2012). Importantly, each asset on the balance sheet of a bank was given a
weighting between 0 per cent and 100 per cent, where 0 per cent represented the safest assets such
as government bonds (which is now heavily criticized since the outbreak of the Eurozone crisis in
2009-10) and 100 per cent the riskiest exposures such as corporate debt and unsecured personal
loans. Banks would be required to hold tier 1 capital of at least 4 per cent of RWAs and total capital of
at least 8 per cent. Basel I is now widely viewed as outdated.

57

By the late 1990s, banks had become much more sophisticated in their operations and risk
management were increasingly able to find ways to reduce a bank's risk weighted assets in ways that
did not reflect lower real risk (what has become known as regulatory capital arbitrage). It was therefore
decided that a new capital standard was required and work began on Basel II.
In June 1999, the Committee issued a proposal for a revised Capital Adequacy Framework
(issued on June 26, 2004). The proposed capital framework consists of the now commonly known
three pillars (BIS, 2004a):

Pillar 1: calculated minimum capital requirements for credit, market and operational risk;
refines the standardized rules set forth in the 1988 Accord;

Pillar 2: supervisory review of an institution's internal assessment process and capital

adequacy; supervisors evaluate whether a bank should hold more capital than the Pillar 1
minimum; and

audit authorized by the Federal Banking Supervisory Office (BAKred) discovered in March 1974 that Herstatts open exchange
positions amounted up to DM 2bn, eighty (!) times the banks limit of DM 25mn. The FX risk was thus three times as large as the
amount of its capital (Blei, 1984). Germanys supervisors prompted the bank to close its open FX positions. Finally, the failure of
the bank could not have been avoided. On 26 June 1974, BAKred withdrew Herstatt's license to conduct banking activities. It
became obvious that the bank's assets of about DM 1bn were more than offset by its DM 2.2bn liabilities (BIS, 2004). Attentive
readers recognized that the Herstatt crisis took place shortly after the collapse of the Bretton Woods System in 1973. The bank
had a high concentration of activities in the area of foreign trade payments. Under the Bretton Woods System this area of
business was manageable with a low risk profile. But clearly, in an environment of floating exchange rates, this area of business
was suddenly attached with much higher risks (Kaserer, 2000). Besides being the case for introducing the Basel Committee, the
Herstatt crisis had many implications for the regulatory framework. In 1976, the Second Amendment to the German Banking Act
(KWG) came into force, which strictly limited risks in credit business and tightened the controls of the BAKred. Among other
things, the Association of German Banks decided to set up a deposit protection scheme for German banks (BIS, 2004).
57
The Committees publications on the Basel I framework (and also the rules for Basel II and III) can be found under the BCBS
section of the BIS homepage.

38

Pillar 3: effective use of disclosure to strengthen market discipline as a complement to

supervisory efforts.

Keep in mind the three pillars: minimum capital requirements, supervisory review, and market
discipline. The revised framework from 2004 serves as a basis for national rule-making and for banks
to complete their preparations for the new framework's implementation. The Core Principles and the
Methodology were revised recently and released in October 2006 (BIS, 2012).
Basel II took five years to develop and then another four years to implement the framework.
Basel II has only been in place since January 2007 (or 2008 for those on the advanced approaches
under Basel II). Having seen the urge of sophisticated risk management practices rise under Basel I,
under the Basel II framework credit risk regulatory requirements may be calculated using one of three
methods which are, in increasing order of sophistication, the Standardized Approach (SA), the
Foundation Internal Ratings Based approach (FIRB), and the Advanced Internal Ratings-Based
approach (AIRB). Most large international banks use AIRB for the majority of their exposures)
(Barfield, 2011).
The Committees approach extends a wide array beyond capital adequacy. Its other global
standards and consultations include, inter alia, liquidity risk, deposit insurance, risk management,
corporate governance, stress testing and alignment of risk and reward (Barfield, 2011).
Importantly to consider is that the Committees conclusions and recommendations do not
have legal force (the USA, for example, never implemented Basel II): its role is to formulate
supervisory standards and guidelines. Basel recommends best practices in the expectation that
individual authorities will implement them through detailed national arrangements that should be a
tailored fit to their own national systems. Furthermore, the Committee encourages convergence
towards common approaches and standards without attempting detailed harmonization of member
countries supervisory techniques. Even in the EU, where Basel III will be implemented in the Capital
Requirements Directive IV (short: CRD IV), there are likely to be some differences in national
interpretation and implementation (Barfield, 2011).

4.3 A PRIMER ON B ASEL III

The main aim of Basel III is to improve financial stability through a strengthening of regulation,
supervision and risk management of the banking sector (BIS, 2012). In response to the latest crisis,
the new Basel proposals focused on five topics (Barfield, 2011, p. 11):

Raise the quality, quantity, consistency and transparency of the capital base to ensure that
banks are in a better position to absorb losses;

Strengthen risk coverage of the capital framework by strengthening the capital requirements
for counterparty credit risk exposures;

Introduce a leverage ratio as a supplementary measure to the Basel II risk-based capital;

39

Introduce a series of measure to promote the build-up of capital buffers in good times that can
be drawn upon in periods of stress. Linked to this, the Committee is encouraging the
accounting bodies to adopt an expected loss provisioning model to recognize losses sooner;

Set a global minimum liquidity standard for internationally active banks (includes a 30-day
liquidity coverage ratio requirement, underpinned by a longer-term structural liquidity ratio).

The Basel changes mentioned here are implemented in Basel II.5 and Basel III. Basel II.5

58

refers to

the Revisions to the Basel II market risk framework that was issued in January 2009 the final
version was published later in July 2009. It included additional capital requirements for trading books
and recommended a new treatment of securitizations. Basel II.5 came into effect on 1 January 2012
(Barfield, 2011).
Continuing the Primer on Basel III, we will now review nine elements of the new Basel framework
59

(mainly to the revised version of the Basel III rules from 1 June 2011 Basel III: A global regulatory
framework for more resilient banks and banking systems except point 3, which was first published in
Enhancements to the Basel II framework, 2009):
(1) Minimum capital ratios: under Basel III, the Tier 1 capital ratio is pegged at 6 per cent, with a
core Tier 1 at 4.5 per cent. Implementation starts in January 2013, when Core Tier 1 rises
from 2 to 3.5 per cent, with full phase-in of the Tier 1 rules to be completed by January 2015.
Currently, banks are required to have a Tier 1 capital ratio of 4 per cent respectively 2 per cent
Core Tier 1 in the form of top quality capital such as retained earnings or shares, for maximum
shock absorption;
(2) Capital definition: this aims to improve the quantity and quality of capital and therefore the
predominant form of Tier 1 capital must be common equity and retained earnings. Banks are
allowed to include deferred tax assets, mortgage-servicing rights and investments in financial
institutions up to an amount of 15 per cent of the common equity component. The capital
requirement of a minority interest in a bank can only be counted in the group's capital if the
investment is in form of a genuine common equity contribution. A buffer range will be
established above the regulatory minimum capital requirement, capital distribution constraints
will be imposed on a bank when capital levels fall within this range;
(3) Securitization and trading book (Basel II.5): introduction of higher risk weights for
securitization exposures to better reflect the risk inherent in such products, and requiring that
banks conduct more rigorous credit analyses of (externally) rated exposure are part of the
Basel II amendments dubbed Basel II.5. Additionally, trading book rules introduce higher
capital requirements to capture the credit risk of complex trading activities and include a
stressed value-at-risk (SVaR) requirement, which the Committee believes will help dampen
the cyclicality of the minimum regulatory capital framework and promote a more forwardlooking approach to provisioning (introduced at the end of 2011);
58

Sometimes also referred to as Basel II plus.

Be aware that the new framework Basel III was explained in detail by various documents published all on the BCBS
homepage http://www.bis.org/bcbs/basel3.htm.
59

40

(4) Counterparty risk: the main objectives of the BCBA regarding to the counterparty credit risk
(CCR) are to increase the correlation assumptions (and hence risk weightings) of SIFIs, to
increase the risk weightings of CCR for financial institutions using an internal model (expected
positive exposures, or EPE) through a set of measures such as the concept of stressed EPE,
and, finally, to add a new Pillar 1 capital charge aimed at capturing the potential increase in
credit valuation adjustments (CVAs) during one year due to credit spread widening of
counterparties;
(5) Leverage ratio: BCBS now proposes a volume-based leverage ratio (which is not riskadjusted) to complement the risk-based minimum capital requirements under Pillar 1. The
ratio is designed to put a cap on the build-up of leverage in the banking system as well as to
introduce additional safeguards against model risk and measurement errors by supplementing
the risk-based capital requirements with a simple, transparent measure of leverage;
(6) Liquidity Coverage Ratio (LCR): the 30-day liquidity coverage ratio requirement is designed to
ensure that there is sufficient high-quality liquidity to survive an acute stress scenario lasting
for one month:

(7) Net Stable Funding Ratio (NSFR): the NSFR will be in place to measure the amount of longerterm, stable sources of funding employed relative to the liquidity profiles of assets funded and
and the potential for contingent calls on funding liquidity arising from off-balance-sheet
commitments and obligations:

(8) Conservations and countercyclical buffers: BCBS aim is to create buffers in good economic
times that can absorb shocks in periods of severe market conditions. There will be two types
of such buffers: a capital conservation buffer to absorb banking sector losses conditional on a
plausibly stressed financial/economic environment and a countercyclical buffer that would
extend the capital conservation range during periods of excess credit growth (or other
indicators deemed appropriate by supervisors for their national context);
(9) Systemic risk: this new approach to address systemically important financial institutions could
include combinations of capital and/or liquidity surcharges, contingent capital and bail-in debt.
Furthermore, work is still under progress to strengthen resolution regimes.
It is obvious that the above outlined Basel III framework has a significant impact on the current
banking landscape. Considering the nine selected features of Basel III, conservation buffers present
an obvious starting point for contingent capital.
The key rationale is to create buffers in good times that can absorb shocks in worse times.
The framework envisages capital distribution constraints when capital levels fall within a pre41

determined range above the minimum requirements, with the constraints increasing the closer a
banks capital level get to the minimum threshold. Therefore the capital conversion buffer should be
available to absorb losses conditional on a plausibly severe stressed financial and economic
environment (PricewaterhouseCoopers, 2010).
The capital conservation buffer must consist of common equity, as a capital cushion to be
maintained above the minimum capital requirements. The buffer will be set at 2.5 per cent of RWAs.
Although banks will be permitted to draw on the conservation buffer during periods of stress, as
regulatory capital levels get closer to the minimum requirements (i.e., as the buffer is depleted),
greater constraints on earnings distributions such as dividend payments and discretionary employee
bonuses will be triggered. Institutions subject to Basel III are likely, as a practical matter, to target
levels of capital that exceed not just the regulatory minimum levels, but rather the regulatory
minimums plus the capital conservation buffer (Mayer Brown, 2010).
In a public report from November 2010, McKinsey & Company, an advisory company, sees
Basel III having a significant impact on the (European) banking sector. To put the significant into
context, Table 3 will present McKinsey & Companys findings in detail.
TABLE 3: BASEL III AND THE IMPACT ON EUROPEAN BANKING

McKinsey & Companys estimated Basel III impact on the European financial industry

Based on Q2 2010 balance sheets, by 2019 the industry will need about EUR 1.1tn of additional Tier 1 capital, EUR
1.3tn of short-term liquidity, and about EUR 2.3tn of long term funding (absent any mitigating actions)

Assuming a 50 per cent retained earnings payout ratio and a nominal annual balance-sheet growth of 3 per cent
through 2019, capital requirements in Europe are expected to increase to about EUR 1.2tn, short-term liquidity
requirements to EUR 1.7tn, and long-term funding needs to about EUR 3.4tn

Ceteris paribus, Basel III would reduce the return on equity for the average bank by about 4 per cent in Europe and
about 3 per cent in the U.S.

Retail, corporate, and investment banking segments will be affected in different ways: retail banks will be affected
least, though institutions with very low capital ratios may find themselves under significant (funding) pressure;
corporate banks will be affected primarily in specialized lending and trade finance; investment banks will find several
core businesses profoundly affected, particularly the trading and securitization businesses. Most banks with
significant capital markets and trading operations will likely face significant business-model challenges over the next
years

Banks are already seeking to manage the new return on equity-world cutting costs and adjusting prices. There are,
however, a number of additional interventions, both general and specific to Basel III, that banks should consider: (1)
interventions to reduce capital and liquidity inefficiency from suboptimal implementation of the new Basel rules; (2)
balance-sheet restructuring to improve the quality of capital and reduce capital needs arising from Basel IIIs
deductions, as well as more efficient management of scarce resources; (3) business-model adjustments to create
capital- and liquidity-efficient business models and rethink the scope and viability of specific business lines

Despite the provided transition period until the end of 2018, compliance with new processes and reporting must be
largely complete before the end of 2012. For an average midsize bank, McKinsey & Company estimates that the
technical implementation alone will add about 30 per cent to 50 per cent to the significant outlay already incurred for
Basel II
Source: McKinsey & Company (2010)

More than four years after the outbreak of the U.S. subprime crisis, the European banking sector does
not seem to be able to manage the consequences without significant support from the ECB. Since late
2011, the ECB provided more than EUR 1tn in three-year loans, a move, Mario Draghi argues, that
averted a severe credit crunch across the EMU (Financial Times, 2012a). But, besides the obvious
frictions that still dominate the financial sector, how would a macroeconomic analysis of the new
regulatory framework look like? Angelini, et al. (2011) found that each percentage point increase in the
capital ratio causes a median 0.09 per cent decline in the level of steady state output (relative to the
42

baseline). Furthermore, they find that the impact of the new liquidity regulation is of a similar order of
magnitude, at 0.08 per cent. However, consider that Angelini, et al. (2011) did not estimate the
benefits of the new regulation in terms of reduced frequency and severity of financial crisis, as
analyzed, for example, in An Assessment of the Long-Term Impact of Stronger Capital and Liquidity
Requirements (BCBS, 2010). Finally, Angelini, et al. (2011) concluded that the reform should dampen
output volatility and that an adoption of countercyclical capital buffers could have a more sizeable
dampening effect on output volatility. The conclusions are fully consistent with those of, for example,
the Macro Assessment Group (MAG, 2010).
For the last chapter of this work, capital buffers, which should dampen overall volatility, are
exactly the part of the new regulation where the contingent capital idea kicks in. In November 2011,
the BCBS published the rules text Global systemically important banks: assessment methodology
and the additional loss absorbency requirement in which the section on Instruments to meet the
additional loss absorbency requirement explains the potential use of contingent capital. Basel III offers
various topics for a further evolution of capital management practices.
Before we start with the final chapter of this work, consider how authorities handled
contingency planning within the financial industry before the latest financial crisis of 2007-09 and how
the Basel III framework is approaching it now (see Table 4).
TABLE 4: PRE- AND POST-CRISIS CONTINGENCY PLANNING

Contingency Planning Approach

Pre-Crisis

Post-Crisis

- No developed capital contingency planning/living wills in

place

- Integrated management approach for capital and liquidity

- Capital and liquidity management separated

- Detailed capital and liquidity contingency plans in place to

strengthen the recovery and resolution planning processes
Source: own representation

43

5. Contingent Capital
After we have heard in detail what economic reasons for running financial intermediaries within an
economy (Chapter 2) exist, and how a sophisticated regulatory framework of banks looks like (Chapter
3), we will now focus on a specific detail from the new Basel rules (Chapter 4): contingent capital
financial instruments that should smoothly recapitalize banks in difficult times and therefore contribute
to a more stable, less volatile financial system.
The Basel Committee has taken the view that G-SIBs should be required to hold more capital
than other financial institutions. In that regard, Switzerland has implemented a higher regulatory
capital requirement (19 per cent of RWAs) for its two largest banks, UBS and Credit Suisse, of which 9
per cent may be held in the form of contingent convertibles (Pazarbasioglu, Zhou, Lesl, & Moore,
2011).

60

Last year, 2011, the Basel Committee released a methodology

61

for assessing which

institutions are systemically important. The assessment methodology for SIFIs an indicator based
approach that comprises the categories size, interconnectedness, lack of substitutability, global
activity and complexity follows the purpose to enhance the going-concern loss absorbency of GSIBs and to reduce the probability of their failure.
The proposed additional loss absorbency requirements, a function that could be supported by
contingent capital, will range from 1 per cent to 2.5 per cent Common Equity Tier 1 (CET1) depending
on the systemic importance of an institution with an empty bucket of 3.5 per cent CET1 as a means to
discourage banks from becoming even more systemically important (BIS, 2011). The tougher rules
for SIFIs will be introduced hand in hand with the Basel III capital conservation and countercyclical
buffers between 1 January 2016 and 31 December 2018, fully effective on 1 January 2019.
Based on the analysis of the usefulness of contingent capital, the Basel Committee concluded
in November 2011 that G-SIBs should meet their additional loss absorbency requirement with
Common Equity Tier 1 only. Paragraph 88 of the Global systemically important banks: Assessment
methodology and the additional loss absorbency requirement rules text states that the Group of
Governors and Heads of Supervision and the Basel Committee will continue to review contingent
capital, and support the use of contingent capital to meet higher national loss absorbency
requirements than the global requirement, as high-trigger contingent capital could help absorb losses
on a going concern basis (BCBS, 2011). It seems to me that the Basel Committee is playing save and
prefers to take some time to analyze the new instruments in detail.
So far, there have been a few issues of CoCo-bonds by Lloyds, Rabobank and Credit Suisse.
For example, on 2 November 2011, Rabobank issued USD 2bn in CoCo write-down bonds priced to
yield 8.375 per cent. The issue was oversubscribed (PricewaterhouseCoopers, 2011a) a signal that
investor appetite exists for attractive returns, especially where the probability of a conversion seems
small.
In this final chapter we examine the technical features of contingent capital in detail, draw a
conclusion about its practicability, and finally provide the reader with a literature overview (Appendix 1)
on selected CoCo-features (issued volume, type of trigger and terms of conversion) including every
60

More specific, under the Swiss regulatory rules, a major bank must have Tier 1 capital equal to 10 per cent of its RWAs
(whereas Basel III requires only 7 per cent), and must issue an additional 9 per cent in contingent capital (Coffee, 2010).
61
See Global systemically important banks: Assessment methodology and the additional loss absorbency requirement consultative document (BCBS, 2011).

44

authors conclusion on contingent capital. In view of their potential, CoCo-bonds are attracting a great
deal of attention in the current debate on recognition as regulatory capital and their ability to
strengthen the financial system. Therefore, to better assess the practicability of contingent capital, the
next sections will address the following issues:

Definitions, forms and functions of contingent capital;

The trigger, the decisive feature of every contingent capital structure;

Economic rationale behind the contingent capital idea;

Should contingent capital be considered instead of equity?

Legal, accounting, and tax issues;

Bail-ins as another regulatory approach in comparison to contingent capital; and

An assessment of where the contingent capital idea stands right now.

5.1 DEFINITIONS, FORMS AND FUNCTION OF CONTINGENT C APITAL

Contingent capital, categorized as a credit derivative, is a type of put option that entitles a bank, or any
other firm, to issue new securities on pre-negotiated terms, usually after one or more risk-based
triggering event. No new funds enter a banks balance sheet. Rather, as Flannery (2009, p. 5) states,
its leverage is reduced by replacing some of its outstanding debt with (converted) common stock:
contingent convertible capital (CoCo-bonds) are long-term subordinated debt securities with a fixed
coupon rate that can be converted automatically from debt into equity when certain predetermined
triggers are met, turning what were previously providers of debt capital into shareholders (Zhres,
2012, p. 4). The most important feature of contingent capital, the trigger, will be discussed below (see
Chapter 5.2).
Merrill Lynch, the U.S. financial management and advisory company, filed their contingent
convertible financial instruments patent in August 2002.

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To honor the work of Merrill Lynch

employees and to represent the wording of the initial construction, I will state the summary of the
invention regarding to the patent published February 20, 2003 (WIPO, 2003, p. 5): A contingent
convertible debt instrument contains a provision permitting conversion only if any of certain
economically substantial contingencies is satisfied. For example there may be a provision that
conversion is permitted only if the issuers stock price reaches some price, defined as some
predetermined price substantially higher than the conversion price, is reached. This contingent
conversion trigger price may be 110 per cent or 120 per cent more of the conversion price. The debt
instrument may be a negotiable long-term zero-coupon note, and a provision may be included that the
number of underlying instruments issuable or deliverable at conversion or exchange is adjusted under
certain circumstances (e.g. merger, acquisition, or formulae amounts). Corresponding methods and
systems are employed for offering and servicing such financial instruments. The patent application

62

International Application Number: PCT/US02/25667 (WIPO, 2003).

45

offers valuable information on the exact structure of a contingent convertible instrument (with all the
practically important details) and the instrument is also illustrated with the help of event-driven process
chains (EPCs). As Culp (2009, p. 23) points out it is important not to confuse reverse convertibles and
contingent reverse convertibles with contingent convertibles or CoCo-bonds: [i]ntroduced by Merrill
Lynch in 2000, CoCos are convertibles with a second trigger tied to the issuers stock price, essentially
turning the normal call option embedded in a convertible into an up-and-in barrier call option. Culps
statement demonstrates a current feature of literature discussing contingent convertible: only a
minority refers to the original definition of CoCos as introduced by Merrill Lynch and therefore one
should be careful about different statements raised by different authors.
However, as we can figure out from the above definition(s), these bonds can be converted into
liable capital under adverse market conditions (or regarding to specific problems within a firm) and are
63

able to absorb losses. Is the triggering condition not met , CoCo-bonds are straight bonds (or zero
coupon bonds as introduced, for example, in the Merrill Lynch patent) that will be redeemed at
maturity. To get a better impression of the rationale and evolution of the contingent convertible capital
idea, see Table 5.
TABLE 5: CONTINGENT CONVERTIBLE CAPITAL IN A NUTSHELL

The evolution of the contingent convertible capital idea

Contingent convertible capital, known as CoCo-bonds, is a relatively new form of hybrid bank capital. Regulators and
bankers hope these bonds will help shore up a banks capital cushion in times of extreme stress.
Bank Capital is made up of equity (which is permanent) and debt (which must be paid back). Before the crisis of 2007-09,
banks tried to operate on very small cushions of equity capital and borrowed most of what they needed. This high leverage
improved their return on equity, their return on share, and helped lift their stock prices.
Banking Regulations limit exactly how small an equity cushion a bank can operate with they demand certain amounts to
cover the risks of a banks assets going bad. To comply with this, but still structure their balance sheets to get a good return
on equity, bank managers increasingly turned to hybrid bonds. Hybrids, including CoCos, sit between debt and equity in a
banks capital structure because they contain elements of both. This allowed regulators to count them against their banks
required capital cushion because they thought they were equity, but most investors considered them to be bonds.
Depending on how exactly the bonds were structured, credit rating agencies also considered them mostly equity. This meant
they did not risk weakening a banks credit rating, as pure debt would have done.
On the surface, pre-crisis hybrid looked just like regular bonds, that is, investors lend institution money for a certain period of
time in return for regular interest or coupon payments. They were however designed to help share the losses of equity
investors when a bank began to struggle. But during the crisis, banks were pressured by bondholders, who were the biggest
buyers of hybrids, not to let this (pain sharing) happen. Investors knew they could be called upon to share this pain, but
considered they had a gentlemens agreement that this would not happen; they were outraged about the idea.
Because banks borrow so much and help their clients tap the bond market too, these investors carry considerable influence.
Some threatened to boycott anyone who held on to hybrid cash and most banks shunned the way of upsetting their
investors. This in turn however upset the European Commission and many national governments who felt that this negated
the point of giving hybrids credit for the equity component if investors threatened to veto anyone that tried to use this feature.
The European Commission has since forced most bailed-out banks to invoke the equity features and force bondholders to
take the losses. This standoff between what investors thought they had and what regulators want, meant that to issue new
hybrids, bankers would have to come up with something different. And this is where CoCos come in!
Unlike existing hybrid, CoCo-bonds will actually forcedly convert into equity if a pre-agreed level is breached. This level could
be, for example, if a banks Core Tier 1 ratio falls below 5 per cent. Core Tier 1 is a key regulatory measure of a banks
health. If that happens, CoCo-holders will no longer hold bonds but shares. Immediately providing the bank with fresh equity.
Bankers think that this sort of shock-booze, which will raise the ratio to healthy levels in one go, should help reassure the
market that the bank is save. However the question remains whether investors will buy into this concept.
Source: Financial Times Lexicon, 2012)

63

Basically, the choice is between triggers based on market values that are subject to stochastic processes, and triggers based
on balance sheet ratios, avoiding the disadvantages of potential manipulation.

46

Continuing, it may be useful to review the debt overhang problem. When a firms asset value falls, it
becomes less probable that lenders will be fully paid off. In corporate finance theory, the firm need not
recapitalize promptly and the debts market value declines due to the higher expected credit losses.
Because value is transferred from debt holders to shareholders (by operating at a higher leverage
level), shareholders are reluctant to replace lost equity value (Flannery, Stabilizing Large Financial
Institutions with Contingent Capital Certificates, 2009). Myers (1976), who pioneered the work on the
debt overhang problem, concluded: considering a firm has outstanding debt, a part of any new equity
injection will increase the value of outstanding deposits. Therefore, selling e.g. EUR 100 worth of
shares will increase the firms total equity value by e.g. only EUR 98 because the larger capital
account raises the market value of promised debt repayments (Flannery, Stabilizing Large Financial
Institutions with Contingent Capital Certificates, 2009). CoCo-bonds are designed to limit this sort of
wealth transfer. Instead of permitting a bank to continue operating with a too small equity cushion,
Coco-bonds, when converted, restore the equity level to the regulatory perceived comfort zone. This
conversion therefore averts the wealth decline that would be suffered by fixed claimants in the
absence of the CoCo-bond conversion (Flannery, Stabilizing Large Financial Institutions with
Contingent Capital Certificates, 2009).

64

The banks achieved recapitalization takes place on the capital market and thus only concerns
the private sector. The firm immediately receives fresh equity, while at the same time reducing its
interest payment obligations. It is important here to differentiate between liquidity and capital: although
CoCo-bonds do not introduce fresh capital into the firm, they themselves transform from a debt
instrument into new common stock, supporting the bank with a higher equity cushion to better deal
with (future) losses. Converting CoCo-bonds is synonymous to an immediate improvement in the
quality of the companys capital structure. The automatic conversion could also facilitate access to
other sources of private sector funding, which would ultimately make government intervention
unnecessary or at least less likely (Zhres, 2011).
From a financial stability point of view, CoCo-bonds have the further advantage that they do
not profit from the earnings potential of high risk. And since the risk premium for CoCo-bonds is likely
to increase with a banks risk, the convertible bonds could also have a disciplining effect. Banks will
have to bring their capital management in compliance with the altered regulatory requirements and the
new standards applying to their core capital. Issuing bonds that are available to absorb losses under
the new rules thus could provide a single part of a solution for forward-looking capital management by
the banks (Zhres, 2011).
We have to be aware that the term contingent capital is often used very generally; many
constructions and terminologies can be subsumed under this heading. Therefore we have to define
about which type of contingent capital we are exactly talking. Contingent capital is, as Furstenberg
(2011, p. 3) describes it, as heterogeneous as the contingencies both positive and negative to
which it can be linked. Contingent capital can be assigned to a class of securities that has
contingently convertibles as one of its objects, which in turn have CoCos with their distinctive trigger
as a subspecies (Furstenberg, 2011). This class can be defined as the increase in common equity

64

If we think of a CoCo-bond containing an implicit (default) put option, the maturity of that put generally coincides with the
bonds maturity. In this case, facing a conversion, CoCo-bonds make the maturity of that put option very short (think of just a
few days), and hence virtually worthless (Flannery, 2009).

47

capital that would be provided if (1) holders of rights to subscribe or convert to common stock, and (2)
of contingently triggered conversion obligations attached to convertible bonds or to preferred stock
exercised their options, warrants, conversion rights, and contingently-triggered obligations.

48

Taking a closer look, we can differentiate between other types of contingent capital (Zhres, 2011, p.
4):

Write-down bonds: write-down bonds are market-based financing instruments. Rather than
being converted, their value is written down instead. The difference is that no additional capital
is made available; the liabilities are simply reduced as a result of the valuation adjustment. So
while the companys financial position looks better on paper, equity is created only to the
extent of the write-down made, since release of the liabilities generates exceptional gains that
can be allocated to retained earnings;

Temporary write-down bonds: temporary write-down bonds (also known as step-up, stepdown bonds) are debt instruments which can have their liabilities reduced once a predetermined trigger event occurs but also have upside potential. In other words, a valuation
adjustment can also step up their value proportionately, meaning that the bonds are written
down only temporarily. Bonds structured this way already exist in the marketplace; but, so far,
accounting regulations have prevented bonds of this kind from being counted towards
regulatory capital.

Call Option Enhanced Reversible Convertibles (COERCs): COERCs, at the time of writing this
study, are a theoretical proposition describing a bond that is automatically converted when a
pre-determined trigger is met. The conversion rate is below the price that triggers conversion
and the bonds feature a buy-back option for existing shareholders, i.e. a kind of subscription
right (Pennacchi, Vermaelen, & Wolff, 2010).

Used by insurance companies and non-financial corporations since the 1990s (Culp C. L., 2006a),
banks have not historically relied on contingent capital instead they preferred to provide it to other
types of firms (Culp C. L., 2009). This is because traditional debt is more attractive to banks, insofar as
they do not have to bear the full systemic costs of leverage. Regulators and authorities willing to
overcome this conflict between private and social costs will have to encourage financial institutes
aggressively to use contingent capital (Squam Lake Working Group on Financial Regulation, 2009).
Starting in 2007, the U.S. subprime problem blossomed into a full-blown worldwide credit and
liquidity crisis; banks found themselves largely unable to raise significant new equity from market
participants other than their governments. Consequently, some banks have recently begun to consider
contingent capital as a tool to pre-arrange recapitalizations in any future crises. So far, only a few lossabsorbing securities have been issued in the European market and their terms vary considerably
(see Appendix 2) and therefore make it impossible to have more structured look on CoCo-bonds and
their features.
To strengthen self-insurance within the financial industry, the Group of Central Bank
Governors and Heads of Supervision have agreed (BIS, 2010) that banks will be required to hold a
conservation buffer: on top of a minimum common equity equal to 4.5 per cent of RWAs, banks have
to maintain the buffer from the start of 2015 on. With the buffer scheduled to be up to 2.5 per cent of
RWAs by the start of 2019, total common equity of up to 7 per cent of RWAs would then be required.

49

Although CoCo-bonds might get credit for helping to satisfy the conservation buffer, they
operate differently. A conservation buffer is implemented to absorb losses, in case they happen to the
bank. The permanent maintenance of such a buffer in all but the worst of times would be costly. Since
the conservation buffer requirement is non-contingent, it differs from the equity injection provided by
CoCo-bonds when a trigger event occurs. A CoCo conversion alone then provides for automatic
deleveraging without balance-sheet contraction beyond that associated with capital ratios declining to
the trigger point (Furstenberg, 2011, p. 5).
Conversion may be triggered by a negative contingency that drives the chosen capital ratio
below the mark that has been set for it in the bond issue prospectus. Investors in cocos will help
signal through the yield they require where the trigger should optimally be set [], states Furstenberg
(2011, p. 5). There are academics, for example Berg and Kaserer (2011), who argue that CoCo-bonds
might have perverse incentives for bank owners if the conversion price is set wrongly (Berg &
Kaserer, 2011, p. 1). As a result, Berg and Kaserer (2011) promote a different form of CoCo-bonds, a
type which would totally wipe out existing equity holders to increase bank owners risk aversion. This
type of contingent capital combines the functions of raising common equity capital and bankruptcy risk
management (Culp, 2002).
To go beyond the idea of CoCo-bonds (thinking outside the box), consider mechanisms that
would allow common equity to be issued in bad times. Instruments other than CoCo-bonds that can
provide Core Tier 1 capital countercyclically are illustrated in Table 6. What the five instruments in
Table 6 have in common, is that they can provide an alternative to direct issuance of common shares.
As the Squam Lake Working Group on Financial Regulation (2009) explains: when a troubled bank
issues new equity, the act amounts to a transfer of wealth from existing shareholders to bondholders
who gain protection of an increased equity buffer. Thus shareholders will be looking for alternatives as
exhibited in Table 6 that can provide an increase in the equity cushion and lower expected bankruptcy
costs without stock dilution.

50

TABLE 6: INSTRUMENTS PROVIDING COMMON EQUITY IN DISTRESS

Common equity issue mechanisms

Interest Rate
(IR)

Maturity or
Expiration

NA

Short-term

(1) Rights
Issue

Trigger for
Conversion or
Exercise

Option
Equivalent in
Exercise or
Conversion
Call Option

Frequent Purpose

Market price >

Shield existing
exercise price at
shareholders from dilution
maturity
(2) Partly
NA
Balance due
Insolvency or
None
Raise liquid assets for
Paid-Up
when triggered
threat of
pay-out to creditors
Share Capital
bankruptcy
(3) Reverse
Higher than for
Short-term notes
Share price
Company put
Debt relief and new equity
Convertible
comparable
with rollover
specified fraction
option of shares
issue in adversity
Issue
straight debt
of its reference
for its notes
price
(4) Mandatory
Above rate on
Generally five
Pre-specified
None:
Issue new equity for debt
Convertible
plain convertible
years or less
conversion date
mandatory
by date certain
Bonds
bonds
and number of
exchangeables
(MCBs)
shares
(5) CoCoHigher than for
Varies, could be
Violating
Company put
Raise new equity required
bonds
comparable
perpetual
regulatory
option of shares
to stave off bankruptcy
straight debt
capital
for its bonds
maintenance
requirement
Notes: When triggered, both (1) and (2) are sources of capital and equity as new funds are provided. Under equity-related
debts (3), (4) and (5), the book value of equity is raised by that of the debt converted to common shares when conditions
have deteriorated. Under (4), the number of shares per bond sometimes may be adjusted to provide a guaranteed minimum
redemption value; under (3) and (5), the number of shares in the conversion tends to be pre-specified and fixed in total (3) or
as a share of all common stock outstanding at maturity (5).
Source: Furstenberg, 2011

The conditions at which a CoCo-bond is converted comprise the conversion ratio, the price, and time
at which conversion takes place. They are laid down in the offering memorandum. The specific
features are determined by the individual credit institution (see examples in Appendix 2). Having
explained how contingent convertible capital works, the next section will review the core feature of
contingent capital, the trigger.

5.2 THE TRIGGER

The decisive element of contingent capital instruments is the trigger that determines whether and
when the bond converts to equity, or is written down, to recapitalize the financial firm. There are three
principal options for the trigger (Pitt, Hindlian, Lawson, & Himmelberg, 2011, p. 5):

Capital-based;

Regulatory discretion-based; and

Market-based.

For a list of possible triggers and their computation see, for example, De Martino, Libertucci, &
Marangoni (2010, p. 15). See Table 7 where the three types of triggers are evaluated from different
perspectives.

51

TABLE 7: TYPES OF TRIGGERS

Triggers

Capital-based

Regulatory

Market-based

discretion-based
Benefits and
drawbacks

Benefits: not subject to

market manipulation,
transparent and objective
Drawbacks: difficult to
structure as capital
thresholds must be set
carefully

Preferences of
investors

Other considerations

Most investors prefer this

type of trigger because it is
transparent and can be
modelled.

Benefits: gives regulators

flexibility and discretion to
respond in the face of a
crisis
Drawbacks: is opaque and
thus hard to model; likely
to operate too late to
prevent large losses
Many regulators seem to
prefer this type of trigger.
Investors dislike a
discretionary trigger
because it is difficult to
assess the likelihood of
triggering or the
appropriate price to pay.
The Basel Committees
gone-concern proposal
endorses this kind of
trigger.

Enhanced bank
disclosures and/or
regulatory stress tests can
bolster confidence in the
reliability of the trigger.

Benefits: is objective and

transparent
Drawbacks: subject to market
manipulation and could result in
unnecessary conversions

A few regulators prefer this type of

trigger because it is objective and
allows market discipline to play an
important role (although disclosure
is an important issue here too
because markets cannot assess
what they cannot possibly know).
Investors generally dislike this kind
of trigger because they cannot
assess its likelihood.
The risk of market manipulation
and/or a share- or CDS-price death
spiral is high.

Enhanced bank
disclosures would give
regulators more comfort
that they are not surprising
the market and would
reassure investors that
regulatory forbearance is
not at play.
Source: Pitt, Hindlian, Lawson, & Himmelberg (2011, p. 5)

A capital-based trigger would force mandatory conversion when, for example, Tier 1 core capital falls
below a certain level specified either by regulators or by the issuing firm in the contractual terms.
Because of its objectivity, this trigger would likely be the most effective trigger. And regarding to the
issued bonds, as shown in Appendix 2, this type of trigger is so far the dominant choice of issuing
banks. Investors would be able to assess and model the likelihood of conversion if required banks
disclosure and transparency are enhanced.

65

Furthermore, a capital-based trigger removes the

uncertainty from potential regulatory discretion and the threat of market manipulation that the other
options entail (Pitt, Hindlian, Lawson, & Himmelberg, 2011).
But structuring an effective capital-based trigger is a challenging operation between the high
trigger (going-concern approach) and the low trigger (gone-concern approach) decision (see Table 8
for a detailed explanation of the two different approaches). If contingent capital is to be the goingconcern kind, the trigger must be set at a high enough capital level in order that it operates while the
65

Capital-based triggers are vulnerable to financial reporting that fails to accurately reflect the actual health of a bank. Lehman
Brothers, for example, reported a Tier 1 capital ratio of 11 per cent in the period before its demise (usually considered as a
healthy level and than almost three times the regulatory minimum) (The Economist, 2010). Therefore, this issue must be
resolved for investors to feel comfortable with capital-based triggers. Fortunately there are several ways to make capital ratios
more robust, whether by stressing them through regulator-led stress tests or by enforcing more rigorous and standardized
disclosure requirements that would allow investors to better assess the health of the bank. Such standardized disclosures could
relieve regulators of the burden of conducting regular stress tests, and would significantly enhance transparency. The value of
stress testing and greater disclosures is clearly one important lesson from the financial crisis of 2007-09. Stress tests, while not
perfect and heavily criticized in the media for their casually conduct, offer greater transparency and comparability of bank
balance sheets than investors were able to derive from public filings. Without greater transparency, capital-based triggers might
need to be set at very high levels to reflect the potential for deterioration in a banks underlying financials relative to its reported
capital levels (Pitt, Hindlian, Lawson, & Himmelberg, 2011).

52

firm remains fully viable (but not so high that it could be too easily triggered). On the contrary, the
trigger cannot be so low that it allows losses to mount for too long, leaving little or no value left in the
firm and effectively making the contingent capital the gone-concern kind (Pitt, Hindlian, Lawson, &
Himmelberg, 2011).
TABLE 8: GOING- AND GONE-CONCERN APPROACH

Gone-concern and going-concern contingent instruments

Contingent capital is typically differentiated as either going- or gone-concern:
Going-concern contingent capital for an early supervisory
intervention:

Operates well before resolution mechanisms

come into play;

Gone-concern contingent capital contributes to a resolution

framework when supervisors consider a firms financial
condition as not viable any more:

Operates at the point of non-viability;

Recapitalization occurs when significant

enterprise value still remains;

Significant regulatory discretion is usually

involved;

Control of the firm may shift when contingent

capital is triggered, and a change in management
may occur, creating incentives for banks to delever and de-risk earlier.

Financial liabilities are made clearly junior to

business ones;

Should be thought of as a resolution mechanism.

Going-concern contingent capital converts to common

equity early, well before financial non-viability, for even
modest erosions of capital. Further, conversion would be
triggered by a breach of a given threshold, such as a capital
ratio, or when the banks stock price falls below a
predetermined level, or when the aggregate value of the
banking sector, falls below a trigger value.
Going-concern contingent capital is focused on dealing with
forbearance a tendency of some supervisors to
accommodate troubled institutions and to refrain from
intervening with corrective measures. This could occur
because the supervisor lacks adequate incentives (the will
to act) or the powers (the ability to act) to intervene
effectively as the financial condition of the bank deteriorates.
In other words, going-concern contingent capital aims to
reproduce elements of early intervention by emphasizing a
rule that provides for the automatic recapitalization of the
institution in the form of conversion of debt and capital
instruments to common equity when a specific metric is
breached, thereby reducing the scope for the exercise of
supervisory forbearance. (Depending on the trigger, such an
approach could transfer the operation of forbearance to the
manipulation of the trigger variable if the supervisors
objectives and incentives are not well specified.)

Gone-concern contingent capital converts to common equity

when the financial condition of a bank is judged by its
supervisor to have deteriorated to the point where it is no
longer viable. Given this timing, gone-concern contingent
capital would contribute to a resolution framework.
Gone-concern contingent capital and bail-in debt (see
Chapter 5.6) share two related objectives:

to support the resolution of a failing bank by

providing sources of capital when the institution
cannot recapitaliz through private markets; and

to ensure that equity holders and other providers

of regulatory capital, as well as major creditors of
banks, face risk of loss, even if the troubled bank
is liquidated.

Such instruments could improve the incentives affecting

private behaviour by exposing holders of common equity to
a risk of significant dilution, and by widening the pool of
market participants with credible skin in the game.
Accordingly, market discipline could be improved and moral
hazard reduced. As a result, such contingent instruments
would reduce the likelihood of a government bailout of a
large, complex institution and, in the event of such a bailout,
would reduce the cost to taxpayers.
Source: D'Souza, Gravelle, Engert, & Orsi (2010, p. 52 f.) and Pitt, Hindlian, Lawson, & Himmelberg (2011, p. 3)

Some comments made by authorities have shown a preference for the other two types of triggers;
unfortunately, their views do vary. A few regulators appear to favor market-based triggers, which
would convert when a financial firms share price or their CDS spread passes a certain level over a
certain period of time. Market triggers are appealing because market discipline is generally considered
less forgiving than regulatory discipline. But where this theory has been embraced in the past, results
have been uneven. The notion that bond markets, for example, would discipline banks risk-taking now
appears to have been overly optimistic (for a discussion of this see, for example, Morgan & Stiroh,
66

1999). It is important to conclude that markets simply cannot know what has not been disclosed, and
66

Not only did ratings-based capital market discipline not work as imagined, but the crisis also provided plenty evidence that
neither ratings agencies nor bond market investors possess any special informational advantages over banks regulators when
it comes to the assessment of bank credit quality quite the opposite, in fact. But it may be worth mentioning that CDS spreads

53

market discipline cannot function without proper information. By all means, better regulation has to
take the transparency issue into account (Pitt, Hindlian, Lawson, & Himmelberg, 2011).
While a market-based trigger is appealing to some, Pitt, Hindlian, Lawson, & Himmelberg
(2011) think it is an unattractive option even in an environment of higher disclosure requirements:
there is a clear risk that market sentiment (or even market manipulation) could force an unnecessary
recapitalization. On the opposite, a capital ratio leaves far less scope for market participants to directly
affect the outcome. While regulatory preferences may vary, investors across the board strongly prefer
an objective, capital-based trigger that is enhanced by greater, standardized disclosures (Pitt,
Hindlian, Lawson, & Himmelberg, 2011).

67

Continuing with the modelling of a proper trigger, a second critical choice is: what happens
once the trigger is pulled? (See Table 9 for an analysis.) One option is that contingent capital converts
into common equity. If this conversion would cause a dilution of well in excess of 50 per cent (a highly
dilutive rate), control of the firm would automatically shift to the contingent debt holders. If conversion
to equity were paired with a high trigger, the contingent capital holders would gain control of a firm with
significant remaining enterprise value. Once in control, the new owners could replace existing
management and enforce a de-risking and de-leveraging that is needed to put the firm on a stronger
foundation. Conversion to equity is far less attractive if a low trigger is implemented: this would leave
the contingent capital holders owning a firm with little remaining enterprise value, and potentially little
upside in the resulting equity (Pitt, Hindlian, Lawson, & Himmelberg, 2011).
TABLE 9: AFTER THE TRIGGER-EVENT

Type of conversion

Conversion to equity

Write-down of principal

Benefits and drawbacks

Benefits: if conversion is highly

dilutive to existing shareholders,
banks can be incentivized to reduce
risk and leverage at the early signs
of distress; if conversion happens
early, contingent debt holders can
gain control of a firm with significant
value remaining.

Benefits: recapitalizes a troubled firm without

requiring fixed income investors to hold
equity, which could violate their mandates;
potentially attractive to a larger pool of capital.

Preferences of participants

Other considerations

Drawbacks: if conversion happens

late, contingent debt holders gain a
firm with little remaining value and
perhaps little potential equity upside.
Most
traditional
fixed-income
investors dislike conversion to equity
because their fund mandates
preclude
them
from
holding
convertible securities or equities.

Drawbacks: possible that debt holders could

take losses before equity owners, inverting
the capital structure.

Fixed income investors prefer this type of

conversion, especially if it includes a writeback option.

Regulators should prefer this type of

conversion because it can reduce
systemic risk.
-

Does not work with an early trigger, because

debt holders would suffer losses well before
shareholders.
Source: Pitt, Hindlian, Lawson, & Himmelberg (2011, p. 8)

did react to investor concerns about the problems in credit/mortgage quality before the problem was widely recognized (Pitt,
Hindlian, Lawson, & Himmelberg, 2011).
67
This is because (potential) investors cannot properly assess the likelihood of whether and when a discretionary trigger could
be breached and how much of the debt might be converted once triggered; as a result, this uncertainty prevents investors from
assessing the risk associated with a contingent capital security, and therefore whether they should buy it or what price is
appropriate to pay (Pitt, Hindlian, Lawson, & Himmelberg, 2011).

54

From a regulators perspective, incentives created by a highly dilutive equity conversion are favorable
in that they should help to reduce the aggregated risk level. However, most fixed income investors
operate under fund mandates that prevent them from holding equity or convertible securities. There
are reasonable ways, as Pitt, Hindlian, Lawson, & Himmelberg (2011) point out, to structure the
contingent convertible securities around this.

68

It is important to consider that many fixed income

investors may still face substantial hurdles to holding convertible securities, and these hurdles could
prevent a deep contingent capital market from forming. The obvious alternative to conversion into
equity is a write-down of principal, which fixed income investors appear to prefer. The write-down
could be permanent or it could include a write-back feature if the bank regains its market power, as
seen in the contingent capital securities issued by Intesa Sanpaolo and Unicredit (see Appendix 2). A
write-back is considered attractive by many fixed income investors, because it offers the hope of
regaining some, or even all, of the principal, and also because some fixed income fund mandates
deny investing in securities with an embedded permanent write-down feature. A permanent writedown also carries the risk that contingent capital holders could take losses ahead of shareholders, or
even lose more than shareholders, and they may have no upside (equity) potential. As a result, this
would effectively invert the priority of claims of the capital structure. Investors may find that a high
coupon (or a high issue spread) can adequately compensate them for this risk but this would also
raise the (re-)financing costs. Banks may ultimately prefer to issue a security with a lower up-front
coupon, but allow the investor to benefit from a principal write-back (Pitt, Hindlian, Lawson, &
Himmelberg, 2011).
Finally, contingent capital could offer a partial return of principal to investors at the time of
write-down, such as, for example, Rabobanks senior write-down bond does.

69

Pitt, Hindlian, Lawson,

& Himmelberg (2011) do not see that most regulators will consider these sorts of securities to be the
desired solution of strong regulatory capital securities because they reduce liquidity at a time when it is
needed most. This could compound a solvency crisis by introducing a liquidity problem as well eventually making these securities destabilizing and defeating the purpose of contingent capital.

5.3 PRICING OF CONTINGENT CAPITAL

The pricing of contingent capital instruments, an issue that depends on the overall set up of the
instrument, is hard to discuss without picking one particular structure from the heterogeneous
contingent capital genus. Additionally, it is difficult to comment on where the pricing of such
instruments will end up, given their current scarcity (PricewaterhouseCoopers, 2011a). Obviously, as
Culp (2009, p. 27) states, [p]ersuading existing investors to take a more subordinated position in a
banks capital structure and write a put option to the bank on its own stock will be neither cheap nor
easy. So far, markets absorbed any contingent capital as illustrated in Appendix 2 without hesitation.
(But this may have been so because of restrictions on coupon payments on other debt securities as it

68

As an example, the contingent capital security could convert into shares in a trust, which would be liquidated at a point in the
future. At that time the contingent-capital holders would be compensated either in equity or in cash at a level determined by the
current equity price. This option is not significantly different from a write-down with a write-up feature, although it could allow
investors to recoup more than their initial principal if the firm recovered in the intervening time (Pitt, Hindlian, Lawson, &
Himmelberg, 2011).
69
At conversion, 25 per cent of the Rabobanks principal (see Appendix 2) is immediately repaid in cash, the rest is
permanently written down (company information).

55

was the case at Lloyds Banking Group, were discretionary interest payments on existing notes were
stopped in 2009 due to an intervention of the European Commission (Bloomberg, 2009).)
Pricing contingent capital will depend on conversion triggers, types of conversion, and
conversion rates (Pazarbasioglu, Zhou, Lesl, & Moore, 2011, p.12). The trigger defines the
conversion risk and therefore, for a given conversion rate, the cost of issuing a bond, the coupon paid
to investors, with a low trigger should be cheaper than one with a high trigger. But as we can see in
Appendix 2, this is not always the case since a lot of other factors have to be considered. Additional
specifications from the authorities on how they determine the various features of contingent capital will
help to add a more unified pricing model.
A first step to a homogenous market, usually an important factor for the success of a financial
70

product, is a standardized term sheet published by the EBA in December 2011 : in their bank
recapitalization press statement from December 2011, the EBA states that [b]anks should first use
private sources of funding to strengthen their capital position to meet the required target, including
retained earnings, reduced bonus payments, new issuances of common equity and suitably strong
contingent capital, and other liability management measures. (EBA, 2011) The EBA said new
issuances of strong private convertible capital would be acceptable as long as it is in line with criteria
set out in an ad-hoc term sheet. The deals have to be issued by the end of June 2012, the EBA said.
This ad-hoc term sheet we may see it as a first blueprint for European CoCo-bonds is the first
undertaking to get use of contingent capital to strengthen the financial system. The common term
sheet Buffer Convertible Capital Securities (or BCCS) is being provided on EBAs homepage.

71

The

two most important sections of the term sheet, the definition of contingency and viability events, state
the following:

A CT1 ratio contingency event means that the bank has to give the EBA notice when the ratio
falls below 7 per cent (by reference to the EBA recommendation EBA/REC/2011/1). The firm
has to give notice without delay when it has established that its CT1 ratio is below 7 per cent.
(The CT1 ratio is equal to the definition used in the EBAs 2011 EU-wide stress test.

72

This

definition excludes all private hybrid instruments which encompass all the BCCS to be issued
under the term sheet Buffer Convertible Capital Securities.)

A CET1 ratio contingency event means that after 1 January 2013, the issuing firm has to give
notice that its CET1 ratio, in accordance with the final provisions for a regulation on prudential
requirements for credit institutions and investment firms to be adopted by the EU and taking
into account the transitional arrangements, is below 5.125 per cent (or a level higher than
5.125 per cent as determined by the institution to be defined on a case by case basis). A
bank shall give notice as soon as it has established that its CET1 ratio is below 5.125 per cent

70

European banks, or more specific their ability to meet their continuing funding needs, have been some of the principal
victims of the continuing uncertainty surrounding the future of the Eurozone, due to their exposures to Eurozone sovereign
debt. As part of its general efforts to increase market confidence in European banks, the European Banking Authority published
a recommendation on 8 December 2011 as to the creation and maintenance of temporary capital buffers by European banks
(EBA, 2011).
71
http://stress-test.eba.europa.eu/capitalexercise/Term%20sheet%20FINAL.pdf (retrieved: April 3, 2012)
72
http://www.eba.europa.eu/News--Communications/Year/2011/The-EBA-details-the-EU-measures-to-restore-confide.aspx
(retrieved: April 3, 2012)

56

(or a level higher than 5.125 per cent as determined by the institution to be defined on a
case by case basis).

Regarding to the EBA, a viability event, regarding to BCCSs, is the earlier of: a) a decision
that a conversion, without which the firm would become non-viable, is necessary, as
determined by national/relevant authorities; and b) the decision to make a public sector
injection of capital, or equivalent support, without which the firm would have become nonviable, as determined by national/relevant authorities.

The EBAs definition of contingency and viability events of the BCCS term sheet demonstrates that the
European regulator is intended to use contingent capital as a going-concern instrument. However,
there are certain provisions which the EBA has indicated should be determined by national
supervisors on a case-by-case basis, subject to a minimum requirement specified by the EBA. Now
that the EBA term sheet has been published, the capital-raising exercises of European banks until
mid-2012 may give a clearer indication of the extent to which contingent capital securities, which
qualify to form part of a banks Tier 1 capital, can be issued on terms that are acceptable to both
banks and investors.
To refer to the so far issued contingent capital securities, where capital-ratios are used to
trigger the conversion, consider the following literature: Glasserman & Nouri, (2010) present a
valuation model for contingent capital with a capital-ratio tigger where the firms assets are modeled as
geometric Brownian motion that results in formulas for a fair yield spread on the convertible debt. But
as already mentioned before, the contingent capital is as heterogeneous as the contingencies any
useful pricing approach has to be related to the specific features of a contingent capital security.
Also interesting in this regard is the work presented by Corcuera, De Spiegeleer, FerreiroCastilla, Kyprianou, Madan, & Schoutens (2011). The authors look at the problem of pricing CoCobonds where the underlying risky asset dynamics are given an exponential Lvy process incorporating
discretionary movements and heavy tails (for an introduction on Lvy processes see, for example,
Tankov, 2007 or Kou, 2008). Interestingly, the authors perform their analysis using a special class of
-processes (known as -VG) which have similar characteristics to the classical Variance-Gamma
model. Additionally, case studies on the Lloyd and Rabobank CoCo-bonds are performed.

5.4 ECONOMIC R ATIONALE OF CONTINGENT CAPITAL

To put the explanation of contingent capital into context of their desired help for stabilizing the financial
system, we will now look at the economic rationale for contingent capital as stated in Pazarbasioglu,
Zhou, Lesl, & Moor, (2011, p. 7 f.):

Contingent capital provides an automatic mechanism for increasing capital and reducing debt
payments, when the trigger event is met: importantly, raising capital is enabled at times when
other options are impossible, either due to unfavourable market conditions are because it is
unattractive to shareholders (Duffie, 2010). The latter stated reflects the unwillingness of
shareholders to dilute their equity position by share issuance or by fire sale in unfavourable
market conditions (Brunnermeier, 2009 and Adrian & Shin, 2010). An automatic conversion,
57

that would circumvent potential fire sales, could help avoiding contagion in times of severe
market conditions;

Contingent capital instruments are expected to deal with market failure associated with the
TBTF-problem: depending on the choice of triggers/conversion rates, contingent capital
instruments hold the potential to increase capital buffers, supporting banks with an instant
recapitalization, or increase loss absorbency before a default event;

The threat of losses/dilution due to conversion could help reduce risk taking by bank
managers, equity-, and bondholders: the threat of dilution should encourage shareholders to
require more prudent corporate governance and strengthened risk-control procedures within a
bank. Similarly, requiring bondholders to bear part of the cost of a future bank recapitalization
would enhance their incentive to exercise greater market discipline. It also has been
suggested and backed by officials that bank manager bonuses could be paid in the forms of
contingent convertible debt instruments to limit excessive risk taking (The Guardian, 2011).
Pazarbasioglu, Zhou, Lesl, & Moore (2011) developed a simple two-period model to illustrate
the benefits of CoCo-bonds in promoting market discipline. The model illustrated in
Pazarbasioglu, Zhou, Lesl, & Moore (2011, p. 7) [] implies that the effect of CoCo-bonds
on the banks risk-taking behavior is equivalent to that of a risk-based, pre-funded bank
resolution fund;

Contingent capital may be preferred to equity (from a banks point of view): first it may
potentially be cheaper (if tax deductibility is granted); second, before conversion, it could be a
non-dilutive source of capital, so that issuance does not change corporate control; and third it
may be acceptable as Pillar 2 capital (see Chapter 3.2 above);

Contingent capital instruments should be considered in addition to common equity: while

contingent capital instruments may be used to replace existing hybrid capital that had poor
loss absorption during the 2007-09 financial crisis, they should not compromise the objective
of capital transparency and their use should be based on an enhanced capital structure under
the Basel III framework (Pazarbasioglu, Zhou, Lesl, & Moore, 2011, p. 8). There is no doubt
that common equity is higher-quality capital in terms of loss absorption but an excessively high
common-equity requirement could lead to perverse risk seeking because bank managers
would most certainly struggle to maintain a ROE ratio demanded by shareholders;

Contingent capital differs from existing hybrid instruments in two ways: first, contingent capital
instruments are dated debt with a conversion feature or a contractual write down clause, while
existing convertible hybrid bonds are perpetual debt, which offer loss absorbency mainly
through the deferral of coupons or an extension of maturity (this argument stated by
Pazarbasioglu, Zhou, Lesl, & Moore (2011) is not completely correct when considering the
latest contingent capital issues listed in Appendix 2 where most of the bonds are perpetual
debt). Second, the conversion of contingent capital structures happens automatically through

58

the pre-determined trigger in contrast to the conversion of existing hybrids that is conducted
largely at the discretion of banks, unless regulatory capital ratios are breached;

During the latest financial crisis, most hybrid bonds did not absorb losses as they were
designed to do: this was because banks were reluctant to send negative signals to the market
and partly due to regulatory forbearance (Pazarbasioglu, Zhou, Lesl, & Moore, 2011, p. 8),
overestimated capital ratios and/or (guaranteed) bail-outs from the government, which made
the breach of regulatory ratios not happen. The latest cirsis has demonstrated the
weaknesses in banks capital structure and measurement and therefore the Basel III
framework has raised the minimum common equity ratio from 2 per cent to 7 per cent (of
which 2.5 per cent is represented by the conversion buffer) and essentially enhanced the
quality of capital. A critical issue is to avoid CoCo-bonds repeating the same failure as hybrids,
including marring once again capitals loss-absorbency availability and transparency
(Pazarbasioglu, Zhou, Lesl, & Moore, 2011, p. 8).

But since contingent capital instruments add an additional layer of complexity to the regulatory
framework, we have to consider if this approach really provides the needed stability to the financial
sector. This leads us to the question if it would be better to have regulators demanding a higher
(common) equity cushion instead of requiring banks to issue contingent capital instruments. We will
examine this question in the next section.

5.5 WHY CONTINGENT CAPITAL INSTEAD OF E QUITY?

We have already heard about the specific features and the economic rationale of contingent capital.
Obviously, one important question cannot be ignored: why should banks issue contingent capital
(bonds) instead of simply running higher equity cushions? Interestingly, only two out of about 30
academic studies (see Appendix 1) on contingent capital discussed this issue. Why should
banks/authorities make use of (complex) structures such as CoCo-bonds when issuing equity is the
simpler and also more suitable solution for a strengthening of the financial system? (Additionally
considering that the new Basel III regulation is already a huge organizational effort for the firms.) We
have to analyze that case in detail.
One widespread argument against higher equity cushions is that equity capital

73

is expensive.

Therefore, if banks were required by policymakers to have more equity, bank profitability would fall,
interest rates on loans would increase, resulting in a threat to economic growth.

74

This argument

against higher equity cushions also implements that leverage forces bankers to manage loans

73

In finance, the cost of equity is the return a firm theoretically pays to its equity investors to compensate for the risk they
undertake by investing their capital. Firms obtain capital from two kinds of sources: lenders and equity investors. The first group
demands interest and the latter seeks dividend and/or appreciation in the value of their investment. From a firm's perspective, in
aggregate, it must pay for the capital it obtains from others, which is called its cost of capital. Such costs are separated into a
firm's cost of debt and cost of equity. While a firm's present cost of debt is relatively easy to determine from paid interest on its
issued securities, its current cost of equity is unobservable and must be estimated. Finance theory and practice offers various
models for estimating a particular firm's cost of equity such as the Capital Asset Pricing Model (CAPM). Another method is
derived from the Gordon Model, which is a discounted cash flow model based on dividend returns and eventual capital return
from the sale of the investment. Moreover, a firm's overall cost of capital, which consists of the two types of capital costs, can be
estimated, for example, with the weighted average cost of capital (WACC) mode.
74
In an interview, Josef Ackermann (CEO Deutsche Bank) stated, that [e]in hheres Eigenkapital mag zwar die Stabilitt der
Banken erhhen [...] aber [zugleich] werden ihre Mglichkeiten eingeschrnkt, die brige Wirtschaft mit Krediten zu versorgen.
Das kostet Wachstum und damit Wohlstand fr alle. (Deutsche Bank, 2009)

59

efficiently, and therefore represent an indispensable element of efficient banking (see, for example,
Diamond and Rajan, 2001).
The simple notion that equity has a high required rate of return that is independent of
leverage is a fallacy routinely debunked in introductory finance courses. (McDonald, 2010, p. 18) The
Modigliani-Miller (MM) theorem states (Modigliani & Miller, 1958) that absent other frictions, if firms
were less levered, the cost of equity would be less. Furthermore, the MM theorem assumes a world
without taxes and bankruptcy costs. The tax deductibility of interest does create a reason for banks to
actively prefer high leverage. From a policy perspective it seems questionable to grant interest
deductions to govern bank capital rules. With no social benefit to leverage per se, a more direct
response would be to legislatively remove the tax advantage of debt finance for financial institutions
(McDonald, 2010). Given the cost of the latest financial crisis, it is quite confusing to hear bank
managers deemphasize the substantial benefits associated with the reduction of systemic risk that
result from more equity funding of banks. A more sophisticated capital regulation framework must be
based on an analysis that accounts as fully as possible for the social cost and benefits associated
with any change in equity requirements (Admati, DeMarzo, Hellwig, & Pfleiderer, 2011, p. 9).

75

But as

Bolton and Samama (2011, p. 5) point out [t]here is little disagreement about this [higher equity
requirements for a more resilient financial system] benefit. The debate is more about the costs of such
high equity capital requirements.
Other reasons for banks to prefer leverage are, for example, the government safety net. But if
debt does provide incentives for management, could these incentives be provided at less cost via
compensation policies or the market for corporate control (McDonald, 2010)? Another question would
be: if equity capital is not that costly and damaging to economic growth as bank managers are trying
to make us believe, why then consider contingent capital at all? One possible answer is that policy
undertaken with incomplete information runs the risk of unintended consequences (McDonald, 2010,
p. 19). Contingent capital permits regulators to implement a system wide capital cushion that will be
(automatically) activated in times of financial distress, without altering the current regulatory framework
too much. If there should be important reason for banks to be highly levered, contingent capital
instruments permit banks to maintain high leverage while contributing less to systemic risk (McDonald,
2010). But other prominent commentators (among them Admati, DeMarzo, Hellwig, & Pfleiderer
(2011), Greenspan (2010), and Kashyap, Rajan, & Stein (2010)) opt for minimum capital requirements
in excess of 14 per cent (book equity to asset ratios), a value that is far above the current Basel III
requirement and a point on which most policymakers have thus far been conspicuously silent (Stein,
2010, p. 250). Continuing, Stein (2010, p. 250) explains the 14 per cent threshold as follows: [f]irst, a
rough calculation suggests that a 14 per cent ratio would provide the banking sector with a buffer
adequate to see it through a crisis equal in magnitude to that of the last few years. And second,
another back-of-the-envelope exercise yields the conclusion that a 14 per cent regulatory minimum
would not be overly burdensome, in the specific sense that it would not prevent banks from earning a
return on equity in line with historical averages.
75

Miles, Yang, & Marcheggiano (2011) attempt to quantify the benefits as well as the costs of increased equity capital
requirements; the authors estimate that an optimal bank capital should be around 20 per cent of RWAs. Unfortunately, they are
less precise on the cost of equity argument (Miles, Yang, & Marcheggiano, 2011, p. 39): It is far from clear that the costs of
having banks use more equity to finance lending is large. It is certainly not clear that the decline in banks capital levels and
increase in leverage had improved economic performance prior to the financial crisis.

60

Banks argue that it will become much more difficult to meet the return on equity demanded (Table 1
above exlaind the implications of the banking industry ROE targets) by shareholders with such high
capital requirements and that as a result a significant credit crunch may be caused by such a sharp
increase in required capital (see, for example, Ackermann, 2010). As Admati et al. (2011) have
pointed out, under classical MM perfect capital markets the required ROE should be lower when bank
leverage is lowered, as bank equity is then less risky. Kashyap, Stein, & Hanson (2010) argue that
even when one accounts for the tax deductibility of interest payments, an increase in required equity
capital only translates into a small increase in banks WACC.
Steins (2010) analysis to the costs associated with raising capital requirements by several
percentage points is nothing more than an application of the WACC: suppose that equity capital
requirements are raised very substantially (Stein suggests 10 percentage points). Additionally,
suppose that at the margin, this additional equity displaces long-term debt in the capital structure of
the affected firms. Regarding to MM, the only net effect on a banks WACC (and, for example, also on
the rate they charge for corporate and consumer loans) comes from the lost tax deductions on the
long-term debt that is eliminated. Thus, Stein (2010) continues, if the displaced debt yielded, say, 7
per cent, than given a 35 per cent corporate tax rate, a 10-percentage-point reduction in the debt tax
shield would raise the WACC by about 25 basis points (0.10 x 0.07 x 0.35 = 0.00245). This is the
impact of a very large increase (10 per cent) in the equity capital requirements, equivalent to going
from a low 4 per cent regulatory minimum requirement all the way up to the suggested 14 per cent
level.
But, as Stein (2010) notes, this above WACC-calculation comes with a number of caveats:
[f]irst [] it should be thought of as capturing the long-run steady-state costs of having to hold more
equity on the balance sheet, while disregarding the transitional flow costs of associated with raising
the required new equity. Given the adverse selection problems associated with new equity issues
(Myers & Majluf, 1984), these flow costs may be significant. This implies that if higher capital
requirements are phased in too abruptly so that banks have to get there through large external
equity issues, rather than by gradually accumulating retained earnings the transitional impact on
their lending behavior may be much higher that my [Stein, 2010] 25-basis-point figure suggests.
There is indeed, as Bolton & Samama (2011) corretly point out, a very large array of
(empirical) literature in corporate finance that finds large costs of issuing new equity over and above
the classical WACC. These costs comprise: the underwriters fees, the under-pricing of the equity
issue, and the negative stock price reaction to the rights issue announcement (the Myers & Majluf
(1984) dilution costs). Some early estimates of the total fixed cost of a new equity issue exceed 21 per
cent of the market value of the new issue for firm commitment offers, and 31 per cent for best efforts
offers. Estimates for more recent issues are somewhat lower, but they remain very large, so much so,
that corporations try to avoid to tap the equity market.
The above stated arguments from Admati et al. (2011) are not beeing denied, but the authors
state that while information asymmetry might make the issuance of equity more expensive, it is not
said that this is a valid reason to allow high leverage and to argue against higher equity requirements:
(1) equity issuance is less needed and is less costly when banks use less debt financing on an
ongoing basis, such as would be the case if equity requirements were significantly higher. In that case
retained earnings, which do not entail issuance costs and which will be more plentiful with lower debt
61

service requirements, can be used to maintain or even grow banks operations; (2) regulators can
mitigate issue costs associated with asymmetric information by removing banks discretion over
payout and issuance decisions. These may be correct observations, but in the absence of any solid
empirical evidence they remain largely speculative (Bolton & Samama, 2011). Equity holders face
76

lower risk when the bank is less levered, dilution costs (due to balance sheet opaqueness ) from new
equity issues could be just as high as when the bank has higher leverage.

77

Furthermore, a dividend

cut or a reduction in payout, also comes with a substantial negative impact on equity value, as a large
corporate finance literature on dividends has established. Finally, removing discretion over payout and
issuance decisions is unlikely to significantly reduce information dilution costs, as investors will
continue to worry about the quality of the claims they are holding or purchasing. It is not entirely clear
how discretion over equity issuance can be removed. A bank can always refuse to issue new equity
and simply comply with the higher equity requirements by selling assets. It is far from obvious how
regulators could stop such compliance through such asset sales.
All in all, as Bolton & Samama (2011, p. 7) stated, existing evidence shows that there are
significant costs of issuing equity over and above the Modigliani and Miller risk-adjusted required
ROE. Therefore, Bolton & Samama (2011) conclude that there are three advantages of contingent
capital over straight equity capital:

By purchasing a capital line of commitment, banks will have the issued amount of capital when
they need it. Bolton, Santos, & Scheinkman, Outside and Inside Liquidity (2011) make the
point that an ex-ante capital line commitment dominates a straight equity buffer in case of
there are short- and long-term investors with different interest;

A pre determined (strike) price for a contingent equity-issue reduces equity dilution costs as
explained by Myers & Majluf (1984). As a firm is less likely to have an informational advantage
over investors about its future balance sheet, the risk of adverse selection for investors in
contingent capital is reduced;

Finally, as Bolton & Samama (2011) closing their argumentation for the advantage of
contingent capital over equity, it helps to overcome pro-cyclical amplification effects. Building
or maintaining captial buffers is relatively expensive. In recessions, when it is extremely costly
to raise outside equity capital, banks mostly meet their captial requirements by cutting lending,
selling assets, and by deleveraging their balance sheets. Doing this, banks amplify the
recession by contributing to lower asset prices (with so called fire-sales).

Bolton & Samama (2011) are closing their arguments in support for contingent capital that when there
are equity issuing costs above the risk-adjusted ROE then the balance sheet of the firm that issued
contingent capital is more efficient.

5.6 ANOTHER REGULATORY APPROACH: BAIL-INS

76

It may be worth to point out that banks' balance sheets in 2007-08 were so opaque that even the biggest losers appeared to
have sufficient regulatory capital.
77
In Myers & Majlufs (1984) article, equity dilution costs of new equity issues are derived for an all equity firm.

62

When governments injected hundreds of billions into banks to rescue them, most bondholders were
left untouched (even the subordinated bondholders). The result was anger and a desire to make
bondholders share the burden in future by taking losses to bail in a bank before taxpayers are called
up on to bail it out. In theory, this will force them to be more careful with their investments and protect
the taxpayer from a re-run of the recent crisis (Financial Times, 2012).
Bail-ins are in line with new intervention rights for financial market regulators, with the
according regulatory authority deciding at the right time for a haircut

78

that would then affect all

bondholders alike while leaving untouched other creditors of similar stature, such as derivatives
counterparties (Financial Times, 2012). No automatic triggers are in place. As a rule bail-ins are
implemented in the course of restructuring a company rather than as part of an early rescue package
(Zhres, 2011). Bail-in regimes have made bondholders feel uneasy because in contrast to traditional
bankruptcies, which have strict rules and are court-supervised, bail-ins represent an uncertainty. And
as it is, higher risk needs a higher premium: investors are likely to require more interest if they are at
risk of losing money to a bail-in (Financial Times, 2012). The bail-in approach would likely require
regulators with statutory powers to cancel, write-down, or convert existing debt holder claims, or
override option rights (Pazarbasioglu, Zhou, Lesl, & Moore, 2011). Furthermore, Pazarbasioglu,
Zhou, Lesl, & Moore (2011), see two positive features of such a statutory approach to debt
restructuring:

Unlike contingent capital, bail-in schemes are able to deal directly with the resolution of SIFIs.
Supervisors are under the bail-in model enhanced with discretionary power to recapitalize an
insolvent SIFI instantly. Furthermore, moral hazard will be reduced because the
recapitalization will be based on the conversion of private debt into equity rather than a bailout;

A bail-in approach is better suited to deal with larger shocks/tail risks, because financial
institutions would ordinarily maintain a substantially large amount of unsecured debt that could
be eligible under bail-in schemes for conversion into equity.

But on the contrary, bail-ins could face tough legal challenges and strong political opposition adding to
difficulties with a cross-border implementation (Pazarbasioglu, Zhou, Lesl, & Moore, 2011).
CoCo-bonds, in comparison, are a financial market product which feature predetermined,
legally set, automatically triggered, observable and transparent conversion terms and conditions.
Essentially, they are a new breed of credit derivatives on fixed terms, issued ex ante enabling the
company to strengthen its capital base as the necessity arises (when the trigger is met) (Zhres,
2011). Zhres (2011, p. 16) correctly points out two different features between bail-ins and CoCos:
the timing of and responsibility for the measure. CoCos are an independent, ex ante precautionary
measure, while bail-ins are subject to a statutory process and constitute an ex post measure.

78

Here a partial waiver of the borrowers claim.

63

5.7 LEGAL, ACCOUNTING, AND TAX ISSUES

Converting a CoCo-bond, the case when shareholders suffer a dilution, may confilct with shareholder
protection rights. Permission from the ordinary shareholders may be required to issue a contingent
capital instrument. Varying solutions of a CoCo-bond design will apply in different jurisdictions, which
in turn would lead to the prevention of a single, globally tradable, asset class obviously a threat to
liquidity and investor demand (PricewaterhouseCoopers, 2011a).
A major uncertainty, as employees of PwC point out, is, if it is possible to over-ride the
bankruptcy regime in a certain jurisdiction. We can explain this issue in case of the U.S. bankruptcy
code: under section 365 the terms of an executory contract

79

may not be amended unfavourably to the

80

debtor just because the debtor files under Chapter 11 . Currently there are cases of these sorts of
provision but, as of November 2011, the outcome is yet unclear (PricewaterhouseCoopers, 2011a).
Another issue is the supervisors legal enforceability

81

of the discretion to trigger the write-

down or conversion, in which case it would not be a CoCo-bond in the narrower sense. The
implication is that insolvency regimes will need to be amended to accommodate bail-in debt
(PricewaterhouseCoopers, 2011a).
82

Loan loss provisions , which drive the level of book capital, are also a major issue when it
comes to legal aspects for the practicability of CoCo-bonds. Exercised by the discretion of a banks
board, there are usually various views on the required level for provisions. Considering a capital
structure with convertible instruments on the edge of a conversion, a bank will need to be aware of (1)
the provisioning methodology, and (2) the regulatory capital models, for not causing unintended
conversions. For both groups, a banks board members and regulators, these could be dangerous
waters (PricewaterhouseCoopers, 2011a).
As the IFRS/US GAAP convergence project

83

is delayed, the treatment of contingent

convertible capital/bail-in debt over the long term is somewhat uncertain concerning the treatment of
the liability element of such instruments. In the meantime, IAS 39 continues to be the relevant
standard.

84

For issuers it is important to know that the future replacement standard (IFRS 9) retains

the same accounting principle. Therefore IAS 39 requires the embedded derivative to be valued
separately. However, if such credit instruments are not accounted for as a compound instrument, how
should the issuer value the embedded derivative? Issuers cannot take the difference between the
79

One or more parties have not yet performed their duties as stipulated in the contract document. For example, an on-going
lease agreement is an executory contract.
80
Chapter 11, named after the U.S. bankruptcy code 11, is a form of bankruptcy that involves a reorganization of a debtor's
business affairs and assets. Generally filed by corporations, which require time to restructure their debts.
81
In many common law jurisdictions, such as under English law, the courts have protected their right to hear claims of judicial
review of any decision made under powers given to a public body, where any individual or group can show that they have
suffered as a result of that decision. Therefore ordinary shareholders, who have seen the value of their holdings reduced by the
execution of a conversion of bail-in capital into equity, may feel aggrieved and seek to have the decision reviewed by the courts.
Attempts by Parliament, including so-called ouster clauses in legislation, to restrict the ability of the UK courts to review
decisions, have not proven to be practical, as the courts have always found a way to exercise their jurisdiction to review such
decisions (PricewaterhouseCoopers, 2011a).
82
An expense set aside as an allowance for bad loans. Loan loss provisions are also known as a valuation allowance or a
valuation reserve; equivalent of a manufacturing company's allowance for returns on goods sold.
83
The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are working on
nearly a dozen joint projects designed to improve both U.S. Generally Accepted Accounting Principles (US GAAP) and
International Financial Reporting Standards (IFRS), and ultimately make the standards fully compatible. Through these projects
the boards intend to improve financial reporting information for investors while also aligning U.S. and international accounting
standards.
84
More on IAS 39 Financial Instruments: Recognition and Measurement can be found under
http://www.iasplus.com/standard/ias39.htm (retrieved: April 3, 2012).

64

issue price of the structured bond and the theoretical price of a straight bond with the same maturity.
The issuer has to value the embedded derivative and then take the difference between it and the issue
price as the bond component. For everyone who has once valued an option, the problem is obvious:
how does one value a put option when the strike price is unknown? (Which is the case, for example,
when the conversion is triggered based on capital values.) Also bail-in terms may vary (for example,
between write-down, write-off or conversion) and/or the volatility is unknown, because the probability
of exercise is impossible to gauge (PricewaterhouseCoopers, 2011a).
Tax, surely, will be an important consideration for instruments to develop to meet the new
regulatory requirements. Importantly, a number of the required regulatory features of such instruments
make the tax treatment under the present tax rules. While issuers of existing Tier 1 and Tier 2 debt
instruments generally enjoy tax deductions for any coupons paid to investors, loss absorbent
instruments may not be tax deductible under current rules. As far as CoCo-bonds are concerned, the
tax position is unclear. Tax authorities may regard these as being much closer to equity than debt in
nature and thus not considered as tax-deductible (PricewaterhouseCoopers, 2011a). (What we have
seen from previous issues, return demanded by investors of such instruments indicates that they are
indeed much closer to equity.) But this issue has also to be thought of in a broader context: there is a
debate amongst tax policymakers whether steps should be taken to correct the perceived bias of tax
systems towards debt (i.e., through provision of tax relief for interest costs), considering that this is
one of the factors which may have encouraged excessive leverage within the banking sector in the
past (PricewaterhouseCoopers, 2011a).
Although much of the debate to date has focused on the taxation position of the issuers, i.e.
the banks, the taxation position of investors will also need to be taken into account. Similar debt
versus equity considerations may arise since, in various jurisdictions, interest income is taxable whilst
dividend income may not be. Another likewise point is the tax deductibility of losses incurred on the
occurrence of a conversion. Enhancing the taxation treatment of these instruments (e.g., through
making coupons tax exempt) may contribute substantially to making them more attractive to investors
(PricewaterhouseCoopers, 2011a).

5.8 WHERE ARE WE NOW?

Basically, as Zhres (2011) points out correctly, three groups with different interests need to be
reconciled to establish a CoCo market successfully:

First are the regulators, who must be convinced that CoCos has full loss absorbency in the
recovery phase and who then must aggressively promote the use of CoCos;

Second are the shareholders, whose stock is diluted by the automatic capital increase when
CoCos are triggered and who are therefore eager to avoid dilution;

And third investors, who do not yet really know what to expect or whether they will even be
able to hold these instruments.

Both shareholders and investors still have mixed feelings about CoCo-bonds. This makes it essential
that the individual banking institutions get the individual design of their bond terms just right, difficult as
this may be. Even though an established price formation mechanism exists for the two basic elements
65

of CoCos, i.e. subordinated bonds and equity, pricing CoCos themselves presents a real challenge.
The choice of conversion trigger and the terms on which a CoCo-bond is converted are the crux in any
discussion on the practicability of these bonds. There is no single one-size-fits-all structure for
designing their features. A decision must always be tailored to the individual companys situation
(Zhres, 2011).
In December 2011, the European Banking Authority (EBA) issued guidelines for CoCo-bonds
as part of the result of its latest stress tests. EBA calls them buffer convertible capital securities and
suggests a trigger at 7 per cent of core Tier 1. Regarding to EBA, contingent capital should be issued
by banks since the stress tests were aimed to evaluate potential, or contingent, losses. For the EBA,
any issued buffer convertible capital security (BCCS), would have to meet very strict and fully
harmonized criteria. The envisioned structures are classified as a type of hybrid Tier 1 capital
(Financial Times, 2011). Clearly the EBA is going to re-stress-test European banks now the value of
such tests is unquestioned and the overall stability of the European banking sector is still largely
dependent on cheap central bank money from the ECB. If there is a continued emphasis on stresstest capital levels in the future, CoCo-bonds could be in demand as they make sense as stress testspecific capital.
A number of countries, notably Switzerland, the United Kingdom and Sweden have already
taken action to implement higher capital requirements SIFIs at the national level. Noteworthy, the
Swiss TBTF package, which was approved by the Swiss Parliament in September 2011, came into
force on March 1, 2012. The package, which is particularly demanding with respect to capital
requirements, consists of a capital buffer of 8.5 per cent of RWAs. This is in addition to the Basel III
minimum requirement of 10.5 per cent. Of this 8.5 per cent, at least 5.5 per cent must be in the form of
common equity while up to 3 per cent may be held in the form of convertible capital. The CoCo-bonds
would convert when a bank's common equity falls below 7 per cent. The two big Swiss banking
behemoths, Credit Swiss and UBS will have to hold a total of 10 per cent common equity tier 1 capital.
This exceeds both Basel III and the internationally agreed capital surcharge for G-SIBs. Interestingly,
the regulatory approach also includes a so-called progressive component equal to 6 per cent of RWAs
consisting entirely of CoCo-bonds. Unlike the CoCos under the buffer, the Cocos under the
progressive component will convert when capital levels falls below 5 per cent common equity (Ingves,
2012).
With Switzerland as frontrunner in the regulatory use of CoCo-bonds, the European mainland,
the EBA, seem to get more confident with the possibilities contingent capital offer to strengthen the
financial system. But so far no widespread, systematic use of contingent capital is in place, neither in
Europe, nor in the U.S.

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6. Conclusion
Global financial regulators who gather in Basel agreed to force banks to build bigger capital cushions
to absorb losses and to keep more money in (easy to sell) liquid assets. Now, about five years after
the outbreak of the U.S. subprime crisis, we're in a phase, in which the Basel framework is being
implemented. Bankers regularly protest that governments are going too far and choking off credit
needed to nourish economic growth. Jamie Dimon, CEO J.P. Morgan, goes as far as calling certain
rules of the new regulations as downright idiotic. His adversaries counter, that there are still too
many banks that are TBTF or complain that rule writers are bending too much to bankers' pressure.
Without starting a discussion on specific rules, we can sum up the following:

Obviously, the oversight of the financial system was broken and needed prompt fixing. The
crisis exposed huge vulnerabilities and repairs were urgently needed. The precrisis banking
wisdom that increased financial intensity, complexity and innovation would ensure stability
was wrong, Adair Turner, the British financial regulator, has said (Turner, 2011);

Finance has nothing to do with gambling. It is central to every economy: it takes savings from
those who have them, channels them to productive investment, and it shifts risk to those most
able and willing to bear it (see Chapter 2). But a lot of what finance did before the crisis served
neither end. Forcing financial institutions to hold more capital and to avoid 30:1 leverage ratios
(Tier 1 capital/adjusted assets)

85

may make them smaller or less profitable. It also makes

them less likely to bring world economy on its knees;

Profit hasn't been outlawed by all the new regulatory rules. (It is the same Jamie Dimon whose
86

company was able to announce record profits post-Lehman. ) Although 2011 was a tough
year for the financial industry, the six largest U.S. lenders may post an average profit increase
of 57 per cent in 2012 (Bloomberg, 2012);

87

It is difficult to distinguish between useful financial innovations and those that only make
money for the innovating bank. Despite former Federal Reserve chairman Paul Volcker's
88

frequent quote that the last useful financial innovation was the ATM , continued financial
innovation is necessary for managing the risks that enable society to transform creative
impulses into vital products and services (Shiller, 2012, p. 3).
The good thing with contingent capital is that they certainly pose no threat

89

to the financial system

and instead offer a mechanism to reduce costs for the taxpayers in case of a financial meltdown.
85

Consider that by counting contingent capital as Tier 1 capital might allow banks to operate with a 100:1 debt-to-equity ratio
(Coffee, 2010).
86
The controversy about Jamie Dimons criticism and J.P. Morgan Chases market position is well documented on the New
York Times online edition: http://topics.nytimes.com/top/reference/timestopics/people/d/james_dimon/index.html (retrieved: April
6, 2012).
87
European banks, in large parts because of the European sovereign-debt crisis, are in a different state compared to their U.S.
peers and addicted to cheap ECB funding.
88
At a speech in winter 2009, Paul Volcker stated that the advent of the ATM machine was more crucial than any assetbacked bond (Reuters, 2009).
89
At least no direct threat from the securities themselves as, for example, synthetic CDOs do with the creation of money out of
thin air. Coffee (2010, p. 847) states that contingent capital is not a panacea, nor a substitute for preventive regulation, but
nothing is more certain than that regulators will again miss a crisis and therefore [c]ontingent capital offers a systemic shock
absorber to mitigate that next predictable failure.

67

Therefore, critically weighting all the above heard arguments for and against contingent capital, I have
to come to the conclusion that contingent capital can be a useful tool for strengthening the financial
system. The trickier question seems to be how contingent capital structures should be designed to
meet regulatory requirements. Here the national supervisors have to step in and define exactly how a
proper use of contingent capital in comparison to local law makes sense. This starts with the decision
if a gone- or going-concern approach has to be adopted and ends with the definition of the triggering
event(s). Albul, Jaffee, & Tchistyi (2010) already presented an excellent study on how contingent
capital should be used on different firms

90

- supervisors just have to refine such research for their own

purpose. And to establish a functioning, liquid market for these instruments, as Pitt, Hindlian, Lawson,
& Himmelberg (2011) repeatedly state in their work, an overall transparency of all the regarding issues
is of utmost importance. The above mentioned EBA blueprint for BCCS is a first step in the right
direction to make contingent capital a significant part of a enhanced regulatory framework. In the U.S.,
the Dodd-Frank Act clearly authorized financial regulators to impose a contingent capital requirement
(Coffee, 2010, p. 842).

91

In short, as Coffee (2010) puts it, the Dodd-Frank Act makes contingent

capital securities an option and not a mandate, but the issue is still discussed repeatedly within the
FSOC.

92

An obvious alternative would be to follow the Swiss approach and require contingent capital

instruments to supplement the minimum required equity under Basel III.

At the turn of the year 2012, a survey conducted by the research institute CSFI (in association
with PricewaterhouseCoopers), indicate that bank managers rank among its top 10 risk factors the
availibility of capital, the negative impact of regulation, and growing political interference in the
business (CSFI, 2012). Interestingly, the historical recordings of the survey shows, that in 2006 at the
peak of the U.S. credit boom, the fear of too much regulation was at its peak. However, a few of the
currently perceived most feared risk factors can be addressed with contingent capital. Of course
contingent capital securities the are no immediate solution in the post-Lehman aftermath but as
explained above, contingent capital can, for example, help with liquidity constrains and capital
availability to help mitigate the next crisis (referring to Coffee, 2010, that there will always be a next
crisis). And as the survey additionally shows, regulators do have the same views on the most urgent
risk developments for the financial institution. It is up to the supervisors to put the proper regulatory
tools in place.
Unquestionable, the stakes are high. The value added to modern economies by the financial
sector varies between 5 to 10 per cent in terms of gross value-added, the banking sector ranks third
in Germany, even ahead of mechanical and electrical engineering (Schildbach, 2007). People who
work in finance have every incentive to enlarge their turnover, even if it means pursuing innovations of
limited social value that expose the system to more frequent and severe crises. An issue, to which a
more sophisticated regulatory framework has to pay more attention as authorities did it so far. In this
light, we are watching the well-known arms race, a contest in which the rules get ever-more
complicated as well-staffed banks try to outflank regulators and regulatory lesser-paid personnel tries

90

They differ between unleveraged, leveraged with straight debt, leveraged and TBTF firms.
Dodd-Frank Act, Pub. L. No. 111-203, 165(b)(1)(B), 124 Stat. 1376, 1424 (60 be codified at 12 U.S.C. 5365)
92
The Financial Stability Oversight Council Annual Report fulfills the Congressional mandate to report on the activities of the
Council, describe significant financial market and regulatory developments, analyze potential emerging threats, and make
certain recommendations. Is seems likely, that the Federal Reserve will not take any dispositive action until the U.S. Congress
receives the FSOCs report in 2012 (Coffee, 2010).
91

68

to catch up. If banks succeed, we'll get more frequent and severe financial crises. If the regulators
tighten their grip too much, we'll lose the benefits of truly valuable financial innovation and posing a
threat to economic growth.

69

APPENDIX 1: CONTINGENT CAPITAL LITERATURE OVERVIEW

Author(s),
Recommended Use of
CoCos/Conclusion

Recommended
Volume of CoCo
Issuance

Culp
(2002):
contingent
capital facilities are designed
to help in risk management
and capital structure decisions
at the same time; contingent
capital can help to reduce
overall cost of capital by
limiting the costs of financial
distress,
reducing
underinvestment
problems,
providing more cost-effective
management of reserves and
regulatory
capital,
and
mitigating information costs
that complicate the task of
raising capital in difficult times.
Flannery (2002): Flannery
refers to reverse convertible
debentures (RCD) in his study;
RCDs provide a transparent
mechanism for un-levering a
firm if needed; RCDs convert
at the stocks current market
price, forcing shareholders to
bear the full cost of their risktaking decisions.

Culp shows different forms of contingent capital but evaluates the instruments from a
corporate finance perspective; therefore, no useful statements were made in terms of
stabilizing banks in severe market conditions.

Marquardt
&
Wiedman
(2005): the likelihood of firms
issuing CoCos is significantly
associated with the reduction
that would occur in diluted
EPS if the bonds were
traditionally structured.
Kashyap, Rajan & Stein
(2008): as in Flannery (2005),
the authors propose that
banks use reverse-convertible
securities in their capital
structure but with different
design features.

Flannery (2009): contingent

capital certificates (CCCs) can
reduce the probability that
firms will suffer losses in
excess of its common equity
and will provide market
discipline
by
forcing
shareholders to internalize
more of their assets poor
outcome.

Type of Trigger

Terms of Conversion

Outstanding
RCDs
convert to restore the
equity
cushion.
Therefore, only a portion
of the outstanding RCDs
may convert, at random
or pro rata preferably
in a pre-specified order.

Concludes, that a banks

equity (ratio), at current
market prices, seems to
be a reasonable trigger;
share prices should be
averaged over some
interval
to
avoid
manipulation; the equity
ratio then should be
evaluated weekly.

In
the
presented
examples, a pay-out
function (see p. 458)
with an embedded highwater test is introduced.
Given the four-quarter
rolling
window
for
computing losses, only
incremental losses in a
given quarter lead to
further pay-outs of the
overall
outstanding
insurance amount.
Firms would not be
required to issue, but
CCCs could be used to
offset
the
required
amount of equity capital.
Conversion could only
be partial, if that satisfies
requirements.
Supervisors determine
minimum equity capital
ratio and trigger point.
SIFIs cannot hold any
CCC for their own
account.
Since
conversion
may
be
partial, the allocation
mechanism has to be
chosen:
(1)
convert
shortest
remaining
maturities first; (2) sell
with various seniorities

A trigger should be
based on aggregate
bank losses over four
quarters (only pays off in
systemically bad states
of nature and will
therefore be expensive,
but not relative to equity
financing.

No further details on the terms of

conversion provided.

Would
convert
into
equity if firms capital
falls below some critical,
pre-specified
level.
Conversion trigger must
be expressed in terms of
contemporary value of
equity and scaled by the
book value of assets.

The contemporary market price

determines how many shares the
holders of CCCs to obtain. The
terms for conversion should
ensure that they suffer no capital
loss. Conversion must happen the
day after the trigger is crossed. If
firm is insolvent (due to sudden
collapse
in
asset
prices),
covenants in CCC must specify a
conversion price that wipes out
original shareholders.

If the trigger condition is met,

shares would convert on the first
trading day of the month*;
regulators could require that
converted RCDs be replaced
within a week. [*] Inserting a few
days
between
the
trigger
evaluation and the conversion
date would permit bond investors
to sell their bonds to traders with
lower costs of liquidating the
converted shares. RCDs would
deprive existing shareholders of
some option value.
Marquardt & Wiedman examined whether firms structure their convertible bond transaction
to manage diluted EPS no analysis has been undertaken in regard to the recapitalization
usability of contingent convertible bonds for banks under stress.

70

Huertas (2009): contingent

capital can limit too big to fail
and/or
too
complete
to
contemplate problem
Dudley (2009): Dudley sees
three needed improvements
for
capital
regulation
standards:
(1)
a
more
thorough and complete risk
capture so that the capital
adequacy
rules
more
effectively
encompass
a
broader set of risk exposures
than before; (2) rules that
encourage the conservation of
capital in adverse economic
and financial circumstances;
and (3) tougher regulatory
requirements, including the
use of a contingent capital
instrument
that
would
automatically replenish equity
capital in times of stress.
Culp (2009): newer proposals
of
contingent
reverse
convertibles (CRCs) have
departed from the contingent
capital facilities used so far but
CRCs do not generate new
cash for a bank and are thus
unlikely to stop a liquidity
crisis; sees difficulties with
pricing: persuading existing
investors to take a more
subordinated position and
write a put option will neither
be cheap nor easy.

Squam Lake Working Group

(2009):
regulatory
hybrid
securities would help avoid ad
hoc measures such as those
taken in the latest crisis to the
benefit of the overall financial
system.

Albul, Jaffee, & Tchistyi

(2010): the paper provides a
formal model of contingent
convertible bonds (CCBs) for
all types of firms.
Coffee (2010): contingent
capital is an idea whose time
is coming. Its special virtue is
that it responds to the problem

so that some bonds

must convert fully before
others can begin to
convert; (3) select bonds
randomly
within
a
common-maturity
or
common
seniority
tranche; (4) select CCC
by lottery.
An amount equal to a
specified proportion of
risk-weighted
assets
(Core Tier 1 Capital to
RWAs).
Capital Buffers should
be large because cost
should not differ much
from cost of straight
debt. Shareholders must
face the potential for
automatic
and
substantial dilution (from
the whole amount of
CoCos outstanding).

Finding by regulators
that the Core Tier 1
capital ratio has fallen
below a certain level.
Trigger could be tied to
deterioration
in
the
condition of the specific
bank and/or to the entire
banking system. Should
be
tied
solely
to
regulatory measures of
capital, but might work
better when linked to
market
measures
because they tend to
lead
regulatory-based
measures.

Implicitly, all contingent capital will

be converted. To the common
shareholder, contingent capital
holds out the prospect of death by
dilution.
The conversion terms could be
generous to the holder of the
CoCos (so that debt holders could
expect to get out at or close to par
value).

Insists that CRCs are No recommendation of a One possibility is a fixed strike

not contingent financial specific
trigger; price defined at the time of
capital: whether issued mentions the possibility issuance. Alternatively, the strike
as debt or hybrids, of numerous kinds of price could be linked to one of the
CRCs are already a triggers but finds the additional triggers in the facility.
form of financial capital Squam Lakes (2009) The conversion rates could
at the time of their logic sound.
depend, for example, on the
original issuance and
market price of the CRC or the
more
accurately
banks stock price.
described as financial
capital that can be
contingently converted
into common stock. No
statement
to
a
recommended volume.
But if CRCs are held in
high concentrations by
insurance
companies
(too), significant crosssector correlation risks
could arise in the future.
Banks must be required Two
triggers
are A conversion based on market
to issue CoCos because necessary:
(1) values
can
create
market
they will otherwise issue Declaration
by manipulation (average stock prices
other debt securities regulators
that
the over a longer period does not
more likely. Regulators financial system is in solve this issue). Better approach
must
aggressively crisis mode; and (2) the is to convert each dollar of debt
encourage the use of bank is in violation of into a fixed quantity of equity
regulatory
hybrid bank covenants in CoCo shares.
securities.
When contract, such as the
conversion is triggered, ratio of Tier 1 capital to
probably all CoCos are RWAs.
converted (the report
does not state this
explicitly).
CCBs generally have the potential to provide most of the tax shield benefits of straight debt
while providing the same protection as equity capital against bankruptcy costs. But it is
important that the banks are required to substitute CCBs for straight debt, and not for
equity, in their capital structure. Furthermore, the regulatory benefits of CCBs for bank
safety also are greater the higher the trigger at which conversion occurs.
The report, published in the Columbia Law Review, lacks detailed recommendations but
states many, especially legally relevant, information. But Coffee did state two design
principles (relevant for SIFIs): (1) incremental conversion in a series of steps should be
preferred over a massive, one-time conversion, and (2) shareholder pressure from short-

71

of high risk-correlation among

major financial institutions
without relying on the ability of
regulators to always make
wise and farsighted decisions
in politically heated crises.
Although the use of contingent
capital may be costly, this cost
is another way to tax the
externality that arises when
creditors come to believe that
some financial institutions are
TBTF. Contingent capital can
be designed to give provide
two reforms in one package: a
safer,
less
default-prone
capital
structure
and
counterweight to shareholder
pressure.
Collender, Pafenberg, &
Seiler (2010): by creating the
potential for shareholders to
bear
significant
losses,
contingent
capital
notes
(CCNs)
would
increase
shareholder
incentives
to
monitor and limit the firms risk
taking.CCNs
would
more
reliably than capital insurance
mitigate the negative spillovers
associated
with
financial
distress. The authors prefer
CCNs over capital insurance
for three reasons: (1) market
for catastrophic risk capital
appears
constrained
and
pricey; (2) cat bond market too
small and capital insurance is
less attractive to investors; (3)
the incentive for shareholders
to limit risk taking. The authors
note,
that
the
specific
mechanisms
need further
investigation.
D'Souza, Gravelle, Engert, &
Orsi (2010): several issues
concerning contingent capital
require
further
analysis,
including the precise form of
any prudential rules to bring
these mechanisms into effect;
the amount of such contingent
instruments to require; and the
determination of the period
over which such requirements
would become binding. Other
issues
are
how
such
instruments would relate to
other
regulatory
tools,
incentive effects on market
participants, including when
conversion seems likely; and
the implications for investors
holding instruments that are
not subject to conversion.
Glasserman & Nouri (2010):
Glasserman & Nouri present a
contingent capital valuation
model where the firms
securities are modelled as
geometric Brownian motion to
identify the fair yield spread on
the convertible debt. A key
step in the analysis, as the
authors put it, is an explicit
expression for the fraction of
equity held by the original
shareholders and the fraction

term profit and higher leverage is best countered by giving the debt holders a limited right
to vote in times of financial distress.

The authors consider

restrictions
on
the
volume an issue which
should
be
further
analysed, before CCNs
are allowed to be
counted as accepted
regulatory
capital;
therefore, no specific
proposal on the volume
was made.

Only
references
to
Flannery (2005, 2009),
Squam Lake Working
Group (2009), and Wall
(2010).

Again, references to Flannery

(2005, 2009) and Squam Lake
Working Group (2009). The
authors offer no own research.

As the conclusion from DSouza, Gravelle, Engert, & Orsi indicates, no specific
recommendations on the design features are offered. Although, worth mentioning is the
analysis of the differences between contingent capital and bail-in mechanisms.

Model allows partial

conversion to convert
just enough debt to
equity to maintain the
required
ration
until
contingent capital is fully
exhausted.

Capital
ratio
trigger
based on accounting or
book values

Potential liquidation costs for

shareholders and also for bond
holders are implemented.

72

held by converted investors in

the contingent capital.
(Kamada, 2010): contingent
capital
(CC)
has
great
advantages for enhancing the
soundness of banks and
increasing the stability of
financial systems. In order to
enable many banks to enjoy
the advantages of CC and
thereby improve the stability of
financial systems in a large
number of countries, it is not
desirable for regulators to put
excessive restrictions on the
design of CC (but not any CC
design should be accepted).
Kamadas objective is to clarify
the characteristics of CC,
using a model that is the
simplest possible.
(Maes & Schoutens, 2010):
the paper raises concerns
about the pricing of the
contingent capital instruments
by highlighting the similarities
between CoCo-bonds and
equity barrier options and
CDS. The barrier-like features
and the fact that CoCo-bonds
are fat-tail event claims, in
combination with calibration
and model risks imply that
these securities are very hard
to value under a particular
model. Since CoCo-bonds are
expected not to be highly
liquid instruments, the extreme
complexity
of
mark
to
modelling CoCo-bonds will be
a big disadvantage that may
hamper their success.

(McDonald, 2010): compared

to other proposals, contingent
capital has both benefits and
costs. The primary benefits
are the complete reliance on
market prices as opposed to
accounting
numbers
or
regulatory dicta, and the fact
that the claim could permit
bankruptcy
for
a
bank
performing badly in good
times. A Fixed share premium
conversion scheme is likely to
be the most immune to
manipulation,
that
price
pressure from delta-hedging
should not be a serious
concern, and that the dualtrigger claim is likely to err on
the side of giving firms too
much capital rather than too
little, except when other banks
are
doing
well.
The
disadvantages of the dualtrigger claim relate primarily to
the fact that there is an index
trigger. If the index trigger
condition were not met, the
stock
price
could
fall
signicantly below the stock
price trigger, leading to a
situation where it might be
protable to manipulate the

Kamada analyses different designs of contingent capital with always the same features: a
failure trigger, a conversion trigger, a conversion price, and the priority of the bonds.

The authors only state

that
if
sufficient
insurance is given to a
sufficient amount of
banks, it may avert the
banking distress and the
resulting general loss of
portfolio value we have
observed in the latest
crisis.
No
specific
recommendations on the
volume to be issued on
a firm wide basis are
made.

No statements regarding
to the volume are made.

Triggers could be bankspecific, such as a CDS

spread, the CT1 ratio
falling below x% or
some
other
related
indicator. The frequency
that the trigger ratio is
monitored is important
but since these ratios
are not always publicly
disclosed and often
there
is
room
for
discussion.
The
appropriate
level
of
conversion is difficult to
determine before a crisis
effectively hits. It may
take some time for the
contingent
capital
market to develop norms
for trigger levels, and
also
it
may
be
complicated to compare
these across banks.
McDonald presents a
dual
market-based
triggers example where
two conditions have to
be met: the stock price
of a bank, adjusted for
splits and dividends,
falls below a certain
share price level and
additionally the value of
a financial index has
also to breach a certain
level then the trigger
condition is met.

No recommendations to a distinct
conversion mode are made.

Possible ways to reduce price

manipulation have an impact on
the conversion terms: (1) use a
fixed share conversion; (2) have
the shares convert at a premium
(the value of the newly converted
shares is worth less than the par
value of the bond); (3) have the
index conversion condition be
based on an average price over
time; and (4) retire bonds
gradually
and
randomly
as
maturity approaches in order to
avoid the very large gains from
manipulation that can occur at
maturity.

73

index (assuming this is even

possible) or to try to force
bankruptcy.
Pennacchi, Vermaelen, &
Wolff (2010): compared to
other forms of contingent
capital proposed in the
literature,
the
authors
suggested
Call
Option
Enhanced
Reverse
Convertibles
(COERCs)
should be less risky in a world
where bank assets can
esperience sudden jumps.
Furthermore the presented
form of contingent capital
eliminates concerns about
putting the firm in a death
spiral
as
a
result
of
minipulation and/or panic.
Finally, a bank that issues
COERCs has a smaller
incentive
to
choose
investments that are subject to
large losses. The COERCS
proviedes an alternative form
of coercion that is not
demaded by supervisors, but
by the fear of dilution. Please
note, that the authors present
some
caveats
to
their
assumptions (p. 13 f.).
Sundaresan & Wang (2010):
For a security, therefore also
for contingent capital (CC)
structures, to be robust to
price manipulatin, it must have
a unique equilibrium. CC with
floating coupon rate is shown
to have a unique equilibrium if
the coupon rate is set to be
qeual to the risk free rate. This
structure of CC anchors its
value to par all the time befor
conversion,
making
it
implementable in practice.
Although a CC with unique
equilibrium is robust to price
manipulation, the no value
transfer
condition
may
preclude it from generating the
desired incentives for bank
managers or demand from
investors.
De
Martino,
Libertucci,
Marangoni, & Quagliariello
(2010):
countercyclical
contingent
capital
(CCC),
based on a double trigger
which interact and determine a
quasi-default
status
is
presented.
The
authors
conclude that the calibation of
the triggers is a challenging
task. Regulators have to deal
with the trade-off of the
potential benefit of this tool
and the risk that a complex
design leaves room for
excessive financial innovation
and arbitrage opportunities.
Furstenberg
(2011):
Furstenberg
models
a
stochastic process by which
an initially very well capitalized
bank come to violate its
minimum capital requirement.

No specific proposition
on the volume is made.
A numerical example
indicates
that
the
authors are calculating
with contingent capital of
3 per cent of deposits.

Trigger should be based

on
market
values.
Pennacchi, Vermaelen,
& Wolff do not suggest
forcing banks to issue
COERCs, but regulators
should
facilitate
the
issuance by considering
COERCs as very close
to Tier 1 capital. Any
realistic pricing model of
contingent capital should
allow price jumps (of the
firms shares).

Considering, that shareholders are

buying back their shares (to
escape dilution), COERC bonds
end up being paid their par value.

The authors suggest

that it may be worthwhile
to include a optional
sinking fund feature in
the design of CC so that
there is a periodic and
orderly retirement of
principal
(balloon)
payment, which should
further serve to mitigate
the
incentive
for
speculative short sale
attack. The sinking fund
structure reduces the
volume of conversion
that must occur once the
equity
trigger
is
breached by the stock
price
leaving
a
speculative attack more
vulnerable.

Sundaresan & Wang are

using
stock
price
triggers for their CC
model. (They perform an
analysis in continuoustime models.)

To avoid multiple/no equilibriums,

the conversion ratio has to be set
so that there is never a value
transfer between equity holders
and CC investors. The authors
state that for any given Trigger,
there exists a unique equilibrium
that satisfies the conversion ratio
mt = Ct/Kt, where C represents the
value of un-converted CC and K
the trigger level. CC designed with
a floating coupon rate and a
conversion of mt as stated above,
will always sell at par. This CC
design leads to a unique
equilibrium.

The study analyses how different double triggers would have worked in the past. The
choice of the appropriate threshold depends on the characteristics and role of the buffer
that contingent capital is supposed to cover (country-specific thresholds may be
preferable). Regarding the conversion mechanism, the authors support an approach based
on a variable number of shares, which penalizes shareholders more.

Cross
ownership
of
CoCos needs to be
restricted to prevent
cross-gearing within the
banking
sector.
All
CoCos
outstanding

Market-value accounting
is
as
exposed
to
accounting gimmicks as
regulatory accounting. In
reality that policing is
done, if at all, for

Conversion condition depends on

the model set up, where von
Furstenberg runs different setups.

74

A CoCo-bond conversion then

provides a second chance
because the firms initial
capitalization
is
restored.
Although regulatory insolvency
remains a distant threat, the
expected reductions in the
cost of bankruptcy and hence
the cost of capital are such
that CoCo-bonds may win a
place in the liability structure of
financial institutions without
the need for mandates.
Barucci and Del Viva (2011):
Countercyclical
contingent
capital (CCC) is analysed in
the context of optimal capital
structure. Therefore, CCC
reduces the spread of straight
debt but that comes with
significant additional costs.
Furthermore, the effect on
bankruptcy cost is limited (it is
strong when contingent capital
is not countercyclical) because
CCC reduces the asset
substitution incentive. CCC is
useful for macro prudential
regulation
where
the
countercyclical
feature
is
important
depending
on
priorities (moderate the asset
substitution
incentive
or
reduce bankruptcy costs).
Calomiris & Herring (2011):
CoCos can create strong
incentives for the prompt
recapitalization of banks. That
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 required to hold, and
the changes in that amount
over time. Therefore, a
(proper)
CoCo
structure,
alongside common equity,
would be more effective as a
prudential tool and less costly
than a pure common equity
requirement.
Berg & Kaserer (2011):
CoCo-bonds
might
have
perverse risk-taking incentives
for banks (asset substitution
problem) and discourage them
from investing in positive NPV
projects and issuing new
equity in times of crisis (debt
overhang problem). A new
type of contingent convertible
capital for bank is introduced
by the authors - which they
label
Convert-to-Surrender

should be converted at
one time or in several
steps [to meet capital
requirements;
von
Furstenberg refers to
Glasserman and Nouris
(2010) exemplary work].

Optionally
a
partial
allocation of equity to
CCC holders or a full
conversion.

regulatory
compliance
and bank supervision 93 ,
thereby
providing
a
high[er]
degree
of
measurement certainty.
The presented model
uses a trigger of 3% 94
leverage ratio (CT1/total
balance sheet assets
minus goodwill) and
lacks the detail required
to compute RWAs on
their evolution.
CCCs will be converted
only if the bank is
performing bad (reaches
the lower barrier of the
operational cash flow)
and
the
authority
recognizes the existence
of a global crisis.

CCC holders obtain a portion of

equity equal to their par value or
otherwise, if equity results to be
lower than the par value of CCCs,
they will take over completely the
company, i.e., they will receive the
full value of equity.

In combination with a 10
per cent requirement for
the ratio of the book
equity relative to book
assets, CoCos should
have
a
similar
magnitude
for
the
required ratio of CoCos
relative to book assets.
Calomiris & Herring find
it plausible to propose
that
the
minimum
required
amount
of
CoCos should be set at
roughly 2 per cent of the
quasi market value of
the firms assets

Equity values would

provide the best source
of information to design
a trigger.

To maximize the incentive effects

from the threat of dilution upon
conversion, all of the required
CoCos should be converted when
the ratio hits the trigger. To ensure
incentives for pre-emptive equity
offerings, the conversion ratio
should
be
set
such
that
stockholders
face
significant
dilution from conversion. The
onversion should
require a
sufficient number of shares per
face value of CoCos such that the
market value of shares received is
greater than the face amount of
the CoCos.

In the example, CoCobonds represent 5 per

cent of the total asset
value.

Conversion of the CoCobonds takes place, if the

asset value has fallen
below
a
certain
threshold. The trigger
may be observed on a
quarterly basis. In the
presented
valuation
model, equity value is a
function of the asset
volatility.

CoCo bond holders take over the

whole company and equity holders
are totally wiped out. This is
equivalent to saying that the
conversion price is USD 0 or that
the conversion rate is indefinitely
high, i.e. there are an infinite
number of shares granted per
USD
1
CoCo-bond-notional.
Therefore, Berg and Kaserer label
CoCo-bonds with this special
feature as Convert-to-Surrender
bonds (CoSu-bonds).

93

The IASB requires expected credit losses to be reassessed each period and then the effects of any changes in expectations
to be recognized in the income statement (von Furstenberg, 2011). The U.S. FASB is still based on an incurred-loss model, and
not an expected-loss model like IASB. For a systematic comparison see PricewaterhouseCoopers (2011).
94
Using the rule of thumb that RWAs amount to about half as much as total assets for financial institutions.

75

Bonds (CoSu-Bonds) - that

eliminates both the asset
substitution and the debt
overhang problem. CoSuBonds convert into equity once
the equity ratio falls below a
certain threshold and CoSuBond holders take over the
bank while equity holders are
totally
wiped
out.
This
structure makes equity holders
naturally risk averse and gives
incentives to equity holders to
raise new equity and to invest
also in slightly negative NPV
projects in times of financial
distress.
Bolton & Samama (2011):
the economic case for a
contingent
capital
(CC)
solution to foster greater
stability of the banking system
is compelling: CC is a superior
investment in banks for longterm investors than equity
invstments at the onset of a
recesseion, as it lets long-term
investors charge an insurance
premium for the provided
capital-line commitment, and
also
protects
long-term
investors against the risk of
investing in lemons. By
selling contingent capital, longterm investors can monetize
their
counter-cyclical
investments
strategies
in
banks, and, thus obtain an
adequate return as long term
investors. Regulators are able
to implement a more efficient
form
of
equity-capital
regulation. Banks have a
special need to maintain their
equity-capital base in the
event of a crisis. SWFs and
other long-term investors have
proved to be the only available
counterparties for banks in
crisis times. This is why Bolton
& Samama argue that these
investors must be able to
monetize the countercyclical
asset-management strategies
they are trying to implement by
obtaining a higher return on
their cash reserves. The
proposed CAB reflects a
balance between investors
preferences,
issuers
constraints, and regulators
objectives.
Hilscher & Raviv (2011): the
authors
show
that
an
appropriate CoCo design can
virtually
eliminate
stockholders incentives
to
risk-shift. This effect is robust
to times of crisis and for
regulators with different bank
closure policies. Introducing
CoCo-bonds into the capital
structure may thus be able to
cancel out adverse effects of
equity-based compensation.

One concern raised by

Furstenberg (2010) is
that a CAB with a single
strike price may be too
rigid an instrument to
deal
with
all
the
contingencies that could
arise in a crisis. Bolton &
Samama address this
point by suggesting that
banks
should
issue
multiple
CABs
with
multiple strike prices, in
effect offering a strike
price ladder through
which
issuers
can
convert as a crisis
deepens.
(But
the
authors did not introduce
a
volume-related
suggestion added to the
ladder model.)

In the valuation model

presented, Bolton &
Samama
present
a
equity trigger at 50 per
cent of the initial stock
price.

The authors are

using a
conversion ratio of the principal
value divided by the strike price.
Bolton & Samama compared the
costs of an equity issue with CABs
with full tax deductibility: with a
required ROE of 10 per cent, the
cost of a contingent capital issue is
35 per cent less than the cost of a
straight equity issue (for the used
parameters), and the reduction in
expected cost is even bigger with
a 20 per cent required rate of
return, since it amounts to 62 per
cent. They also discuss the
expected gains for long-term
investors in CABs. By the
presented estimates, an investor
gets a 54 per cent bigger coupon
compared to a regular bond for a
probability of incurring a loss at
any time until maturity that is less
than 3.2 per cent.

The authors do not sate

a proper ex-ante value
of CoCo-bonds to be
issued.

The presented model

applies an asset related
trigger.

For relatively low (stock-friendly)

conversion ratios, stockholders
have an incentive to increase
asset risk, while a high (CoCofriendly) conversion ratio leads to
a desire to reduce risk. Hilscher &
Raviv show that for intermediate
levels of the conversion ratio, bank
managements
incentives
to
change risk can be virtually
eliminated, encouraging banks to
make the best possible investment
decisions instead of trying to
transfer wealth from depositors to
equity holders by choosing high
risk levels. Therefore, a well-

76

designed CoCo-bond reduces the

ability of shareholders to gain by
transferring wealth from debt to
equity.
Koziol & Lawrenz (2011): the
study analyzes CoCo-bonds
within a dynamic continuoustime framework. The authors
results indicate that the
beneficial impact of CoCobonds crucially hinges on the
assumption if bank managers
have substantial discretion
over the banks business risk.
If the bank cannot change the
risk technology, or in other
words, if complete contracts
can be written, CoCos are
unambiguously
beneficial.
However,
results
change
dramatically when we allow for
incomplete contracts. Koziol &
Lawrenz show that CoCobonds always distort risk
taking incentives. Therefore,
equity holders have incentives
to take excessive risks. It is
demonstrated that, although
investors anticipate distorted
incentives and demand a
corresponding
higher
premium, CoCos can still be
value maximizing for equity
holders and therefore an
optimal financing choice. More
importantly, the study main
result shows that although
CoCos can be Pareto-optimal
from the perspective of the
individual firm, they have the
potential
to
substantially
increase the banks probability
of financial distress as well as
expected proportional distress
costs. Thus, CoCo-bonds may
be
an
example
where
individually rational decisions
can
have
systemically
undesirable outcomes.
Pennacchi (2011):
(Hart & Zingales, 2011): to
ensure that LFIs do not default
on either their deposits or their
derivative contracts, it is
required that they maintain a
cushion of equity and junior
long-term debt sufficiently
great that the credit default
swap price on the long-term
debt stays below a threshold
level. If the CDS price moves
above the threshold, the LFI
can issue new equity to bring it
back down. If the CDS price
still stays above the threshold
for a predetermined period of
time, the regulator intervenes.
Hart & Zingales show that this
mechanism ensures that LFIs
are always solvent, while
preserving some of the
benefits of debt.

Strictly speaking, the Hart & Zingales paper is no contingent capital study as the most of
the other here presented works but their thoughts are concerned with the same targets (to
foster a fortified financial system). Regarding to Hart & Zingales, the TBTF problem arises
from a combination of two problems: (1) the economic problem of the cost of defaulting in
systemic obligations is too large to bear and (2) the political economy problem which is a
time inconsistency problem that induces the government/regulator to sacrifice the longterm effect on incentives to avoid the short-term costs of a possible systemic collapse. The
presented mechanism to address these problems is similar to existing capital requirements
in that it creates two layers of protections for systemic obligations, represented by equity
capital and junior long-term debt. Hart & Zingales equity capital requirement relies on
CDS-prices as the trigger mechanism. Secondly, the government has to penalize longterm debt-holders if the company is too risky. The authors show that this mechanism
ensures that LFIs do not face any risk of bankruptcy, while preserving some of the
disciplinary effects of debt. By triggering an early intervention, their mechanism is able to
shift the government trade-off between restructuring and bailout in favour of the former.
Therefore, the government has a way to commit to tougher rules, overcoming its time
inconsistency. Beyond the TBTF problem, the Hart & Zingales approach addresses
possibly the fundamental agency problem generated by debt (i.e., the perverse incentives
managers and shareholders have to gamble for resurrection when a company
approaches default). Equity can be seen as an option on the value of the underlying
assets, with a strike price equal to the value of the face value of debt. Much of the agency
costs of debt arise from the fact that some actions (e.g. undertaking negative NPV
investments) can increase the value of this option, while decreasing the value of the
underlying assets. The Hart & Zingales CDS-based capital requirement eliminates the
divergence of interest between shareholders and creditors by forcing the equity-holders to
exercise this option when it starts to become valuable. As a result, no negative NPV
project will be undertaken, in spite of the risk-shifting possibility present. Finally, this
approach highlights the important role that CDSs can play in regulation.

77

Spiegeleer & Schoutens

(2011): the article provides an
in-dpth analysis of pricing and
structuring CoCo-bonds. The
pricing of Cocos is handled
using
two
different
approaches.
The
first
approach starts from a credit
derivatives background. A
second approach tackles the
pricing and structuring of a
CoCo as an equity derivatives
problem.
The
developed
equations have their roots in a
Black-Scholes setting. As a
result, the authors came up
with easy to use closed form
pricing solutions. Spiegeleer &
Schoutens found that CoCos
carry a lot of fat-tail risk
typically a risk that the BlackScholes model can only
handle by using a higher
volatility for low strike options.
Therefore these instruments
demand a stock-price model
that deals with this particular
kind of risk.
Pazarbasioglu, Zhou, Lesl,
& Moore (2011): contingent
capital instruments should be
considered as part of a
comprehensive and consistent
crisis
prevention
and
management framework but
they are not a standalone tool
and should avoid adding more
procyclicality during crisis
times. Triggers on capital
ratios are preferable and high
enough to ensure conversion
will be well ahead of the
emergence of distress. But as
a tool for an orderly resolution,
conversion triggers may be set
at a ow level.

The paper is concerned with a derivatives pricing approach for contingent capital
structures no recommendations for an ideal set up were made.

78

Appendix 2: Selected Features of Outstanding Loss-Absorbing Securities

Lloyds

Rabobank

Unicredit

Intesa

Rabobank

Sanpaolo
Announcement

3 November

date

12 March 2010

14 July 2010

23 September

2009

17 January 2011

2010

Coupon

9.125%

6.875%

9.375%

9.50%

8.375%

Maturity

15 July 2020

19 March 2020

Perpetual

Perpetual

Perpetual

NA

NA

21 July 2020

1 June 2016

26 July 2016

First call date

and if issued
replacement
securities3
Equity conversion

Conversion

Write-down

Write-down

Write-down

Write-down

GBP 147.6mn2

EUR 1.25bn

EUR 500mn

EUR 1bn

EUR 2bn

or write down
Issue amount
Priority

Lower Tier 2

Senior

Tier 1

Tier 1

Tier1

Write-back

NA

No

Yes

Yes

No

Coupon reset

NA

NA

3m Euribor +

5 yr EUR CMS +

5 yr UST +

749bp on July

757bp on June

642.5bp on June

21,2020

1, 2016

1, 2016

Regulatory capital

Yes

No

Yes at any time

call

Yes, on or after

Yes, prior to

January 1, 2013

First Call Date. If

Base 3 Event or
Capital Event
occurs, terms
can be varied

Regulatory capital
call price

Par + accrued

NA

interest

Par + accrued

102% of original

Par + accrued

interest

principal +

interest

accrued interest
Trigger

Extent

of

write-

Core Tier 1

Equity

Total capital

Total capital

Equity

capital/RWA

capital/RWA

ratio <6%

ratio <6%

capital/RWA

<5%

<7%

NA

down

<8%

75% principal

To the extent

To bring the total

To the extent

write-down with

necessary to

capital ratio

necessary so

25% cash

enable issuer to

above the

that Loss

recovery

continue to carry

minimum

Absorption

on its activities

requirements

in accordance

Event is no
longer occurring

with applicable
regulatory
requirements
Price

of

GBP 0.592093

NA

NA

NA

NA

conversion
Notes: 1) The first European Tier 2 deal where bondholders could lose all principal via permanent write-down rather than the notes converting into equity could
price on February 15, 2012 after UBS opened books for the contingent capital issue. The Swiss bank approached investors with price guidance of 7.5 per cent
area for the 10yr non-call five low-trigger CoCo via UBS (global coordinator), BNP Paribas, Commerzbank, Deutsche Bank and SG and had attracted well over
USD1.5bn of orders from investors (Reuters, 2012). (2) Example is based on one ECN security. In total Lloyds issued approximately GBP 8.5bn of LT2 and UT2
ECNs. (3) Unless the Capital Securities have previously been redeemed or purchased and cancelled, the Issuer has undertaken to exercise its option to redeem
the Capital Securities on the first Interest Payment Date falling on or after January 26, 2041 (i) which is a Relevant Interest Payment Date and (ii) prior to which
the Issuer has previously raised (or caused to be raised by a member of the Rabobank Group) the amount of net proceeds which the Issuer determines (at any
time prior to such date in its sole discretion but in consultation with the Dutch Central Bank, as necessary) is the minimum amount required by the Rabobank
Group to be raised through the issuance of Qualifying Securities to replace the Capital Securities.

79

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