May 27, 2011 – Bank failures around the world during the recent financial crisis put taxpayers on the hook for trillions of dollars in government backstopping. In future, requiring banks to issue contingent capital, which would convert from debt to equity when banks run into trouble, is one way to help avoid that happening again, and limit taxpayer costs if it does, according to an e-brief released today by the C.D. Howe Institute. In “Strengthening Bank Regulation: OSFI’s Contingent Capital Plan,” John F. Chant, Emeritus Professor of Economics, Simon Fraser University, makes the case for contingent capital, critiques the current federal proposal, and makes recommendations for design that would help stave off disaster for banks, not hasten their demise.
Governments of industrialized countries committed over $14 trillion in public funds – almost one-quarter of global GDP – to support financial institutions during the financial crisis, notes Professor Chant. Consequently, governments have proposed a number of initiatives, including increases in the level of capital banks must hold, to reduce the risk that the public will need to rescue banks again. One plan would see banks issuing contingent capital, debt instruments that convert to equity when a bank runs into financial difficulties. The author argues:
- Contingent capital would replenish shortfalls in the institution’s core capital when it is most needed, so that investors do the bailing out, not the taxpayer. Investors’ risk exposures would drive them to monitor bank risk-taking more closely.
- Canada’s Superintendent of Financial Institutions has released a draft contingent capital proposal for implementation. While a welcome initiative, technical improvements are needed. The trigger for conversion, for example, should occur in stages, before banks get deep into financial difficulty.
- In addition, the terms of conversion – the amount of equity that investors get in return for the debt they hold – should expose the holders to market pressures. Debt holders would be required to convert the debt into equity at a conversion ratio that was set when the debt was issued.
In the recent crisis, notes Chant, governments had little choice but to bail out banks in face of uncertainties about the consequences of large, interconnected institutions failing. This experience makes it clear that the time to repair a financial system is not in the midst of a crisis, and that the groundwork for avoiding crises and mitigating them must be laid in advance, he concludes.
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For more information contact:
John F. Chant, Emeritus Professor of Economics,
Simon Fraser University;
Philippe Bergevin, Policy Analyst,
C.D. Howe Institute,
416-865-1904