Engineering Financial Stability

NEW HAVEN – The severity of the global financial crisis that we have seen over the last two years has to do with a fundamental source of instability in the banking system, one that we can and must design out of existence. To do that, we must advance the state of our financial technology.

In a serious financial crisis, banks find that the declining market value of many of their assets leaves them short of capital. They cannot raise much more capital during the crisis, so, in order to restore capital adequacy, they stop making new loans and call in their outstanding loans, thereby throwing the entire economy – if not the entire global economy – into a tailspin.

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This problem is rather technical in nature, as are its solutions. It is a sort of plumbing problem for the banking system, but we need to fix the plumbing by changing the structure of the banking system itself.

Many finance experts – including Alon Raviv, Mark Flannery, Anil Kashyap, Raghuram Rajan, Jeremy Stein, Ricardo Caballero, Pablo Kurlat, Dennis Snower, and the Squam Lake Working Group – have been making proposals along the lines of “contingent capital.”

The proposal by the Squam Lake Working Group – named for the scenic site in New Hampshire where a group of finance professors first met to devise ideas for responding to the current economic crisis – seems particularly appealing. To me, the group’s work has exemplified the creative application of financial theory to find solutions to the crisis. (I am a member, but I am not the source of its important contingent-capital idea.)

The group calls their version of contingent capital “regulatory hybrid securities.” The idea is simple: banks should be pressured to issue a new kind of debt that automatically converts into equity if the regulators determine that there is a systemic national financial crisis, and if the bank is simultaneously in violation of capital-adequacy covenants in the hybrid-security contract.

The regulatory hybrid securities would have all the advantages of debt in normal times. But in bad times, when it is important to keep banks lending, bank capital would automatically be increased by the debt-to-equity conversion. The regulatory hybrid securities are thus designed to deal with the very source of systemic instability that the current crisis highlighted.

The proposal also specifies a distinct role for the government in encouraging the issuance of regulatory hybrid securities, because banks would not issue them otherwise. Regulatory hybrid securities would raise the cost of capital to banks (because creditors would have to be compensated for the conversion feature), whereas the banks would rather rely on their “too big to fail” status and future government bailouts. Some kind of penalty or subsidy thus has to be applied to encourage banks to issue them.

The theory of “debt overhang” – the intellectual origin of the proposal – explains why troubled banks are reluctant to issue new equity: the benefits accrue mostly to the bank’s bondholders and dilute existing shareholders. But the proposal does not follow directly from modern finance theory. It is a real innovation, with no prior precedent.

Why wasn’t the idea of contingent capital seized upon in earlier crises? Wasn’t the same problem of debt overhang prominent in the banking crises of the Great Depression, for example?

I think that part of the reason must be that the problem was poorly understood then, so that contingent capital could not be well articulated and lacked the force of argument that would allow it to be impressed upon government policy makers. Moreover, there is a fundamentally creative element to innovation: it results from an intellectual process that takes time, and that in retrospect always seem inexplicably slow or episodic.

The Financial Stability Board (FSB), headed by Mario Draghi, publicly stated in its September 2009 report to the G-20 that it was studying contingent capital proposals. The FSB was created in April 2009 at the G-20’s London summit as the successor to the Financial Stability Forum. Its member organizations are the G-20’s central banks and top regulatory agencies. The G-20’s member states are committed by the G-20 statement that they signed to implement the FSB’s conclusions on a worldwide basis. As a result, the FSB is in a unique position to make innovation happen.

In its recent reports, the FSB has concentrated on capital requirements, on closing legal loopholes that allow banks to evade them, and on improving accounting standards. The FSB has already facilitated a number of proposals that would help make our financial system more secure.

Contingent capital, a device that grew from financial engineering, is a major new idea that might fix the problem of banking instability, thereby stabilizing the economy – just as devices invented by mechanical engineers help stabilize the paths of automobiles and airplanes. If a contingent-capital proposal is adopted, this could be the last major worldwide banking crisis – at least until some new source of instability emerges and sends financial technicians back to work to invent our way of it.