Stabilizing Large Financial Institutions with Contingent Capital Certificates

Abstract:     
The financial crisis has clearly indicated that government regulators are reluctant to permit a large financial institution to fail. In order to minimize the transfer of future losses to taxpayers or to solvent banks, we need a system for assuring that large institutions always maintain sufficient capital. For a variety of reasons, supervisors find it difficult to require institutions to sell new shares after they have suffered losses. This paper describes and evaluates a new security, which converts from debt to equityautomatically when the issuer's equity ratio falls too low. "Contingent capital certificates" can greatly reduce the probability that a large financial firm will suffer losses in excess of its common equity, and will provide market discipline by forcing shareholders to internalize more of their assets' poor outcomes.

Number of Pages in PDF File: 34

Keywords: contingent capital, market discipline, prudential supervision

JEL Classification: G21, G28

working papers series