Stabilizing Large Financial Institutions with Contingent Capital Certificates
34 Pages Posted: 10 Oct 2009
Date Written: October 6, 2009
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.
Keywords: contingent capital, market discipline, prudential supervision
JEL Classification: G21, G28
Suggested Citation: Suggested Citation