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Why and How to Design a Contingent Convertible Debt Requirement

58 Pages Posted: 21 Apr 2011  

Richard J. Herring

University of Pennsylvania - Finance Department

Charles W. Calomiris

Columbia University - Columbia Business School; National Bureau of Economic Research (NBER)

Date Written: April 19, 2011

Abstract

We develop a proposal for a contingent capital (CoCo) requirement. A proper CoCo requirement, alongside common equity, would be more effective as a prudential tool and less costly than a pure common equity requirement. CoCos can create strong incentives for the prompt recapitalization of banks after significant losses of equity but before the bank has run out of options to access the equity market. That dynamic 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 need to hold, and the changes in that amount over time. If a CoCo requirement had been in place in 2007, the disruptive failures of large financial institutions, and the systemic meltdown after September 2008, could have been avoided. To be maximally effective, (a) a large amount of CoCos (relative to common equity) should be required, (b) CoCo conversion should be based on a market value trigger, defined using a moving average of a "quasi market value of equity ratio" (QMVER), (c) all CoCos should convert if conversion is triggered, and (d) the conversion ratio should be dilutive of preexisting equity holders.

Suggested Citation

Herring, Richard J. and Calomiris, Charles W., Why and How to Design a Contingent Convertible Debt Requirement (April 19, 2011). Available at SSRN: https://ssrn.com/abstract=1815406 or http://dx.doi.org/10.2139/ssrn.1815406

Richard J. Herring (Contact Author)

University of Pennsylvania - Finance Department ( email )

The Wharton School
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Philadelphia, PA 19104
United States
215-898-5613 (Phone)
215-898-2067 (Fax)

Charles W. Calomiris

Columbia University - Columbia Business School ( email )

3022 Broadway
601 Uris, Dept. of Finance & Economics
New York, NY 10027
United States
212-854-8748 (Phone)
212-316-9219 (Fax)

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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