Posted Content•
Stabilizing large financial institutions with contingent capital certificates
01 Jan 2017-pp 277-300
TL;DR: Contingent capital certificates (CCC) as discussed by the authors can 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.
Abstract: The 2008–2009 financial crisis clearly indicated that government regulators are reluctant to let a large financial institution 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 continuously 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 proposed security that converts from debt to equity automatically when the issuer’s equity ratio falls too low. “Contingent capital certificates” (CCCs) 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. The proposed reliance on equity’s market value to trigger conversion creates some problems, which must be compared to the shortcomings of our current applicati...
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TL;DR: In this paper, the authors discuss the potential real effects of financial markets that stem from the informational role of market prices and show that accounting for the feedback effect from market prices to the real economy significantly changes our understanding of the price formation process, the informativeness of the prices, and speculators' trading behavior.
Abstract: A large amount of activity in the financial sector occurs in secondary financial markets, where securities are traded among investors without capital flowing to firms. The stock market is the archetypal example, which in most developed economies captures a lot of attention and resources. Is the stock market just a side show or does it affect real economic activity? In this article, we discuss the potential real effects of financial markets that stem from the informational role of market prices. We review the theoretical literature and show that accounting for the feedback effect from market prices to the real economy significantly changes our understanding of the price formation process, the informativeness of the price, and speculators' trading behavior. We make two main points. First, we argue that a new definition of price efficiency is needed to account for the extent to which prices reflect information useful for the efficiency of real decisions (rather than the extent to which they forecast future cash flows). Second, incorporating the feedback effect into models of financial markets can explain various market phenomena that otherwise seem puzzling. Finally, we review empirical evidence on the real effects of secondary financial markets.
406 citations
Posted Content•
01 Jul 2012
TL;DR: In this paper, the authors perform a set of empirical experiments to assess the relative performance of simple versus complex rules in a financial setting and find that simple metrics, such as the leverage ratio and market-based measures of capital, outperform more complex risk-weighted measures and multiple-indicator models in their capacity to predict bank failure.
Abstract: This paper explores why the type of complex financial regulation developed over recent decades may be a suboptimal response to the increasing complexity of the financial system. Examples from other disciplines illustrate how decision-making in a complex environment can benefit from simple rules of thumb or 'heuristics'. We perform a set of empirical experiments to assess the relative performance of simple versus complex rules in a financial setting. We find that simple metrics, such as the leverage ratio and market-based measures of capital, outperform more complex risk-weighted measures and multiple-indicator models in their capacity to predict bank failure. A consistent message from these experiments is that complexity of models or portfolios can generate robustness problems. We outline five policy lessons from these findings, covering both the design of financial regulation itself and possible measures aimed at reducing complexity of the financial system more directly.
273 citations
TL;DR: In this article, a new, implementable capital requirement for large financial institutions (LFIs) that are too big to fail is proposed, which mimics the operation of margin accounts.
Abstract: We design a new, implementable capital requirement for large financial institutions (LFIs) that are too big to fail. Our mechanism mimics the operation of margin accounts. To ensure that LFIs do not default on either their deposits or their derivative contracts, we require that they maintain an equity cushion sufficiently great that their own credit default swap price stays below a threshold level, and a cushion of long term bonds sufficiently large that, even if the equity is wiped out, the systemically relevant obligations are safe. If the CDS price goes above the threshold, the LFI regulator forces the LFI to issue equity until the CDS price moves back down. If this does not happen within a predetermined period of time, the regulator intervenes. We show that this mechanism ensures that LFIs are always solvent, while preserving some of the disciplinary effects of debt.
247 citations
TL;DR: The authors explored the origins of excessive risk-taking in the banking industry and provided the analytical ammunition required to rigorously examine regulatory policy at a time when it is undergoing a complete metamorphosis.
Abstract: The current crisis and its high social cost have shattered the confidence of economic agents in the banking system and questioned the capacity of financial markets to channel resources to their best use. While it is essential for the well functioning of economic activity that financial institutions do take risk, the decisions taken by financial intermediaries have proven ex post to be excessively risky. So, what was wrong with financial regulation? How were overoptimistic expectations, short termism and inaccurate risk models implicitly encouraged? This book is devoted to exploring the general issue of the origins of excessive risk-taking in the banking industry. In doing so, it will provide the analytical ammunition required to rigorously examine regulatory policy at a time when it is undergoing a complete metamorphosis.
237 citations
Cites background from "Stabilizing large financial institu..."
...23 See Flannery (2009) and Albul, Jaffee, and Tchistyi (2010), who argue respectively that CoCo bonds would reduce the incidence and the costs of financial distress in banking firms. Sundaresan and Wang (2001) discuss the difficulty of pricing contingent convertible bonds....
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...Flannery, Kwan, and Nimalendran (2004) show that the trading properties of banks and the accuracy of analysts’ earnings forecasts for banks are similar to those of nonfinancial firms. Nevertheless, Flannery, Kwan, and Nimalendran (2010) show that this similarity broke down right at the beginning of the financial crisis in mid-2007....
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...Flannery, Kwan, and Nimalendran (2004) show that the trading properties of banks and the accuracy of analysts’ earnings forecasts for banks are similar to those of nonfinancial firms....
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...23 See Flannery (2009) and Albul, Jaffee, and Tchistyi (2010), who argue respectively that CoCo bonds would reduce the incidence and the costs of financial distress in banking firms....
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Posted Content•
TL;DR: In this paper, the authors argue that disclosure of stress tests may interfere with the operation of the interbank market and the risk sharing provided in this market, and while disclosure might improve price efficiency and hence market discipline, it might also induce sub-optimal behavior in banks.
Abstract: Stress tests have become an important component of the supervisory toolkit. However, the extent of disclosure of stress-test results remains controversial. We argue that while stress tests uncover unique information to outsiders – because banks operate in second-best environments with multiple imperfections – there are potential endogenous costs associated with such disclosure.First, disclosure might interfere with the operation of the interbank market and the risk sharing provided in this market. Second, while disclosure might improve price efficiency and hence market discipline, it might also induce sub-optimal behavior in banks. Third, disclosure might induce ex post market externalities that lead to excessive and inefficient reaction to public news. Fourth, disclosure might also reduce traders incentives to gather information, which reduces market discipline because it hampers the ability of supervisors to learn from market data for their regulatory actions.Overall, we believe that disclosure of stress-test results is beneficial because it promotes financial stability. However, in promoting financial stability, such disclosures may exacerbate bank-specific inefficiencies. We provide some guidance on how such inefficiencies could be minimized.
230 citations
Cites background from "Stabilizing large financial institu..."
...Other recent proposals say that banks should issue contingent capital (i.e., debt that converts to equity) with market-based conversion triggers (see Flannery (2009), McDonald (2013))....
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References
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TL;DR: In this article, the authors predict that corporate borrowing is inversely related to the proportion of market value accounted for by real options and rationalize other aspects of corporate borrowing behavior, such as the practice of matching maturities of assets and debt liabilities.
12,521 citations
TL;DR: In this paper, the authors consider three explanations for the volatility of asset prices during exchange trading hours than during non-trading hours: public information which is more likely to arrive during normal business hours, private information which affects prices when informed investors trade, and pricing errors that occur during trading.
1,740 citations
Book•
01 Jan 1967
TL;DR: In this paper, it was shown that structural changes which simply alter the magnitude of the response to policy do not alter the attainable utility level, hence such structural changes do not change effectiveness in the above sense.
Abstract: Economists concerned with aggregative policy spend a great deal of their time discussing the implications of various structural changes for the effectiveness of economic policy. In recent years, for example, monetary economists have debated at great length whether the rapid growth of nonbank financial intermediaries has lessened the effectiveness of conventional instruments of monetary control. Similarly, in discussions of the desirability of the addition or removal of specific financial regulations the consequences for the effectiveness of policy play an important role. One of the striking features of many of these discussions is the absence of any clear notion of what "effectiveness" is. At times it appears to be simply "bang per buck"-how large a change in some crucial variable (e.g., the long-term bond rate) results from a given change in a policy variable (e.g., open market operation). A natural question to ask is why a halving of effectiveness in this sense should not be met simply by doubling the dose of policy, with equivalent results. It seems reasonable to suppose that the consequences of a structural change for the effectiveness of policy should be related to how it affects the policy-maker's performance in meeting his objectives. Suppose, for example, that the policy-maker wants to maximize a utility function which depends on the values of "target" variables. If, after some structural change, the policy-maker finds he is able to score higher on his utility function, then presumably the structural change has improved the effectiveness of policy and vice versa. One of the implications of the "theory of policy" in a world of certainty [6] or "certainty equivalence" [1] [3] [4] [5] is that structural changes which simply alter the magnitude of the response to policy do not alter the attainable utility level.' Hence such structural changes do not alter effectiveness in the above sense. Another feature of the theory of policy in a world of certainty
1,065 citations
TL;DR: The reverse convertible debentures (RCD) as mentioned in this paper can automatically convert to common equity if a bank's market capital ratio falls below some stated value, which is a transparent mechanism for unlevering a firm if the need arises.
Abstract: The deadweight costs of financial distress limit many firms' incentive to include a lot of (tax-advantaged) debt in their capital structures. It is therefore puzzling that firms do not make advance arrangements to re-capitalize themselves if large losses occur. Financial distress may be particularly important for large banking firms, which national supervisors are reluctant to let fail. The supervisors' inclination to support large financial firms when they become troubled mitigates the ex ante incentives of market investors to discipline these firms. This paper proposes a new financial instrument that forestalls financial distress without distorting bank shareholders' risk-taking incentives. "Reverse convertible debentures" (RCD) would automatically convert to common equity if a bank's market capital ratio falls below some stated value. RCD provide a transparent mechanism for un-levering a firm if the need arises. Unlike conventional convertible bonds, RCD convert at the stock's current market price, which forces shareholders to bear the full cost of their risk-taking decisions. Surprisingly, RCD investors are exposed to very limited credit risk under plausible conditions.
326 citations
TL;DR: In this article, a new, implementable capital requirement for large financial institutions (LFIs) that are too big to fail is proposed, which mimics the operation of margin accounts.
Abstract: We design a new, implementable capital requirement for large financial institutions (LFIs) that are too big to fail. Our mechanism mimics the operation of margin accounts. To ensure that LFIs do not default on either their deposits or their derivative contracts, we require that they maintain an equity cushion sufficiently great that their own credit default swap price stays below a threshold level, and a cushion of long term bonds sufficiently large that, even if the equity is wiped out, the systemically relevant obligations are safe. If the CDS price goes above the threshold, the LFI regulator forces the LFI to issue equity until the CDS price moves back down. If this does not happen within a predetermined period of time, the regulator intervenes. We show that this mechanism ensures that LFIs are always solvent, while preserving some of the disciplinary effects of debt.
247 citations