Integrating Regulation, Supervision & Resolutiion for Systemically Important Financial Institutions
1
on
2011 Markets
14,
‐ Wharton ‐ Nomura Conference October Financial
Requirement Brookings
The Case for a Properly-
Structured Contingent Capital
2 a
needs a
be before
bank
a market
problem would
(CoCo)
equity equity 2B2F meltdown
of the governance
the recapitalization ‘08
equity,
Capital
to risk
amount access
to prompt
tool the
avoided time
solution for common
improved
Contingent risk about over
options
for have
Overview of
effective
prudential incentives
out
alongside could
changes
more run
incentives
uncertainty
a
forbearance
that strong
has place,
effective
in how bank If Create Enhance Provide Reduce & Address ‐ designed properly
– – – – – – more requirement, A 9 Background
INTERNATIONAL REFORM TO DATE HAS FOCUSED PRINCIPALLY ON THE NUMERATOR IN THE MINIMUM CAPITAL RATIO
3 Main emphasis has been on more and higher quality capital* & enhanced supervision
THIS HAS GENERALLY PLACED FAR GREATER EMPHASIS ON THE REQUIREMENT FOR EQUITY, WHICH HAD FALLEN FROM THE ORIGINAL 4% OF RWA UNDER BASEL 1 TO 2% OF RWA UNDER BASEL II
*The other innovation in Basel III is two new liquidity 4 requirements that we will not discuss in this presentation. Little Reason to Believe Closer Supervision will work Regulation and supervision is a continual contest between regulatees and less-well-paid & less-well informed regulators
New Yorker, March 9, 2009, p. 52. 5 Lack Confidence in Enhanced Supervision Because
SUPERVISORS CONTINUALLY SURPRISED DURING CRISIS. APPEAR NOT TO HAVE CONTEMPLATED CHANCE OF COLLAPSE
6
to BB ‐ to work
a
on ‐ 20%
re
2008 350% found from
charge
July
from
had
in
discourage
capital tranches
to the
engineers
example tried ‐ rated
raising resecuritizations AAA
Alive & Well good of by
financial the
on Committee ‐ Remic
weeks Re
and tranches
Basel
The particularly
– rated around The Within 40% securitizations 650% A 9 9 9 Moreover, the Regulatory Dialectic is ations: 1. Raised risk weight on ations:
they try BB from 350% to 650% and a AAA from 20% to 40% AAA from 350% to 650% and a BB
But can’t stop arbitrage even when punitive approach to resecuritiz Took Nor is it possible to have much confidence in current capital requirements
NEITHER CAPITAL (AS REDEFINED) NOR RISK WEIGHTS WILL OFFER SUFFICIENT PROTECTION
9
&
10 ING,
Dexia Lynch,
Rock,
risk
Senior these
Merrill
of Wachovia, –
Citi, Northern
AIG, mortgage
–Boards, Mutual,
UBS, Brothers, exposures
etc. Supervisors by
the anyone or subprime
Lehman to Washington
of: America,
Raised Questions sustained
of whether Mac,
Bank Losses Indy Failures – – Managements About institutions comprehended 9 Post-Mortems of Failing Institutions 11
a
going
a
for provide
adequately
to capital
decades & risk
low requirements 2
capacity
too
than failure
measure much
measure explained adequacy
not more
loss set
management not
did for
did bear risk
much safety capital
to
Supervisors Have adequately of on
was comprehensive
a
Never ‐ based • margin Ratio Denominator concern Numerator – – – Focused requirements Risk were 9 9 Disheartening Because Regulators & Regulators Disheartening Because 12 assets Total capital to total Total
in Capital Requirements Source: IMFGFR April, 2009, Chapter 3, p.7 Source: IMFGFR
Experience Has Not Engendered Confidence Experience Has Not Engendered
13
risk
saw
to risk
ante
only prudential ex framework
within not
appropriate
relative because
risk lower
rewarded crisis the external but
effective
that
& the failed equity
an to
apply
constrain losses,
Banks to
&
prior
lacked required
limits ‐ related supervision more
management evidence: &
measure boards crisis
willingness
risk & to
the volatility lower managers Indirect
Control Risk Relative to Capital • appropriate or tools CEOs
Key Problem: Failure to Assess or – regulations underestimated Internal 9 14
AIG,
lost
‐ 2008, financial assets –
UBS,
protect they
2007 risk etc.
to
as Citi,
of largest
2008 from
much Fannie,
as Brothers,
world’s &
capital August
inadequate
in the
equity of
replace
concentrations
equity Lehman
equity
– Freddie not their
lost
when Risk was Realized huge
to several insolvency
did Lynch,
they 2007 from Remaining they As
– – amassed Merrill relative institutions In
In Addition, Failed to Recapitalize Promptly 9 15
by
raise
2008,
own to
raised
and Capital
not problems
all
capital
chose September
of
reverse FIs to
shareholders
of
institutions.
open would many billion
2007
capital
dilution time
were $450
financial
August holdings Hoped Feared • • Nonetheless Recapitalize before Disaster sufficient
Wasted Critical Opportunity to – From global markets roughly 9 16 ‐
risk
of
offer that managed
excessive
be
risk
of
interest
of can’t penalize
of understatement
to
will)
conflicts (& properly, Agencies
Incentives encourage assessments underestimation from
firm Rating for on
in rules &
suffer knowledge
measured
Rely
taking benefits Both Banks Lack not
– Underlying Problem: Distorted Underlying Problem: – – Existing If risk. 9 9 17
&
lost
& buffer equity
(cont’d) measure
incentives? lost
replace to
equity plausible capital
to
mismanagement
change longer replace equity
forced and incentive
to
adequate to
be
how
greater
failure would
‐‐ increased maintain
&
that post supervision—no
risk answer
ex promptly,
understatement challenge: III
& believed ante risk If Basel enhanced equity manage
The Incentive Problem – – interrelated Ex Central of 9 9 18
can
losses
long since risk
loss is
of
distorted: actual
good
losses,
lag for
of equity more
to resurrection
measure equity
even for recognition tend
of
incentives
wrong
timely
gamble issues
become
the shareholders’ occur, understatement
to measures
avoid
on
but
to
dilutive losses
Unlikely to be Sufficient Unlikely to temptation management After avoid Ability Accounting encourages Increased Capital Requirements – – – Emphasis overdue, 9
19 if
ignore
assets
to
of so
crisis any
provides challenge do value
prefer to pressures
beyond
often values throughout
accounting
prefer 7% of
but
political
fair of proven losses
administrative
forbear
ca.1% be
may or
ratio and 1 cap
–to can
surprised, Tier
substantial recognize
a
losses judicial
market
to to
losses to
values possible when
supervisors
as until & sometimes subject Known to Lag? maintained doubt 11.8%
subject
book
long institution
Citi
was delay
of
concealing as
an
Ratio bankers
for – reasonable Example: Supervisors losses Supervisors Moreover, force Result: • • • • • Both Why Rely of Measures that are – scope Amalgam 9
20
of
to
transitions of
lead replacement
but
benefit)
literature because
would public timely
a
debt
for crunch not problem,
that
weak than credit (private
in lending
costs raise
finance
incentive debt
to economy
of
transitional
information bank agency from finding
a
in cost
Would not Solve Problem when costlier
provide
is only savings
raise
Asymmetric Tax Managerial consistent equity
• • •
A Equity – – contraction lost Could Wouldn’t Perhaps important 9 Moreover, Draconian Increases in Book Equity Moreover, Draconian Increases in Book 9 9 Conclusion: Significantly higher capital requirements are necessary
BUT ACCOMPLISHING THE OBJECTIVE PURELY WITH HIGHER EQUITY REQUIREMENT MAY HAVE HIGH COSTS & DOES NOT SOLVE THE PROBLEM OF INADEQUATE CAPITAL RELATIVE TO RISK
21 22
from
at
how CoCos
equity convert
about for
would
that
exchanged necessary—e.g.
consensus
designed
Quest for be bonds
little when
trigger? issue?
converted? of which instruments
should
equity
at
to
conversion? Price Amount Conversion Amount – – – Emphasis on Equity has Intensified – security Unfortunately, debt Financial 9 9 23
in timely
risk &
‐ in” dilutive
risk common – “signaling”
& of
default
– “bail highly ‐ emptive
of
pre
to cushion avoid issuance trigger conversion
signal
is to
to
objective” voluntary, CoCo prior
equity credible – “equity
a contingent
of
when
spread
management objective Incentivizing conversion objective Providing yield Providing issuance equity 9 9 Differences Based on Weight Given 9 24
4
relative
meet
trigger, “quasi
a trigger
‐ existingpre
CoCos of
must
value of
of (QMVER)
average
conversion market ratio dilutive
amount a
effective,
hit
on if ratio
equity moving
most a of
equity based CoCos
be
substantial
all a using
to value
The Case for CoCos conversion
common
shareholders Make Convert market defined Conversion to CoCos Require
4. 3. 2. 1. For criteria 9 25
roughly to trigger
be
when
nightmare should
favorable requirement
be
CEO’s shareholders
CoCos a
converted of capital be
should be 1
shareholders
issue ‐ converted
Tier
price would
CoCos
should existing
the
newly of
to
depends on size of CoCo issue depends required CoCos
Angry Furious – – The equal All hit Conversion holders Incentive to issue equity pre-emptively Conversion 9 9 9 9 26 Data produced by Flannery (2009) suggests that it is, provided debt holders can be assured conversion is unlikely.
Is this amount of debt reasonable? 27
the
for CoCo of
that
debt
so
trigger
valuation rated
way
feature
ideal its
hold in this offering
the
on
at only
of
can predictable
risk
insist
a in CoCo Trigger price
agencies comprehensive
attributes institutions can
&
Ratings Many • • holders Accurate Timely firm Implemented – – – Desirable conversion 9 28
&
forbear
to regulatory
decline
of
recognizing in
reinforce
regulators
discipline
and delays indicator
should
appropriate market problems
lagging
CoCos manipulation
a protracted
with
with
supervisors to to
Book values of equity not dealing Leads – Subject Employing Permits Inevitably discipline 9 9 9 9 29 – past signal
in in cycle
value noise manipulation failure
to of
business
reduce
market fluctuations to
of over
subject predictors average
transitory measure constant
good markets,
moving
not be
smooth
is
to Lehman to
appropriate? & 90 ‐ day volatile shallow
risk
need of candidates
proven comprehensive Enron highly prices Thus Suggest
spreads – –
What market values are But The Relatively Have e.g. Pricing • • • • • CDS Stock obvious – – 2 9 30
Separate Noise from Trend 90-day Moving Average Helps 31 debt (QMVER)
of
of Ratio
value
to
face ratio
of Equity
plus
relative of of
equity equity average
of of
Value
criteria value value moving meet
predictability Market Market Market • • 90 ‐ day Accuracy Timeliness Comprehensiveness And – – – – –
Proposed Market-based Trigger Quasi Would 9 9 Objective: To create the threat of heavy dilution
WILL FOCUS MANAGERIAL ATTENTION ON IMPROVED RISK MEASUREMENT & MANAGEMENT RECAPITALIZATION BEFORE CONVERSION IS TRIGGERED IF SUCCESSFUL
COCOS WILL RARELY BE TRIGGERED 32 CoCo Requirement Also Useful when Uncertain of Optimal Capital Ratio
OVER TIME, THE INDUSTRY HAS CHOSEN A NUMBER OF DIFFERENT RATIOS, BUT CLEARLY DECLINE WITH TAX INCREASES & INTRODUCTION OF VARIOUS COMPONENTS OF SAFETY NET
33 34
obscured by safety net
Optimal equity-to-asset ratio hopelessly 35
safety net
ratio suggests an optimum would exist without
But tendency of industries to cluster around some But
36
capital
for amount
risks as higher
the
right risk
bank time
to with
a the
incentives
risk over for
replacement relative
determining create
maintain
equity changes
increased
to
of
prompt to
CoCos) CoCos
+
difficulty
amount equity
amount respond
that have
encourage to
(equity
issue
‐ designed to only also
Banks to Choose the Appropriate Optimum capital Moreover Not change But roperly Designed CoCos Provide an Incentive for – – – appropriate of Regulators Properly P banks 9 9 How might CoCo Standard have worked in recent crisis?
The following data do not, of course, reflect the crucial incentive effect on managers who should be highly motivated to anticipate & avoid conversion
Assumption: Conversion at 4% QMVER 37 38
made it
Would have distinguished 4 that 39
From 10 that did not 40
More Generally?
How a QMVER Trigger Might Work
41
their the
restructure Measures
and to
otherwise
it to
drop CoCos
SIFIs
incompetent Action make
of would
will
not
some that
value replace will
holders to
Corrective enable to
SIFIs
to market
outflows
paid some pressure
time again
Prompt be
cash
average in
necessarily a cure all to
point
set point increase provide
recapitalize inevitably had
reduce
this trigger weighted management But May May and Conversion will Help, but it is not – – – have should Will At 9 9 42
must
worth,
then
net –which plan
plus… 20%,
ratio plan
transactions economic
sanctions 0
another rates
recapitalization
executives
by affiliate
‐ above unwind insolvency above
interest the
inter falls Undercapitalized” senior
of
on of implement
all
cap to
restated as QMVER deposit pay to
implement regulatory order
But PCA triggers should be significantly Subject An Restrict Restrict Restrictions market hit
– – – – – then be If If “Significantly 9 9
43 a shield
will
tax greater
before higher
the
resolutions late of
much
a
satisfy too
is problems to
requirement panicky
it advantage
banks fewer
CoCo
looming before
shareholders take be
to
still will and
‐ managed and weekends designed
there restructure well
to supervisors
that
buffers
so sleepless
management
alert
enable properly
a
over crisis Will capital incentive Will Give Some failures are inevitable – – – But 9