What’s the Contingency?A Proposal for Bank Contingent

Capital Triggered By Systemic RiskLinda Allen

Yi TangJune 2016

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Contingent Capital (Coco) Securities: The New Hybrid• Regulators are “warming” to coco

• Basel III (Directive 2013/36/EU or “CRD4”): Coco can qualify as Tier 1 if it cannot hinder bank recapitalization.

• Additional Loss-Absorbing Capital provisions: Financial Stability Board (Nov. 2015): As of Jan. 1, 2019 (2022), coco and other bail-ins should be 16% (18%) of risk-weighted assets.

• €150 billion expected to be issued over next 3 years• Automatic capital enhancement proposals• Fire sales of assets contagiously spread as banks delever• Widespread delevering (exacerbated by regulatory capital

requirements) results in a systemic bank crisis, whereas isolated bank delevering equitably redistributes value• Contingent capital (coco) automatically converts debt to equity,

reducing the fire sale pressure on asset prices.• However, protects management and prevents equitable

redistribution from systemic risk, thereby creating moral hazard• Coco should be triggered by systemic crisis only.

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Coco in the Bank’s Capital StructureDEBT COCO EQUITY

Stockholders can put bank Stockholders lose put option Residual assets to bondholders & dilution upon conversion claimants upon insolvency If insolvency trigger, requires

higher yield for loss of priority.Dominated by debt + equity. But: if systemic risk trigger, thenlong coco investors can tradeeach bank’s contribution to systemicrisk.

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Overview of Paper• Are banks over-leveraged?• No, during “normal” periods, but Yes during crises.

• Many systemically important banks approaching insolvency.• Hanson, Kashyap & Stein (2011): “It would be more efficient to … deliver more equity

only in those bad states where it is most valuable.”• During crises, banks try to avoid insolvency by deleveraging, setting off a fire sale

of assets that generates contagious declines in financial markets and a liquidity crisis.• Regulatory bail-outs that protect poor managers and incentivize risk taking would be

replaced by coco.

• Contingent capital: debt instrument automatically converts to equity during systemic crises • Not designed to prevent isolated bank insolvencies (Hilscher & Raviv 2014), but to

decrease systemic risk taking.

• Open Question: how can we design a trigger to convert coco during systemic crises?

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Coco Trigger Proposals• Trigger Based on Condition of Individual Bank

• $70 billion of bank coco issues from 2009-2013 triggered by regulatory capital ratios (e.g., Lloyd’s, Credit Suisse, Rabobank).• TLAC requirements are expected to generate an additional $500 billion coco issues

• Bank stock price or market value of capital (Flannery (2002)), but may generate multiple equilibria(Sundaresan and Wang (2010)) or “death spirals” (Duffie (2009)).

• CDS spreads (Hart & Zingales (2010)), Moving aver. of equity value (Calomiris & Herring (2011)), Market value equity ratio (Pennacchi (2010)), tangible common equity/tangible assets (Duffie 2009)).

• May still generate fire sales of assets as conversion is avoided.

• Dual Trigger Based on Overall Market & Bank Conditions • Regulatory crisis designation (Squam Lake Proposal (2009))• Banking index & bank stock price (McDonald (2013)), total banking sector losses &

bank capital ratio (Rajan (2009)), beliefs about future economic conditions (Davis, Korenok and Prescott (2011), Davis & Prescott (2015)): Discretion inserts uncertainty

• But, lagging indicators that may not forecast systemic crisis. • Does not prioritize coco conversion for most systemically important FIs.

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Proposed Systemic Coco Dual Trigger

• Predictive measure of aggregate systemic risk• CATFIN Allen, Bali, Tang (RFS, 2012)• Forecasts macroeconomic downturns 6-8 months in advance for US, Europe

and Asia• Early warning threshold associated with recessions

• Each individual bank’s contribution to systemic risk• Delta CoVaR Adrian & Brunnermeier (2011)• Difference between the VaR of the financial system conditional on the

distress of bank i minus the VaR of the banking system conditional on bank i’s median financial condition.

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Evaluating Coco as a Callable Put• Straight debt put option that is called (converted into equity – call option

on equity) upon coco conversion• Equity holders have a put option so they can “sell” bank assets to

bondholders if insolvent (A<D)• Coco is a call requiring bondholders to “buy” stock if triggered

• Allen & Saunders (1993) show (perpetual American) callable put option value is:

< put option value (equity loss)Where and is the Asset/Debt ratio triggering conversion

• Coco trigger for bank i at time t: CATFINt *cCoVaRit if CATFINt ≥ if CATFINt <

Where is the early warning threshold forecasting recession.If recession is not forecast, then the put option is not called and coco has the straight, risky debt put option value.

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Calibrating the Coco Trigger (1)• CATFIN*cCoVaR is highly correlated with system-wide default risk

PD measured as: market value-weighted average of Kamakura PD (Chava & Jarrow (2004))

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Calibrating the Coco Trigger (2)• Using the 99th percentile of fitted PD values:

• So: coco conversion takes place for any bank with CATFINt*cCoVarit ≥643.50 for months in which CATFIN exceeds the early warning threshold

• Use a 12-month exponential moving average to smooth• Can use other thresholds (97th, 95th percentiles) to perform

comparative statics. • Regulators can adjust to optimize over social welfare objective function.

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Bank versus Shadow Bank Early Warning Thresholds

• Different types of FIs are exposed to different systemic crises: (2000-2001 broker-dealers; 2007-2009 banks)• Estimate the early warning threshold for CATFIN for each subsector

separately• Banks (SIC code 6000-6099, 6600-6699 or 6712): 32%• Insurance Cos.(SIC code 6300-6399, 6400-6499): 34%• Broker-Dealers (all other in SIC 6000 category): 42%• Banks have most systemic impact on macroeconomic conditions, but

non-banks also have systemic risk.

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Which FIs’ Coco Would Have Triggered in 2007-2009? • Lehman and Bear Stearns both trigger in Nov. 2007; Morgan Stanley

triggers in Feb. 2008• SIFI banks do not trigger until Nov. 2008• Small and regional banks trigger in first half of 2008 (Wilmington

Trust Mar. 2008; Keycorp Apr. 2008; Regions May 2008): so systemic risk ≠ TBTF• Coco triggering FIs are not identical to TARP recipients. At 19% coco

mandate, automatic capital infusion of $121 billion in 2008 and $190 billion in 2009• AIG never triggers

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Comparing the Systemic Trigger to Other Proposals• McDonald (2013) proposes a dual trigger based on individual bank

stock price and banking index• Solving for McDonald’s yield premium α using the trigger month

under the systemic trigger proposal:• All firms assumed to issue coco in December 2006.• τ is set equal to the number of months between 12/06 and the systemic trigger

months. For non-triggered firms, this is the maximum 36 months (until 12/2009).• Yield premiums for triggered firms exceed the yield premiums for non-triggered

firms consistent with McDonald (2013).

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Coco Trigger Proposals Tied to Bank Insolvency• Flannery (2010) and others have proposed coco as a stabilization

mechanism for large banks in danger of insolvency.• Although coco triggered by individual bank insolvency is not designed to

address systemic risk, we examine the leverage of triggering FIs to see if they are closer to insolvency than their non-triggering peers.• Table 6, Panel B shows that the systemic coco trigger is consistent with

insolvency protection since triggering banks have larger leverage than non-triggering banks.• Statistically significant for banks and insurance companies.

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Table 6, Panel B: Comparison of Systemic Coco Trigger to Individual Bank Insolvency Triggers

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Social Costs of Systemic Crisis Prevention• 99th percentile trigger cut-off: 1,452 conversions during 1990-2012,

97.66% around NBER recessions.• 97th percentile trigger cut-off: 8,143 conversions during 1990-2012,

82.59% around NBER recessions.• 95th percentile trigger cut-off: 10,997 conversions during 1990-2012,

78.69% around NBER recessions.• Type I error: False positive: excessive conversions when recession

does not occur. Social cost of destruction of shareholder value and redistribution of value from equity to debt holders, increasing equity ratios, and increasing idiosyncratic risk taking incentives.

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Conclusions• Time consistent, real-time conversion trigger can be estimated monthly

using publicly available data.• Coco automatically infuses capital into the financial system when

macroeconomic declines are imminent.• Automatic deleveraging of the financial sector to mitigate systemic crises.

• Banks with the greatest contribution to systemic risk are most likely to trigger coco conversion, penalizing systemic risk-taking equity holders.• Coco trigger is resistant to manipulation.• Regulators can adjust systemic risk penalties by changing cut-offs

and/or mandated amount of coco issuance.