Richard J. Herring

The role of capital in financial institutions

Abstract This introductory article examines the role of capital in financial institutions — why it is important, how market-generated capital ‘requiremenents’ differ from regulatory requirments and the form that regulatory requirements should take. Along the way, we examine historical trends in bank capital, problems in measuring capital, and some possible unintended consequences of capital requirements. Within this framework, we evaluate how the contributions to this special issue advance the literature and suggest topics for future research.

Financial Regulation in the Global Economy.

In recent years, the major industrialized nations have developed co-operative procedures for supervising banks, harmonized their standards for bank capital requirements, and initiated co-operative understanding about securities-market supervision. This book assesses what further co-ordination and harmonization will be required in an era of increased globalization. This work is part of the Integrating National Economies series. As global markets for goods, services and financial assets have become increasingly integrated, national governments no longer have as much control over economic markets. With the completion of the Uruguay Round of the GATT talks, the world economy has entered a fresh phase requiring different rules and different levels of international cooperation. Policies once thought to be entirely domestic and appropriately determined by national political institutions, are now subject to international constraints. Cogent analysis of this deeper integration of the world economy, and guidelines for government policies, are urgent priorities. This series aims to meet these needs over a range of 21 books by some of the worlds leading economists, political scientists, foreign policy specialists and government officials. All the books in the series are offered at the same price: #22.50 for hardbacks and #8.50 for paperbacks.

Why and How to Design a Contingent Convertible Debt Requirement

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.

How to Design a Contingent Convertible Debt Requirement That Helps Solve Our Too-Big-to-Fail Problem*

As bank regulatory reform tries to come to grips with the lessons of the financial crisis, several experts have proposed that some form of contingent convertible debt (CoCo) requirement be added to the prudential regulatory toolkit. In this article, the authors show how properly designed CoCos can be used not just to absorb losses, but more importantly to encourage banks to recognize losses and replace lost equity in a timely way, as well as to manage risk more effectively. Their proposed CoCos requirement strengthens managements incentives to promptly replace lost capital and enhance risk management by imposing major costs on the managers and existing shareholders of banks that fail to do so. Key elements of the proposal are that conversion of the CoCos into equity would be (1) triggered at a high trigger ratio of equity to assets (long before the bank is near an insolvency point), (2) determined by a market trigger (using a 90‐day moving average market equity ratio) rather than by supervisory discretion, and (3) significantly dilutive to shareholders. The only clear way for bank managements to avoid such dilution would be to issue equity into the market. Under most circumstances — barring an extremely rapid plunge of a banks financial condition — management should be able and eager to replace lost capital in a timely way; as a result, dilutive conversions should almost never occur. Banks would face strong incentives to maintain high ratios of true economic capital relative to risky assets, and to manage their risks effectively. This implies that “too-big‐to-fail” financial institutions would not be permitted to approach the point of insolvency; they would face strong incentives to recapitalize long before that point. And if they should fail to issue new equity in a timely manner, the CoCos conversion would provide an alternative means of recapitalizing banks well before they reach the brink of insolvency. Thus, a CoCos requirement would go a long way to resolving the “too-big-to‐fail” problem. Such a CoCos requirement would not only increase the effectiveness of regulation, but also reduce its cost. It would be less costly for banks to raise CoCos than equity, reflecting both the lower adverse selection costs of CoCos issuance and the potential tax advantages of debt. And precisely because of the low probability of CoCo conversion, the Cocos would be issued at relatively modest (if any) discounts to otherwise comparable but straight subordinated debt. Thus requiring a mix of equity and appropriately designed CoCos would be less costly to banks, and would entail less of a reduction in the supply of loans than would a much higher book equity requirement alone.

The Structure of Cross-Sector Financial Supervision

In this paper the authors note that, over the last decade, in many countries the financial supervisory functions that were once performed by central banks have been combined with those performed by other official agencies and/or self-regulatory organizations to form a single financial services regulator. They consider three questions: (1) Why has this change occurred? (2) What role in supervision, if any, should the central bank continue to play? and (3) Do these organizational changes in financial supervision pose risks to financial stability?

Managing Foreign Exchange Risk

Since the early 1970s exchange volatility has increased markedly. This increased volatility is a major concern not only for government policy makers but also corporations engaged in international activities, because their profitability may be sharply altered by unanticipated exchange rate movements. This situation has posed a challenge to academic researchers, but over the past decade considerable progress has been made in our ability to understand the causes of exchange rate fluctuations and their impact on economic foreign exchange risk and to assess investment opportunities generated by exchange rate fluctuations. This book is a collection of essays by academic experts from the fields of economics, finance, and accounting, and by several distinguished practitioners from international corporations and financial institutions. Together the essays present a broad, up-to-date survey of what we know about foreign exchange risk and how to cope with it.

Sterilization policy: The trade-off between monetary autonomy and control over foreign exchange reserves

This paper investigates the trade-off between monetary autonomy and control over forel in exchange reserves within the context of a structural model of the monetary sector. This structural model integrates the analysis of international capital movements with the determination of the supply of money and the domestic interest rate. Particular emphasis is placed on captial flow offsets to monetary policy and sterilization behavior by the monetary authorities. An expression is derived which explicitly describes the trade of between the control of foreign exchange resetires and the control of bank reserves. Empirical estimaties for this trade-off are presented for Germany.

The Economics of Workout Lending

Lenders are forced to consider a workout loan when a borrower loses access to financial markets and must seek loans from existing creditors to continue servicing outstanding loans. A model of the loan decision is developed that distinguishes socially-useful from socially-wasteful workout loans. The analysis is extended to examine two collective-action problems that may arise when many lenders have claims on a troubled borrower. The paper concludes with a consideration of the implications of the model for the establishment of prudential lending limits and of policies to stimulate new lending to troubled debtor countries. Copyright 1989 by Ohio State University Press.

Disclosure policy and international banking

Abstract We develop general principles to guide the compulsory public disclosure of information about the financial condition of banks and apply these principles to three issues of particular relevance in international banking: (1) the disclosure of the country risk exposure of individual banks, (2) the rationale for hidden reserves, and (3) the disclosure of information regarding the availability to individual banks of emergency liquidity assistance. Our analysis shows why disclosure standards vary from country to country and why disclosure standards in the U.S. go well beyond the requirements elsewhere.

The Interbank Market

The Eurocurrency market is fundamentally an interbank market. Interbank liabilities constitute from two-thirds to three-quarters of the aggregate liabilities of Eurobanks.1 About one thousand banks from more than fifty countries are active in the market (Group of Thirty 1982a, p. 16).