Market-based bank capital regulation

Market-based bank capital regulation

Easy solutions won’t work

Simply doubling or trebling capital requirements won’t do. For instance, in 2008-11 the united states Federal Deposit Insurance Corporation (FDIC) lost money on 413 bank failures. Say that those banks – which required 6% core tier 1 regulatory equity to be classified as ‘well capitalized’ – each held a supplementary 14% of assets in cash, but no extra debt on your day they failed. This infusion could have been insufficient to cover losses in 372 (90%) of the cases. 2 Of course many of these banks were not at all hard; more technical large banks may have better risk management, but also more scope for trouble.

Furthermore, high capital requirements have costs too, creating incentives to go assets to ‘shadow banks’ and other differently regulated institutions. Moreover, merely changing capital requirements would do nothing about the issues of pro-cyclicality, or the pressures on regulators to relax requirements in a recession. We have to transition to a fundamentally better quality system while banks are temporarily less reliant on government support.

Our solution

Our solution is founded on two rules.

  • First, any systemically important lender (SIFI) that can’t be quickly wound down must limit the recourse of non-guaranteed creditors to assets posted as collateral plus equity plus credit card debt that may itself be changed into equity — so these creditors involve some recourse but cannot force the institution into re-organization.
  • Second, any debt guaranteed by the federal government, such as for example deposit accounts, must, over time, be backed by government-guaranteed securities.

The next leg of our reforms is a pipe-dream for the present time. So our interim objective is to ‘ring fence’ government-guaranteed deposits separate from all the liabilities in a way broadly such as current policy proposals such as for example those of the U.K. Independent Commission on Banking (2011). 3 We’d however require their collateralization by assets that are haircut by percentages similar to those applied by lenders (including central banks and commercial banks themselves!) to secured borrowers. 4

Part one: Replace all credit card debt with ERNs

Under our plan we’d first have banks replace all (non-deposit) existing credit card debt with ‘Equity Recourse Notes’ (ERNs).

ERNs are superficially similar to contingent convertible debt (‘CoCos’) but are fundamentally different.

ERNs will be long-term bonds with the feature that any interest or principal payable on a date when the stock price is leaner when compared to a pre-specified price will be paid in stock at that pre-specified price. The pre-specified price will be required to be a minimum of (say) 25% of the share price on the date the bond was issued For instance, if the stock were selling at $100 per share on your day a bond was issued, and fell below $25 by enough time a payment of $1000 was due, the firm will be necessary to pay the creditor 1000 ÷ 25 = 40 shares of stock instead of the payment. If the stock rebounded in cost, future payments could again maintain cash.

Crucially, for ERNs, unlike CoCos:

i. Any payments in shares are in a pre-set share price, so ERNs are stabilizing because that price will be at reduced to the marketplace; 5

  • That’s, ERNs have the contrary effect to so-called "death-spiral" bonds that convert at a discount to the present price. Because ERN conversions are always for a set number of shares at prices above the then current share price, every conversion transfers wealth to current shareholders, therefore shores up the share-price. In place, banks buy puts from lenders whenever they sell an ERN, which transfers risk from shareholders to ERN holders, therefore reduces share price volatility. 6

ii. Conversion is triggered by market prices, not regulatory values-removing incentives to control regulatory measures, and rendering it harder for regulators to relax requirements;
iii. Conversion is payment-at-a-time, not the complete bond simultaneously (because ERNs become equity in the us that matter to taxpayers, they are, for regulatory purposes, like equity from their date of issuance, so there is absolutely no reason behind faster conversion) — further reducing pressures for ‘regulatory forbearance’ and in addition largely solving a ‘multiple equilibria’ problem raised in the academic literature;
iv. We’d replace all existing credit card debt with ERNs, not only a fraction of it.

These distinctions get rid of the flaws of standard contingent convertible debt. 7 Importantly, this design also ensures, as we explain below, that ERNs become cheaper to issue when the stock price falls, creating counter-cyclical investment incentives if they are most needed.

Our plan would additionally require a subtle but crucial transformation of secured (i.e., collateralized) borrowing by banks. Currently a secured creditor includes a claim against the posted assets plus an unsecured claim against the lender for just about any shortfall, if things fail. If there is an excellent chance that the federal government will bail out a failing bank, the terms of the loan depends partially on the government’s credit instead of on the grade of the bank’s. The answer is to limit the recourse a creditor could have, beyond the posted collateral, to either shares of stock or ERNs.

Part two: Deposit accounts as money-market funds

Inside our ideal world, deposit accounts would follow a money market fund model. Government guaranteed accounts will be like existing money market funds that spend money on government-guaranteed debts, such as 100% reserve proposals.

Currently, depositors in place receive short-term government-guaranteed debt, acquired from banks that obtain it in substitution for unsecured bank debt plus mispriced, cheap, deposit insurance. We’d get rid of the ‘middle man’, in order that depositors directly hold loans from the federal government. 8

Creditors could still acquire short-term unsecured (i.e., non-collateralized) bank debt in much just how they are able to acquire short-term debt from, say, mortgage securities. Investment trusts could purchase ERNs and pool and tranche them, issuing more senior and shorter-term claims to those that want them, The difference is that in a panic, which can cause an investment vehicle to market a few of its bonds to pay short-term claims, losses will be borne by those that took levered, junior claims in the trust without the short-term repercussions for the underlying banks’ financial condition. Furthermore, investors who wished to reduce or get rid of the tail threat of their ERNs could do so by buying equity puts. They could transfer the chance to any willing buyer – not to the taxpayer.

A few of the senior unsecured claims generated by such trusts may be held in non-guaranteed money market accounts, operated under rules comparable to those proposed by the united states S.E.C. in 2012, with floating net asset values in order that it would swiftly become clear to investors that the accounts had some risk like in an exceedingly short-term bond fund.

Similar principles could possibly be put on the funding of derivatives and other potential liabilities.

Generating countercyclical pressures

Our bodies generates strong countercyclical pressures:

  • Debt payments automatically convert to equity in times of stress, so automatically repair the administrative centre structure
  • ERNs become cheaper to issue when the stock price falls. If, e.g., the stock price declines from 100 to 40, new ERNs could be issued with a conversion price of 10 rather than 25 – therefore the new bonds is only going to suffer losses following the old bonds have previously taken a 60% haircut. The more the stock price declines, the more senior new issues could be; if a stock hits a minimal new, ERNs will be senior to all or any other unsecured capital therefore especially inexpensive to issue
  • Issuing new senior debt (ERNs) can send an improved signal about the company’s prospects than selling assets, because issuing ERNs is relatively cheap; in comparison, raising new funds in the prevailing system is a worse signal than selling off assets, due to have to raise equity to keep up its regulatory-capital ratio
  • The prevailing system’s ‘debt-overhang’ problem that acts as an investment tax in bad times is reversed.

Because all creditors’ final recourse is to ERNs – which become equity in bad world-states – our bodies alleviates liquidity along with solvency problems. So our bodies also mitigates ‘downward spirals’ and liquidity crises, while allowing poorly-run firms to gradually decline and fail or recover.

The program thus respects a significant ‘time-consistency’ constraint – regulators and politicians can’t be counted to permit sudden failures and, also importantly, institutions know this: our solution allows banks and systemically important institutions to fail, but with a whimper rather than bang.


Many proposals add ever-more elaborate regulations to an already baroque regulatory system – one which has already been unmanageable. We propose instead to create things easier.

ERNs certainly are a counterweight to pro-cyclicality. They make capital raising – and for that reason lending – easier instead of harder in recessions. Counter-cyclicality also escalates the credibility of the program, because you will see no incentive to scrap it in bad times. Jettisoning complex capital rules, and transferring tail risk back where it belongs (with private investors) takes taxpayers off the hook and means that banks with profitable opportunities may use them. ERNs also reduce share-price volatility in accordance with conventional debt.

In short, our bodies eliminates distortionary incentives for regulatory arbitrage and forbearance, facilitates counter-cyclical raising of unsecured capital, and clearly and credibly assigns losses to private investors where they belong.

While we depend on markets to determine banks’ risk capital requirements, our bodies is robust to the marketplace being wrong, or less accurate typically than regulators’ or banks’ internal models. In comparison, current regulatory models will most likely lose money, as well as perhaps result in a crisis, if markets are right.

Full information on our plan are in Bulow and Klemperer (2013). It do not need to (and can not!) be implemented all at one time. In the short run, a few of the top features of our ERNs could enhance the existing design of CoCos; in the medium-term, a complete transition to ERNs, ideally together with ‘ring-fencing’, would substantially stabilise the economic climate.


Bulow, J, and P Klemperer (2013), Market-Based Bank Capital Regulation, mimeograph.

Independent Commission on Banking, ‘Final Report: Recommendations‘, September 2011.

1 By ‘debt overhang’ problem, we mean a requirement that new investments be funded with securities that are normally sufficiently junior that wealth is transferred from existing shareholders to creditors (by transferring expected costs of default in this manner). Specifically, regulatory capital requirements may force a bank desperate to make a fresh investment to improve its share capital by a sufficiently greater fraction compared to the fraction by which it does increase its debt that the full total value of its deposit insurance falls, despite the fact that its guaranteed outstanding debt increases-see Bulow and Klemperer (2013).

3 Inside our system, ‘ring fencing’ isn’t so much a means of limiting the actions of commercial banks as a means of reducing banks’ reliance on deposit insurance, and making certain newly-issued ERNs (as described below) will be senior securities in bad times.

4 See including the Federal Reserve Discount Window and Payment System Risk Collateral Margins Table and the lender of England Summary of haircuts qualified to receive the Bank’s lending operations.

5 That’s, the amount of shares that ERN holders receive in virtually any conversion is computed utilizing a share price above the purchase price during conversion (the contrary of “death-spiral” bonds).

6 ERNs also automatically provide additional protection against downward share-price spirals: specifically, we explain below that ERNs become cheaper to issue when the stock price falls, so raising new money at low stock prices is both easy and in addition transfers wealth to shareholders, further bolstering the stock price; moreover, our full proposal means companies do not have to pay cash so can’t be threatened by liquidity crises. Additional information receive in Bulow and Klemperer (2013).

7 Specifically this design prevents downward share-price “death” spirals-see (i) above.

8 Our interim objective of tight ring-fencing wouldn’t normally accomplish that, but would theoretically require banks to secure deposits with a pool of assets against which other lenders will be ready to provide enough cash to totally back deposits. There will be inevitable pressure to relax regulatory haircuts to below-market levels. In the longer run we’d prefer to start to see the government out from the secured lending business aswell, except in acting as a lender of final resort.

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