(The following post is based on a series of very helpful comments left by Patrick Sullivan. Any mistakes are my own.
When I ask progressives how “deregulation” caused the 2008 banking crisis, many point to Gramm, Leach, Bliley (1999), which supposedly repealed the Glass-Steagall Act of 1933, which had separated commercial and investment banking. (I’m told that’s not quite accurate, but that’s the perception.)
In his recent memoir, Bernanke tends to agree with progressives that bank regulation wasn’t tough enough, but interestingly on page 439 he suggests that Gramm, Leach, and Bliley was not the problem, indeed the law helped to prevent the crisis from being even worse, by allowing JP Morgan to merge with struggling investment bank Bear Stearns and allowing a weak Merrill Lynch to be rescued by Bank of America.
But that’s not all. A 2011 paper by Richard Herring and Charles Calomiris argued that risk of banking crises could be greatly reduced by requiring banks to supplement their capital with bonds that could be automatically converted to equity when capital levels fell too low.
This is from a 2014 Wall Street Journal article by Calomiris, which summarizes the basic idea:
Start with a requirement that a megabank maintain a 10% book equity-to-asset requirement–but add to it the requirement that 10% of its assets be issued in CoCos that convert from debt into equity if the market value of equity relative to assets falls below a critical ratio, say 10%, on average for a period of 120 days. If conversion does occur, the CoCos exchange at a premium of, say, 5%. CoCo holders end up with more shares than the face value of their debt holdings.
By using the market value of a bank’s equity as a conversion trigger, bank managers have an incentive to maintain sufficient true economic capital. Conversion means a significant amount of stock is issued, diluting the value of the equity held by the rest of the owners. To avoid this outcome, bank managers would choose to issue new stock (fewer shares than would be issued than under conversion) to offset declines in their market valuation. Managers would make that choice because dilutive conversion is more costly to existing stockholders; both the holders of newly converted shares and pre-existing shareholders would likely agree to sack management incompetent enough to allow such a conversion to happen.
The 120-day moving average ensures that banks have plenty of time to arrange an offering in response to market perceptions of losses. Setting the CoCo trigger at 10%–far above the insolvency point of the bank–ensures that the bank still will have access to the market to issue new equity.
Relying on the market’s perception of bank losses to encourage new equity offerings sidesteps the problem of bank managers and regulators understating or manipulating the riskiness of their assets. Market expectations about cash flows will determine the market value of a megabank’s equity, avoiding unwarranted emphasis on balance sheets to gauge bank health. And the higher the riskiness of a bank’s cash flows, the more willing the bank will be to maintain a large buffer of equity over and above the trigger threshold. The bank’s voluntarily chosen market-to-equity ratio will vary appropriately with its cash flow risk.
In the longer scholarly article from 2011, Herring and Calomiris report this stunning piece of information:
In response to the mandate within the Gramm-Leach-Bliley Act of 1999 that required the Federal Reserve and the Treasury to study the efficacy of a sub debt requirement, a Federal Reserve Board study reviewing and extending the empirical literature broadly concluded that sub debt could play a useful role as a signal of risk. Despite that conclusion, no action was taken to require a sub debt component in capital requirements; instead the Fed concluded that more research was needed.
So the law that provided the flexibility Bernanke needed to deal with the 2008 banking crisis, also suggested a policy reform that might have prevented the crisis entirely. Maybe Phil Gramm deserves a Nobel Prize in economics.
Apparently that “more research” that was needed has now been concluded, as the Fed is finally adopting the idea:
For immediate release
The Federal Reserve Board on Friday proposed a new rule that would strengthen the ability of the largest domestic and foreign banks operating in the United States to be resolved without extraordinary government support or taxpayer assistance.
The proposed rule would apply to domestic firms identified by the Board as global systemically important banks (GSIBs) and to the U.S. operations of foreign GSIBs. These institutions would be required to meet a new long-term debt requirement and a new “total loss-absorbing capacity,” or TLAC, requirement. The requirements will bolster financial stability by improving the ability of banks covered by the rule to withstand financial stress and failure without imposing losses on taxpayers.
To reduce the systemic impact of the failure of a GSIB, an orderly resolution process should allow a GSIB to fail, and its investors to suffer losses, while the critical operations of the firm continue to function. Requiring GSIBs to hold sufficient amounts of long-term debt, which can be converted to equity during resolution, would facilitate this by providing a source of private capital to support the firms’ critical operations during resolution.
Yes, this is a bit like closing the barn door after the horses have left, but it’s still gratifying to see that after all the time wasted on 1000 page monstrosities like Dodd-Frank, we are finally getting somewhere. From the beginning I’ve argued that moral hazard is the key flaw in our banking system. This is just one solution. We still need to get rid of the GSEs and FHA and reform deposit insurance. I recently discussed some ideas for protecting taxpayers from FDIC bailouts. But this seems like an important step. We don’t need lots more complex regulation of banking, we simply need to eliminate the moral hazard problem, which is caused by poorly designed regulations. However I fear that small banks have too much political power to eliminate the regulations that push them to take excessive risks. I hope I’m wrong.
READER COMMENTS
ThomasH
Nov 11 2015 at 3:40pm
Whether Dodd-Frank or something else, clearly people are still concerned about financial system leveraged risk taking, so much so that some people have even suggested that interest rate have to be raised now before the price level has been restored to its pre-crisis trend to prevent market participants from engaging in risky behavior!
James Alexander
Nov 11 2015 at 5:13pm
A problem with having bail-in bonds as a way to make banks better behaved is that there is an assumption that the fixed income investors who buy them will enforce less risky behaviour at the banks. From what I have observed this class of investor aren’t any better (or worse) than bank management or equity investors. The moral hazard of big banks will always be with us.
Scott Sumner
Nov 11 2015 at 9:42pm
Thomas, Bad banking policies create bad monetary policies, and bad monetary policies create banking turmoil.
James, There’s a difference between bankers making mistakes and moral hazard. In my view if the bondholders were equally bad as equity holders, that would be a HUGE win. It would dramatically reduce moral hazard. The problem now is that bankers are not acting in the interest of their shareholders unless they take socially irresponsible risks. Under the new proposed plan they sill might misbehave, but they would no longer have an incentive to misbehave.
And the taxpayers would no longer be on the hook for their mistakes, the bondholders would suffer instead.
John Becker
Nov 12 2015 at 12:01am
Why should banks have to hold a certain amount of debt to equity (market or book value) in the first place? What if a bank took on a lot of leverage and made winning investments? This is something for the market profit and loss test to figure out. There is no bureaucratic solution. The only reason I suspect that these proposals even sound better than what we have in the first place is because of the massive moral hazards created by the FDIC and TBTF (too big to fail) policies.
Emerson
Nov 12 2015 at 9:00am
The CoCo bond seems to be a near perfect solution to the issue of bank failure. It was mentioned in Dodd Frank as a consideration. There was a report to Congress on CoCo ‘s in July 2012. This report seems to have been ignored, or maybe it was stifled by the bank lobby.
CoCos are near perfect, but here are a few problems.
1): When the CoCo is converted to equity of sufficient quantity to improve the bank’s capital position, there will be share dilution. Given that the bank is already under pressure, this could potentially result in a stock price ” death spiral” that would further reduce the bank’s viability.
This becomes a non issue if, as presented by Prof. Sumner, the trigger for conversion is bank resolution.
This ” death spiral ” issue is the main point of debate concerning the best trigger point for conversion.
2): There are tax issues involved. If a bank sells a normal bond, the interest paid on that bond is considered an expense (tax deductible). However, with a CoCo, the interest payment is likely to be considered a dividend. This issue has not been resolved in the U.S. It will need to be sorted out before CoCo bonds can be implemented.
Overall, it seems as though the potential problems of CoCo bonds are minor and can be easily resolved. Hopefully they will become a standard part of all bank balance sheets in the near future
John Hall
Nov 12 2015 at 9:54am
I liked this post.
Emerson
Nov 12 2015 at 10:00am
For those interested the report by the Financial Stability Oversight Council, July 2012 can be found by simply searching:
“Report to Congress on Study of a Contingent Capital Requirement”
Njnnja
Nov 12 2015 at 10:20am
CoCo’s do have a lot of benefits, but they are not a silver bullet. The negative convexity that Emerson mentions is a big problem, because investors will get paid for that. So you have a security that has great tail risk, is totally wrong way risk, and has a serious problem with “winner’s curse” type of problems (i.e. the owners, namely the highest bidders for them, will be those who least understand the tail risk, and think that the extra yield is “for free”). When the bank that issues the coco’s runs into difficulty, the contagion is merely pushed to coco holders, who may not have properly accounted for the risk. This is very common with complex securities that pay off a little better than plain vanilla securities by bundling with a bunch of out of the money puts. Like picking up nickels in front of a steamroller.
Second, the reality is you will never get rid of moral hazard. Even if today’s Congress creates a perfect system that has no potential for taxpayer money going into a bailout, you can’t bind tomorrow’s Congress (or Fed) from organizing a bailout when East Moneystan has a debt crisis.
Most unfortunately, this is all missing the biggest problem with moral hazard, namely that the decisions to make risks are made by individuals, not companies, and there is a huge agency problem here. Regardless of the consequences to the company, it is very hard to align incentives well enough to avoid the moral hazard that executives face, even if their firms don’t.
It’s not so much, “heads I win, tails I get bailed out,” it’s “heads I win, tails I just have to find a new job/career.” Jimmy Cayne’s compensation was very closely tied to Bear Stearns stock, and he lost almost a billion dollars when Bear Stearns went under. Maybe his entire net worth dropped by 90%, but he still has more than enough to live comfortably. What compensation system could possibly have aligned his incentives to avoid moral hazard? Making him lose more than 100% of his net worth, and eliminate the possibility of bankruptcy? Anything short of that appears not to have worked.
It is true that this is an example of the fallacy of the one sided bet but it is definitely how people in the real world make decisions.
Patrick R. Sullivan
Nov 12 2015 at 11:50am
First, congratulations to Scott for a well-written and comprehensive explication of CoCos and the Fed research team’s belated acknowledgement (without their mentioning it took them 16 years) of their benefits. This press release from the Fed was ignored by almost everyone. Yet, it is a potentially momentous change in the way banks are regulated.
Next, Emerson is correct that Dodd-Frank also has a mention of CoCos. That probably is the nudge the Fed needed.
James Alexander said; ‘From what I have observed this class of investor [bondholders] aren’t any better (or worse) than bank management or equity investors. The moral hazard of big banks will always be with us.’
Yes, moral hazard will always be with us, and not just for big banks. But that doesn’t mean we shouldn’t do what we can to MINIMIZE it. That’s what CoCos will do.
Presumably the people who invested in bonds when they could have chosen equity in the same institution, won’t want to be forced to give them up in an equity swap. And the market price of the bonds will decline as the market value of the bank trends downward toward the trigger. My experience with people losing money on their investments is that that gets their attention.
This is the real genius behind the CoCos; they’ll probably never have to be used. To paraphrase a saying, The prospect of having your interest income taken away from you in the morning concentrates the mind wonderfully.
Patrick R. Sullivan
Nov 12 2015 at 12:01pm
Njnnja wrote;
To which I ask the question every economist should always ask; Compared to what?
Don’t you think that the bondholders who see the value of their investment decline in the market, as the bank’s stock price moves down toward the trigger, will be BETTER positioned to do something than, say, the general public?
Similarly, won’t the current equity holders have an incentive to pressure management of THEIR money to ‘straighten up and fly right’?
Patrick R. Sullivan
Nov 12 2015 at 12:09pm
No, Njnnja, that’s not being missed at all. It’s the entire point of Scott’s post; minimization of the moral hazard that will exist by the nature of banking. By giving both the bondholders and equity holders in the bank a strong incentive to monitor their agents (i.e., the managers).
Managers who lose their investors money can be fired, or threatened with same if they don’t reverse course and move the bank’s stock price upward.
Patrick R. Sullivan
Nov 12 2015 at 1:25pm
From the report to congress that Emerson references above;
Njnnja
Nov 12 2015 at 2:07pm
@Patrick R. Sullivan:
To which I ask the question every economist should always ask; Compared to what?
Compared to straight equity. The risk of equity is levered to the health of the bank, so even a little bit of a problem hits equity holders quickly. CoCo’s are exactly the opposite; they look like a perfectly sound (A+ rated!) bond, until they don’t. It’s like the difference between sending a canary down a coal mine versus sending an olfactory-challenged man down the mineshaft with a match to light the way.
Don’t you think that the bondholders who see the value of their investment decline in the market, as the bank’s stock price moves down toward the trigger, will be BETTER positioned to do something than, say, the general public?
No, I don’t think that. It sounds good in theory, but in practice, selling out of the money puts bundled into an otherwise safe looking FI investment is much more likely to burn the ignorant and greedy than it is to add a new and sophisticated layer of concerned bank supervision. The fact is that regular bondholders didn’t seem to care enough, so why would someone who has less to lose care more?
There is a place for coco’s in the capital structure of banks, and they are better than some awful forms of funding (say overnight repos), and they will certainly help make for a more organized restructuring if it comes to that, but it will not lead to a sudden outburst of market-forced discipline.
Managers who lose their investors money can be fired, or threatened with same if they don’t reverse course and move the bank’s stock price upward.
As I already wrote, it’s “heads I win, tails I just have to find a new job/career.” They know that, but the expected value is great enough that it is worth it to take the risk. Unless you want to make it possible to pierce the corporate structure and actually reach into managers’ pockets it will tend to be more beneficial to take more risk and deal with a bankruptcy if it comes.
Anyways, let’s take a look at the bigger picture. I’ll put the “economist question” back to you: Moral hazard is bad, but compared to what? I have been thoroughly convinced by Prof. Sumner’s posts that the Great Recession was caused by poor Fed monetary policy, *not* by financial system instability. If you say that you are worried about unemployment, then focus directly on not having the Fed make bad decisions rather than worry that moral hazard will cause financial instability which will cause the Fed to make poor decisions. (Yes, NGDP targeting would do this well). If you are worried about taxpayer money, note that the financial institutions bailed out by TARP basically paid everything back.
Patrick R. Sullivan
Nov 12 2015 at 2:32pm
That’s because bondholders stand in line ahead of equity holders AND they had expectations of being protected by the government. Which expectations turned out to be well founded.
CoCos change those incentives.
Patrick R. Sullivan
Nov 12 2015 at 2:37pm
More from the report to congress;
charlies
Nov 12 2015 at 6:21pm
I’ll have to agree with the poster arguing that CoCo bonds are not some ingenious invention that could have saved us all.
In practice, simply requiring banks to have lower leverage would have the same result. The CoCo bonds have some clever features that may make them work slightly better or worse than regular capital requirements and that can be debated. But there is always someone holding the most junior debt and they will have an incentive to monitor, contingent debt doesn’t add much there.
Patrick R. Sullivan
Nov 12 2015 at 7:23pm
You might want to read the Calomiris-Herring paper, charlies. Here’s a bit from near the beginning;
Cocos would have changed that incentive, because of a Sword of Damocles hanging over the CEO’s head. Lehman and Bear Stearns would have played out very differently had they been forced to issue CoCos as part of their capital structures.
Patrick R. Sullivan
Nov 12 2015 at 8:19pm
On page 33 of the Calomiris-Herring paper they actually demonstrate how AIG and Lehman would have turned out differently had CoCos been part of both firms’ capital structure;
Then, eliding a bit of fluff;
Also, they note that bank regulators would have been forewarned about impending problems with AIG and Lehman.
Patrick R. Sullivan
Nov 14 2015 at 12:30pm
Before leaving this discussion, I want to point out that one of the world’s premier economists (and former colleague of David Henderson at the Council of Economic Advisers under Martin Feldstein) Paul Krugman, is unaware of all of what Scott has posted here. Just last month in the NY Times he wrote;
Which indicates that Krugman not only does not know that Glass-Steagall was never repealed (only two of its ‘affiliations’ provisions, which did nothing to GS’s separation of commercial and investment banking under provisions #16 and #21), nor, and much more importantly, of the irony that Gramm, Leach, Bliley DID have a provision that, had it been implemented, probably would have spared the country the worst of the financial crisis of 2008-09.
Scott Sumner
Nov 14 2015 at 8:31pm
John, I agree that government created moral hazard is the root problem. Without that, regulation would not be needed.
Everyone, I read all the comments, and appreciate the information. I didn’t respond because I feel Patrick is more knowledgeable on this than I am. I’ll keep an open mind on the issue.
Comments are closed.