Finally, A Smart Way To Fix The Banking System

CoCo bonds

The problem that brought the banking system to its knees, you’ll recall, was that loan losses wiped out the banks’ equity. 

To remain solvent, banks are required to maintain certain ratios of equity to debt, and the losses on the banks’ boneheaded loans knocked these ratios below the required level.

Normally, when a company’s equity gets wiped out, the company’s bondholders start picking up the tab.  The bondholders are higher in the capital-structure pecking order than the equity holders, so they get their money first, but, normally, this money isn’t guaranteed.   If the bank is so colossally stupid that it wipes out all its equity, then bondholders (usually) have to pay the price.

But when the US government rescued the banks by pumping them full of taxpayer money, they invested the taxpayer money in the form of equity.  As they did so, they protected the bondholders to the tune of 100 cents on the dollar.

This was outrageous–morally and otherwise.  The bondholders were free-willed adults who had voluntarily loaned money to the banks so the banks could lend it to anything with a pulse.  These (extremely well compensated) free-willed adults were saved from paying the price for this stupidity because they scared Tim Geithner the government into thinking that the world would end if they lost money.

Specifically, the bondholders and bankers persuaded the government that they were TOO BIG TO FAIL.  And this concept–the taxpayer must bail out any bank big enough to make headlines–has basically become written into the Constitution.

This is a disaster for everyone but banks and bondholders.  It makes a mockery of the whole premise of capital markets and capitalism–that a good balance of incentives and risk will cause people to behave in a reasonably intelligent manner most of the time (and pay the price if they don’t).  It exacerbates the “moral hazard” that academics and Fed chairmen are always mumbling about (“heads we win, tails the taxpayer loses, so roll away…”).

Banks have understandably fought tooth and nail to prevent any reform of the current system.  For example, banks have argued vociferously that a calamity will befall the country if banks are forced to increase the amount of equity they are required to hold relative to their debt. (What calamity?  Less profit and smaller bonuses.).  And now that the stock market has somewhat recovered, no one cares about financial reform anymore, so bankers stand a good chance of preserving the status quo right up until the next financial crisis.

At this point, the odds that we’ll get any reform at all seem next to nil, but there’s a simple solution that could fix the whole problem.  Shockingly, this solution has actually begun to be implemented in Europe.

What’s the solution?

Debt that automatically converts to equity when a bank’s capital ratio falls below the required level.

What does that mean?  It means that equity holders will still get hit first if the bank makes dumb-arse loans.  But it also means that if the bank makes so many dumb-arse loans that its equity gets wiped out, bondholders, not taxpayers, will pick up the rest of the tab. 

How does it work?

When the bank’s equity falls too far, some of the convertible bonds convert to equity, thus restoring the bank’s capital ratio.

This happens automatically, without bankruptcy or fuss.  It happens without surprise.  It happens without threatening to bring the whole economy to its knees.  It happens without Congressional moaning and hand-wringing and without Treasury secretaries dropping to their knees to beg and plead. 

Bondholders who buy these bonds–now called CoCo’s, or “contingent convertibles”–know full well what they are buying, and the bonds are priced to reflect the equity conversion risk. Lloyds just sold a bunch of these in the UK, and there was a market for them.

To fix the banking system, all regulators would have to do would be to require banks to issue enough CoCos that they could withstand financial Armageddon without the taxpayer getting involved.  The banks’ ability to make huge bets (and huge bonuses) with small amounts of equity would be preserved, so perhaps the bank lobbyists would agree to stand down for a while.  The world could rest assured that SOMETHING had been done to prevent the same mess from happening all over again.  And we could all return to peace, happiness, and prosperity.

The FT has an excellent interactive tutorial on bank capital and CoCos here >


Graphic: FT

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