Although we joined the ranks of critics of Treasury Secretary Tim Geithner’s latest plan to bailout banks that fail stress tests by converting the government’s preferred equity shares into common stock, we’ll acknowledge that there is one way that the plan could help things.
The conversion could improve operating incentives at banks that fail the stress tests, economist Linus Wilson explains. Bank executives will be incentivized to improve performance since having more common equity and less preferred would mean that executives could capture more of the profits. Under a structure with a huge amount of preferred stock, so much of the gains are taken by junior creditors that executives are likely to respond in one of two ways: underperforming because their upside is so limited or ramping up risk in hopes of earning enough gains that they can capture some upside. Neither is healthy for the financial system.
“These poorly performing banks probably should also raise new common equity,” Wilson explains.
“Yet, my research indicates that banks that would do poorly on something as easy as the Fed’s stress tests will resist issuing new common stock because too much of the gains from issuing new common stock are realised by their junior creditors. Issuing new common stock in potentially insolvent banks reduces the default risk on subordinated debt. The stock price would probably fall substantially after a seasoned equity offering is announced for banks failing the stress test because creditors gobble up a large chunk of the gains from such an issue. Unfortunately, what is good for the financial system is not necessarily good for the current shareholders of the banks, which should have been better prepared for the stress tests. This is probably why these poor performers may find the subsidized finance of the TARP a more attractive alternative, despite the strings attached to the government’s money.”
In short, the conversion may be the only way to get new common equity into the banks and new common equity may be the key to making the banks healthier. This new health, however, would come from better performance incentives rather than through what is essentially accounting smoke-and-mirrors changes to the capital structure. The key to this is that the capital structure effects the incentives of the executives at the bank.
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