Generally applicable capital and other regulatory requirements do not take account of the specifically systemic consequences of the failure of a large institution. It is for this reason that many have proposed a second kind of regulatory response – a special charge, possibly a special capital requirement, based on the systemic importance of a firm. Ideally, this requirement would be calibrated so as to begin to bite gradually as a firm’s systemic importance increased, so as to avoid the need for identifying which firms are considered too-big-to-fail and, thereby, perhaps increasing moral hazard.
While very appealing in concept, developing an appropriate metric for such a requirement is not an easy exercise. There is much attention being devoted to this effort – within the U.S. banking agencies, in international fora, and among academics – but at this moment there is no specific proposal that has gathered a critical mass of support.
I support the idea of assessing a progressive surcharge on risk-weighted assets such that, for instance, RWA in excess of $250-billion wiould be increased by 10% for capital calculation purposes, RWA in excess of $300-billion another 10% on top of that, and so on. Very few formal ideas have been proposed in this line; the US Treasury wish-list does not mention such an idea but endorses a special regime for those institutions deemed too big to fail.
A second kind of market discipline initiative is a requirement that large financial firms have specified forms of “contingent capital.” Numerous variants on this basic idea have been proposed over the past several years. While all are intended to provide a firm with an increased capital buffer from private sources at the moment when it is most needed, some also hold significant promise of injecting market discipline into the firm. For example, a regularly issued special debt instrument that would convert to equity during times of financial distress could add market discipline both through the pricing of newly issued instruments and through the interests of current shareholders in avoiding dilution.
I heartily endorse this idea, which was first proposed by HM Treasury in its response to the Turner report and endorsed by William Dudley of the New York Fed. It looks like this idea is gaining some traction!
Of course, financial instability can occur even in the absence of serious too-big-to-fail problems. Other reform measures – such as regulating derivatives markets and money market funds – are thus also important to pursue.
This entry was posted on Friday, October 23rd, 2009 at 2:23 pm and is filed under Contingent Capital.	You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.