Market Discipline Structures

The underlying basis of sound financial institutions and a sound financial system is sound risk management by financial firms. Neither microprudential supervisors nor macroprudential supervisors can oversee all the risk management decisions that are made by financial firms. Pillar 3 of the Basel II Capital Accord recognizes the importance of market discipline in contributing to sound risk management at the firm level. Pillar 3 correctly recognizes that increased disclosure can enhance the market's capability to identify higher-risk banks, but it does not address the market's incentive to exert such discipline. Market participants will price only the risks that they believe they are bearing. Unfortunately, what market participants often observe is that governments will step in to prevent the collapse of financial firms deemed too big to fail (or even too interconnected to fail), with the side effect of protecting many types of claims from taking any losses. What is required for effective market discipline is a credible system of imposing losses on the firms' investors.

Arguably the single most devastating case of inadequate market discipline due to an expectation of a bailout is that of the Reserve Primary Fund, a money market fund that historically provided shareholders with ready access to their investment at a constant value of US$1.00. Accordingly, the Reserve Primary Fund also historically invested in conservative assets, as reflected in its high ratings by both Moody's and Standard & Poor's. However, the SEC says that in 2007 and 2008, the fund began to invest in commercial paper issued by Lehman, Merrill Lynch, and Washington Mutual?all of which subsequently failed or were acquired on distress terms. The US SEC (2009: 14–15) quoted an exchange of e-mail on 12 September 2008 between an employee of Moody's and the Reserve Primary Fund's chief investment officer. The e-mail from Moody's asked about “Reserve's view of the [Lehman] credit.” The response from the chief investment officer was that they were “‘ok holding what we own,' and that he believed that Lehman would, if necessary, be assisted by the federal government.” In effect, the chief investment officer said that he felt comfortable holding the high return Lehman commercial paper because he believed the government was bearing the risk. At the time of Lehman's failure, the Reserve Primary Fund held US$785 million in Lehman commercial paper that became worthless. Shortly thereafter, the Reserve Primary Fund was unable to uphold investors' expectations of being able to quickly redeem their shares at a $1.00-per-share value. According to Acharya et al. (2009: 6), the result of the Reserve Primary Fund's failure was that it

created uncertainty about all money market funds, causing a massive run on the system. Since money market funds are the primary source for funding repos and commercial paper, this was arguably the most serious systemic event of the crisis. The government then had to guarantee all money market funds.

Thus, expectations of a government bailout undermined the Reserve Primary Fund's incentive to engage in sound risk management and exposed the global financial system to systemic problems.

Although exposing market participants to the risk of loss is critical to obtaining market discipline, there is a reason why governments around the world have often elected to engage in bailouts. Governments often feel that they are being forced to pick the lesser of two evils: (i) withdraw the charter, impose losses on creditors, and deal with the resulting financial instability; or (ii) exercise forbearance and/or bail out the distressed firm. The problem from the supervisory perspective is that the supervisors had not been provided with tools to handle failure in a way that would preserve financial stability before the problems arose.

Thus, in order to reverse market expectations that some financial firms are too interconnected to fail, countries must develop and implement credible policies that allow critically undercapitalized financial firms to “fail” without adverse consequences to the financial system. The purpose of this section is to discuss the weaknesses in current systems for dealing with failing financial institutions and some possible solutions.

4.1 Deposit Insurance

Although market discipline depends on some creditors and counterparties of financial firms being exposed to risk, effective market discipline does not depend on all depositors, creditors, and counterparties being exposed to risk. Indeed, exposing some creditors to the risk of loss may be counterproductive to the extent that it weakens the credibility of the government's commitment to resolve failing financial firms without a full bailout of creditors. In particular, exposing depositors with relatively low balances to risk does not add much to effective market discipline and weakens the credibility of commitments not to bail out all creditors. Few small depositors are likely to contribute to informed market discipline because few have the sophistication to understand the financial condition of a large, complex bank. When threatened with loss, the reaction of retail customers is likely to be to withdraw from their bank (if possible) or exert political pressure for a bailout. Moreover, discipline from these depositors is typically not necessary because systemically important banks are generally dependent upon their capability to trade and enter into credit relationships with large and relatively sophisticated counterparties.

Although many countries have deposit insurance, some of these systems contain significant flaws that have undermined their capability to confine protection to small depositors.²³ In the case of Northern Rock in the UK, the capability of de jure deposit insurance coverage limits to limit de facto coverage was overwhelmed by two important flaws. First, UK deposit insurance included coinsurance whereby the guarantee covered all of the first 2000 pounds sterling (£), but only 90% of the next £33,000. Second, the UK system did not promise that depositors would have prompt access to their insured balances but instead permitted delays of up to three months with provisions for a further three-month delay. Such a delay would impose substantial hardships on depositors who needed access to their deposits to pay expenses such as rent, utilities, and groceries. As a result, small depositors at Northern Rock engaged in a well-publicized run on the bank and exerted effective pressure for a bailout of the entire bank.²⁴

The deposit insurance problem is in some ways the easiest problem to fix. Deposit insurers have formed international groups to share their experiences and solutions. One of these groups, the International Association of Deposit Insurers, is developing and publishing principles for sound deposit insurance systems. Although a relatively new system, the Malaysia Deposit Insurance Corporation has been one of the more important contributors to the International Association of Deposit Insurers.

4.2 Special Resolution Regimes for Financial Institutions

If losses are to be imposed on uninsured investors at failed systemically important firms, the supervisors must have a credible mechanism for restructuring or winding down the firm without increasing financial instability. One common mechanism for restructuring and winding down firms is corporate bankruptcy.²⁵ Bankruptcy courts are designed to provide due process to the claims on different groups of creditors. This approach is workable when payments on the claims can be suspended while alternative methods of restructuring or liquidating the firm's longer-term assets are evaluated. However, a large part of the business of almost all systemically important financial firms is the payment of old claims, the receipt of funds that generates new claims, and entering into new financial contracts on a daily basis. If counterparties cannot be sure of their status, they will refuse to deal with a bankrupt financial firm, and that firm will be forced to stop operations almost immediately.

4.2.1 Domestic Firms

One solution to the problem of applying the corporate bankruptcy code to financial firms is the creation of a special resolution regime in which financial experts are given the authority and time to restructure the financial institution. In the case of large or complex financial firms, the authorities are likely to temporarily control the failed institution, as happens with bridge banks in the US. Immediately after withdrawing the charter of the failed bank, US authorities can charter a new bridge bank that is under the control of the deposit insurer. The bridge bank then steps into the shoes of the failed bank, receiving some of the assets, all the insured liabilities, some of the remaining liabilities, and some of the derivatives contracts from the failed bank. Those claims that are not transferred are paid out of the proceeds of the liquidation of the remaining assets plus the profit (if any) when the bridge bank is sold back into the private sector. The bridge bank then carries on the operations of the failed bank until those operations are either sold back into the private sector or wound down in an orderly manner.

In the US, the problem has been that the special resolution regime and bridge bank powers are limited to financial firms that are chartered as domestic insured depositories and certain government-sponsored financial firms.²⁶ All other financial firms are subject to the general bankruptcy code. Thus, had AIG failed, it would have been resolved by the bankruptcy court. Moreover, this limitation extends to those parts of US banking groups that do not have a commercial bank charter. This split treatment of banks and their affiliates is a problem because large financial groups tend to operate as integrated entities with most parts of the group depending on other parts of the group for vital services such as information technology, liquidity management, and risk management.

Although a special resolution regime would appear to be a straightforward solution to the problems posed by AIG, some important details remain. One unsolved detail is what the boundaries of special resolutions are. That is, which financial firms should be subject to special resolutions? This problem has two dimensions. First, should the special regime apply to all financial firms or only to some firms? And if so, to which firms? It is not at all clear that there are net benefits to imposing special resolutions on nonbank financial firms that are not systemically important. Yet if the special resolution is to be limited to systemically important firms, it is important that these firms be clearly identified so that the creditors of these firms understand what rules they are playing under. Doing so will require financial regulators to be much more precise about what is meant by a “systemically important” firm. It also raises questions about the impact on competition of having some firms in a financial sector designated as systemically important and others designated as not systemically important.

Another problem with deciding the boundaries of a special resolution is to decide which resolution regime should apply when a systemically important financial firm is part of a group with large nonfinancial operations. This issue would depend on the extent to which the financial and nonfinancial parts are operating as integrated entities. Separate resolution regimes may not be very efficient if the various subsidiaries depend on the same centralized provision of services (such as information technology) or have integrated management structures. But deciding whether to apply special resolutions to the nonfinancial operations on a case-by-case basis would again leave its creditors unsure about which regime will apply to them. An alternative is to incorporate the nonfinancial operations of these groups in the special resolution regime. However, the use of special resolution procedures for the nonbank parts would deprive creditors of the benefits of using normal bankruptcy proceedings. The special resolution regime may also create competitive disparities between firms operating under the bankruptcy code and those operating under the special resolution regime. Finally, the authorities running the special resolution regime may not have expertise in running nonfinancial operations.

An additional issue with special resolutions is whether the government should provide protection to some creditors to further reduce the risk of financial instability. If so, what criteria should be applied? And should it be paid out of general revenues or a levy on financial firms?

4.2.2 International Firms

The resolution of systemically important financial firms with cross-border operations faces all the problems associated with domestic firms plus the added problem that there is not a global system for resolving internationally active firms. Hüpkes (2004) discussed several difficult problems related to restructuring or winding down large and complex financial institutions (LCFIs) operating across national borders.

One of these problems is that misaligned incentives preclude global solutions. Hüpkes (2004) points out that regulators are accountable to national legislatures for solutions that are optimal on a national level. Their mandate to protect their own national markets and their local creditors will very likely take precedence over solutions that take a more global approach. Rosengren (2009) pointed out an implication of supervisors' accountability to national legislatures. Suppose that the home country supervisor puts the parent operation into a receivership and tries to operate the group as a bridge financial institution. The bridge institution is unlikely to be able to continue normal operation of the firm because host country supervisors will probably impose controls on the transfer of resources to protect creditors in their own countries. Similar problems may arise if the problem is at a systemically important subsidiary located in a host country.

Hüpkes (2004) noted that an LCFI may be too large for the host country (or even the home country) to save. Moreover, even if a country tries to preserve the operations located in its jurisdiction, those operations may depend upon vital services from the parent or subsidiaries located in other countries. If the parent cannot or will not supply these services, the subsidiary in a host country cannot continue.

The problems with resolving part or all of a cross-border LCFI have received some local and regional attention. Mayes (2006) discussed New Zealand's requirements that foreign-owned banking operations be run through subsidiaries and that these subsidiaries be capable of restoring operations within the value day if the parent cannot provide services. According to Mayes, Nieto, and Wall (2008), the problems with cross-border resolution are also being considered in the EU, in which the single passport for financial services firms precludes a New Zealand-type arrangement. However, at this point, it is fair to say that we are a long way from an international framework that would allow the orderly restructuring of a global LCFI in a way that would not have an adverse impact on financial stability.²⁷

4.3 Custom Tailored Failure Plans

The issue of how to maintain financial stability in the presence of a distressed global LCFI cannot be deferred until there is a workable global agreement that provides a general mechanism for resolution. An alternative is to work out tailored solutions for individual LCFIs.

Hüpkes (2004) argued that not all the functions of LCFIs are systemically important to all the countries in which they operate. She recommends that the systemically important functions in each jurisdiction should first be identified. The authorities can then work on arranging a replacement for the important functions or for the systemically important parts to be detached and run separately.

Hüpkes (2004) also recognized that both these alternatives also have problems. The authorities may not be able to arrange for another financial institution to provide timely replacement of some systemically important services of the failed LCFI. Further, detachment can run into a variety of legal problems, some of which have parallels in the problems with resolving the LCFI as a group.

Rajan (2009) proposed that instead of supervisors trying to resolve a complex financial group on their own, the group should be required to develop a “shelf-bankruptcy” plan to be used by the supervisors. He would require that financial institutions track and document their exposures. Rajan (2009: 79) notes that the requirement to develop such a plan would give institutions an incentive to “reduce needless complexity.”

With only minor modifications, Rajan's (2009) proposal could be used to help implement Hüpkes' (2004) recommendation. First, financial institutions could be required to identify activities that they perceive as systemically important. Then the institutions could be required to provide more thorough plans for maintaining systemically important services. These plans could include an analysis of the extent to which replacement providers could step in a timely manner. The plans could also include detailed plans and supporting legal analyses for detaching other systemically important units.

A possible problem with Rajan's (2009) shelf-bankruptcy proposal, according to Thoma (2009), is that of the institution's incentives in preparing the plan. From the institution's perspective, the ideal plan would appear to resolve systemic issues in all its jurisdictions without requiring major changes in the institution's operations or structure. If the authorities ever tried to implement such a plan, however, they would quickly discover that it is unworkable and that the only feasible option is for the concerned governments to provide financial support.

Rajan (2009: 79) recognized the problem with financial firms' incentives and would require that “the mechanism would need to be stress-tested by regulators.” However, the potential advantages of such stress testing go beyond dealing with the institution's incentive conflict. Such stress tests could provide a valuable mechanism to coordinate discussions among the various supervisors and deposit insurers in the home and host countries. These discussions could involve discussions of which operations in which countries are systemically important to those countries. The discussions could then consider which actions would be taken by the various authorities in the event of financial distress to keep the systemically important services in operation. Such discussions are unlikely to produce a definitive plan that could handle all contingencies, but they should facilitate quicker responses to distress with fewer unintended consequences.

Thus, a shelf-bankruptcy proposal has considerable potential and should receive careful consideration. This proposal is not a complete solution, and was not proposed as such by Rajan (2009), because the current version does not fully address incentives of the financial institutions preparing the plan (Thoma 2009) and the incentives of national supervisors to act in a globally efficient way (Hüpkes 2004). But shelf-bankruptcy plans could be a big step toward better preparing for the failure of an LCFI.

4.4 Contingent Capital

A substitute for resolving a firm in bankruptcy proceedings or through a special resolution regime is to recapitalize the financial institution before it fails. Historically, the responsibility for this recapitalization has largely fallen, directly or indirectly, on the government. An alternative is for the recapitalization to come from the private sector. However, private investors will generally participate only if their investment is expected to yield a positive return at the time it is made. This implies that it is generally too late to seek new private funds after a firm is clearly insolvent. However, investors probably would be willing to invest in such claims while the firm is still solvent, provided that the investors can expect to earn sufficiently high returns if the financial firm does well.

Culp (2002: 47) discussed a variety of structures that provide firms with contingent capital that would allow a distressed firm to continue operation. He defined contingent capital as a contract in which the “company pays an investor a fixed price or premium for the right (but not the obligation) to issue paid-in capital later.” The requirement that systemically important financial firms issue contingent capital is at the heart of several recent proposals.

4.4.1 Margin Call

Hart and Zingales (2009) proposed that CDS prices be used to trigger regulatory demands for increased capital at large financial institutions. In particular, if the CDS price (price of protection) rises above some prespecified level, the institution would be told to raise additional capital within a fixed period of time. If the institution fails to raise the required equity, the regulator would determine whether the firm's debt was at risk (i.e., whether it believed the CDS prices). If the debt was at risk, the regulator would replace the chief executive officer with a receiver (or trustee), wipe out the existing debt and equity, recapitalize the institution, and sell the institution back into the private sector.

As Hart and Zingales (2009) acknowledged, the plan to use a market-based trigger is related to prior proposals to use subordinated debt as a trigger for supervisory action, as summarized in Evanoff and Wall (2000). The most important differences are that Hart and Zingales (2009) used a CDS trigger instead of one based on subordinated debt, and that this new plan comes with an explicit warning from the supervisor to recapitalize the financial institution, or the institution is subject to being forced into resolution (bankruptcy or a special resolution regime).

The use of CDS prices is a new contribution, and a reasonable case can be made that the CDS prices have become better measures of a financial institutions' financial condition than subordinated debt prices. However, the addition of the explicit call for additional capital within a reasonable period of time is less of a change than it might appear. Under the older plans that relied on subordinated debt, financial institutions' managers and supervisors had an incentive to monitor the pricing of the institutions' subordinated debt. If the pricing of the debt suggested some market concerns about the institution, the managers would have been given a warning that they should consider the sale of new capital. Moreover, it seems highly likely that the institutions' supervisors would also have been calling for additional capital in their private conversations with the institutions.

What Hart and Zingales (2009) do not change from the prior plans is the reliance on the institution to raise additional capital or face resolution. Yet the primary reason for the recent interest in contingent capital is the great reluctance supervisors have had in forcing institutions into resolution. If the threat of resolution with losses to creditors is not credible to market participants, CDS prices will not provide a signal when the financial institution is in distress. Moreover, even if the CDS market signals the need to issue new capital, the institution may not issue the capital if it perceives that the supervisors are not prepared to resolve the institution.

4.4.2 Capital Insurance

A proposal by Kayshap, Rajan, and Stein (2008) gave financial institutions the option of replacing part of their capital with an insurance policy that is payable in the event of large losses to the financial system. In order for the policy to be able to pay off with certainty, the insurer would need to purchase Treasury securities that would be put into a custodial account for the duration of the policy.

According to Kayshap, Rajan, and Stein (2008: 454), the advantage of this plan over simply requiring financial institutions to hold more capital is that it can reduce the risk that the institutions' managers will try to put the excess capital to work “independent of how the financial sector subsequently performs.” This is beneficial to the institutions' original owners because they would have to bear the full expected costs of any such resource misallocation by the managers.

The benefit of not giving the manager excess capital, however, could be defeated by the managers triggering payments in one of two ways: (i) the proposal could create moral hazard just like deposit insurance by providing a “heads the owners win, tails the insurer covers a large fraction of the losses” environment; or (ii) managers could manipulate the factors used to trigger the insurance payment so that their institutions receive the funds even if they are in good condition. The proposal by Kayshap, Rajan, and Stein (2008) addressed this risk by using a trigger that is based on losses in aggregate capital to financial institutions within some prespecified geographic region, excluding the institution that would receive the insurance payment.

Although the use of aggregate financial institution losses solves the moral hazard problem, it creates another problem in that the insurance provision could not be triggered by problems at one institution, no matter how important that institution is to financial stability. Thus, if the largest financial institution in a country dominated by two or three large institutions were to make a major risk management error not made by the others, no insurance payment would be triggered because the trigger excludes the institution that would receive the payment.

4.4.3 Reverse Convertible Securities

Convertible bonds are securities that convert into common stock at the option of the holder and are typically structured so that conversion is desirable when the firm is doing well. Reverse convertible securities are securities for which the conversion decision lies not with the holders of the securities, but with the firm's managers or is based on prespecified triggers. Reverse convertible securities may be used as a form of contingent capital by requiring the security to convert to common equity when a firm's equity capital is low relative to its risk exposure.

One of the first proposals to require financial institutions to issue reverse convertible bonds came from Stanton (1991: 182).²⁸ He proposed that US government-sponsored enterprises be required to issue subordinated debt that is “structured to convert automatically into common stock under specified circumstances.” Stanton's example of this proposal used the net worth to total size ratio as a trigger for conversion. The advantages of this proposal are that it would reduce the cost of obtaining capital relative to requiring capital in the form of shareholder equity and that it would not dilute shareholder equity “until the capital cushion was clearly needed.”

Flannery (2005) considered the case for requiring banks to issue reverse convertible debt. He noted that bank supervisors recognize the importance of market discipline from uninsured creditors, but he said that in order for this discipline to be exerted, banks must be allowed to fail, something that the supervisors have proven “very reluctant” to do with “systemically important” financial firms (Flannery 2005: 171). The supervisors could require higher equity capital levels to reduce the probability of distress, but bankers argue that this would raise their cost of funding and make them uncompetitive.

As a substitute for requiring higher equity capital levels, Flannery (2005) proposed that banks be required to issue reverse convertible debt. He said that it would provide four benefits: (i) it would protect depositors and taxpayers while providing a transparent method of automatic recapitalization, (ii) it would force shareholders to internalize the cost of the bank's risk taking, (iii) it would not immediately take from the bank the tax shield of issuing debt, and (iv) it would reduce the incidence of costly failures.

The trigger for the conversion in Flannery's (2005) proposal is the financial institution's capital ratio measure falling below some specified level, where capital is measured using its current stock price. His use of stock market prices in the trigger reflects concern about managers exploiting generally accepted accounting principles to avoid loss recognition.²⁹ If triggered, these notes would convert into equity at the current share price, so the conversion does not provide gains to either the shareholders or bondholders.

The Squam Lake Working Group (2009) proposed another version of reverse convertible securities. Its most important difference from Flannery's proposal (2005) is in the mechanism to trigger conversion. The Squam Lake Working Group (2009: 4) proposed that the debt convert only if both of two triggering events occur: (i) a declaration by the regulators that the “financial system is suffering from a systemic crisis,” and (ii) the financial institution violating one of the covenants in the reverse convertible security. The group argued that the advantage of the first trigger is that it disciplines financial institution management risk taking. Conventional debt offers a source of discipline that would be undermined if it “conveniently” converted to equity whenever the institution was in distress. This way, the discipline of debt is retained unless the financial system is in distress. The second trigger addresses the problem that would arise if sound financial institutions were required to accept additional capital because of other institutions' losses. If such conversion occurred, the Squam Lake Working Group (2009: 4) argues that it would “dull the incentive” of these well-managed institutions “to remain sound.”

The Squam Lake Working Group (2009) proposal also differed from Flannery's (2005) in that it would have the debt convert to equity at a fixed quantity of equity shares instead of at a fixed value of equity. This reduces the risk that the debtholders would try to force conversion at too low a price. It would also reduce the extent to which the firm's stock price would depend in part on the probability of conversion.

Although the Squam Lake Working Group (2009) viewed the inclusion of a “systemic crisis” trigger as an important improvement over Flannery's solution (2005), its effectiveness in practice is questionable. If the supervisors view the distressed financial firm's failure as a systemic event in itself, the requirement that the financial sector is in distress will be nonbinding. What it would do in practice is probably add uncertainty as investors tried to determine which firms are regarded as sufficiently “systemic” by themselves to trigger this clause, and which financial firms would be regarded as systemic only when part of a larger group of troubled firms.

The Squam Lake Working Group (2009) also discussed one important limitation of reverse convertible securities: these securities cannot guarantee that a financial firm will never fail. If a firm suffers losses in excess of its original common equity and its reverse convertible securities, it fails. This limitation applies more generally to all contingent capital proposals; these proposals can provide only a limited cushion against losses. Thus, contingent capital should be viewed as a mechanism to potentially significantly reduce the probability that a special resolutions procedure for systemically important firms would be triggered. However, contingent capital is still desirable to the extent that it lowers the probability of failure and is more efficient than special resolutions procedures.

4.4.4 Tier 1 and Tier 2 Reverse Convertible Securities

One way of viewing Tier 1 and Tier 2 capital is that their role is to absorb losses that would otherwise be taken by the institution's creditors, or government guarantors, or both. Tier 1 capital should be able to absorb losses in the ordinary course of business. The use of debt in Tier 2 capital means that it cannot absorb losses in the ordinary course of business, but as the most junior form of debt, it should lose all its value before any other creditor or the government takes a loss.

Viewed from this perspective, the only Tier 1 or Tier 2 capital security capital that has fully achieved its purpose as a cushion to absorb losses is the common equity component of Tier 1 capital. The preferred stock component of Tier 1 capital has taken losses to the extent that dividends have been suspended at some institutions. However, for it to absorb losses beyond that point, it has to be converted to common equity.³⁰ Tier 2 capital has not absorbed losses because governments have not withdrawn the bank charters of systemically important banks.

However, both preferred stock and subordinated debt could fulfill their purposes if they were structured as reverse convertible securities. Such a conversion feature for the parent financial firm would work as follows:

• Preferred stock would be converted on terms consistent with its role as Tier 1 capital. The preferred stock would convert to common equity at the current market price of common stock, as proposed by Flannery (2005). This conversion need not trigger any immediate change in the governance of the firm.
  
  The primary trigger for the conversion would be when the firm's tangible common equity ratio dropped below some threshold level. An additional fail-safe trigger would also be set using a capital adequacy ratio based on the market value of the firm's common stock. The purpose of the fail-safe trigger is to prevent institutions and their supervisors from thwarting the purpose of the tangible common equity by refusing to recognize losses in the asset portfolio. As such, the market value trigger would be set at a level at which the book value threshold should virtually always be violated before the firm falls below the market value threshold if the firm's accounting values are reasonably close to their economic value.
• Subordinated debt would convert on terms consistent with its role as an element of Tier 2 capital that should bear losses only in the event of “failure.” As such, the subordinated debt would convert to common equity on terms intended to approximate that of a “prepackaged bankruptcy,” without the bankruptcy court.
  
  If conversion is triggered, it is done so at a fixed ratio that would give the former subordinated creditors 99% of the outstanding shares. A new board of directors of the firm would be elected within 30 days of the conversion. The existing board members could run for reelection, but the new shareholders would be allowed to nominate new board members that would appear on the election ballot. The existing management of the financial institution would be required to tender its resignation at the first meeting of the new board.³¹ The new board could accept the resignations without triggering any requirement that the firm make additional payments to the managers (such as change of control payments).
  
  As with the preferred stock, the conversion of preferred stock could be triggered by either the firm failing a tangible common equity or a market trigger. The market trigger could be based on the value of the common equity test (in which all the preferred stock would first be converted to common equity), or it could be based on CDS pricing using a mechanism along the lines of that proposed by Hart and Zingales (2009). Again, the market value trigger would be a fail-safe mechanism that should only be triggered if the book values diverged greatly from market values.

An important element of this proposal that would need to be determined is how to set minimum regulatory requirements for common equity and reverse convertible securities. The proposal does require, however, that Tier 2 reverse convertible securities be issued in an amount at least equal to the minimum Tier 1 requirements so that the institution is adequately capitalized after the conversion. Note that this proposal would also permit Tier 1 and Tier 2 capital requirements to be set in a procyclical manner, as recommended by Brunnermeier et al. (2009) to further reduce the risk that an institution will become insolvent.

One limitation of the Flannery (2005) and Squam Lake Working Group (2009) proposals is that they did not address the important difference between parent corporations and their subsidiaries. The conversion of reverse convertible debt into equity will reduce the proportion of shares held by the original owners.³² This change in ownership may be desirable from a prudential supervisory standpoint for the parent corporation in that it imposes costs on owners of firms that did not adequately manage risk. However, such a change in ownership may have an undesirable side effect on the subsidiaries in financial groups: reducing the rest of the group's incentives to work with that subsidiary. For example, if the group has central risk management, the risk managers may decide to transfer some risks out of subsidiaries that are wholly owned by the group and into a subsidiary that is only partially owned after the conversion of the reverse convertible securities.

A better alternative for implementing reverse convertible securities at a subsidiary level is to have the securities convert into the parent's common stock and have the parent then use the proceeds to purchase the subsidiary's stock.³³ This alternative would provide for an increase in the subsidiaries' common stock without weakening the link between the subsidiary and its group affiliates.

4.4.5 Summary

The previous analysis strongly suggests that neither microprudential regulation nor macroprudential regulation is likely to prevent large interconnected financial firms from suffering losses in excess of their capital. If such a firm becomes insolvent, the application of normal bankruptcy procedures risks creating financial instability. A special resolution regime would likely help, but it may not be adequate for firms with large cross-border operations. That suggests that there would be a high payoff for implementing procedures using private funds to recapitalize the financial institutions before insolvency.

There are several contingent capital proposals that would commit private investors to helping to recapitalize financial institutions. None of these proposals would prevent failure, but they would work to substantially reduce the probability of failure, both by providing additional funds and making investors more sensitive to failures in financial institutions' risk management. It is too early to endorse any one of these plans because important details remain to be developed for each plan. However, it is clear that further work on contingent capital should be a priority.

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