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Last updated: June 1, 2009 8:55 pm

Bank capital

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When it comes to banks’ capital, there is no magic number where enough is enough. Higher requirements, with measures to reduce pro-cyclicality, are only one part of the puzzle. Both regulators and investors have proved poor at holding banks to account in the good times or forcing early evasive action when required. And, in extremis, the banks most in need of an equity top-up are the least able to secure it.

Debating what the new regulatory landscape should look like is all very well. But before reaching for the red tape, some creative thinking would be preferable. Consider, for example, a longstanding proposal from the University of Florida’s Mark Flannery, arguing for the inclusion of a new type of debt security in capital structures. Paying tax-deductible interest, these bonds would convert into equity if the issuing bank’s capital ratio fell below a pre-determined level. Conversion would be automatic, but at the market price, thereby offering holders protection.

Leave aside, for a moment, details such as how the trigger would be determined and whether it would reference book value of equity or market value (as Mr Flannery prefers). A pre-programmed safety feature in banks’ capital sounds appealing. Removing the element of choice guards against regulatory forbearance. The prospect of forced dilution could sharpen incentives for existing investors to demand early capital raisings or asset sales – incentives increasingly blunted by the assumption of government support for large banks in trouble. A higher conversion threshold, in fact, could apply to those deemed a potential risk to the system.

Embedding the lessons of this crisis into capital structures could help the policy response prove enduring. New super-duper regulators globally will be given licence to take a heavy hand in their duties. They should also consider alternative means to fulfil their unenviable task.

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