What happens when they are gone? September 3, 2012 at 6:35 am
What is bank capital for? It is a good question, with many possible answers including going concern loss absorption, giving confidence to debt buyers and gone concern loss absorption. There is no need for these functions to be performed by the same security and indeed there are some benefits to separating going and gone concern issues. Given that banks will typically be resolved these days rather than going into bankruptcy, gone concern is mostly about resolution. Suppose then that we have a security that only suffered losses in resolution, when it is available to absorb any losses that equity is not sufficient to deal with. It would sit between equity and more senior debt instruments. It could even be convertible into new equity supporting a bank recapitalisation (although you might not want that, as you might not want the holders of these instruments to try to hedge the embedded equity option). However it would not be convertible before resolution, nor would its coupons be deferrable except during resolution. The price of such an instrument would therefore precisely reflect the market’s perception of the probability of resolution of a bank. The existence of such an instrument would allow regulators to intervene rather later than if it did not exist, as the instrument would be available to reduce losses to deposit protection schemes. The moral hazard whereby regulators seize a bank from its existing shareholders would be mitigated as seizure would only occur when the equity was worth close to nothing anyway.
I know that the history of bank hybrid capital instruments has not exactly been glorious, but I think a lot of prior problems relate to the lack of a clear trigger for taking losses/deferral. A pure play on resolution might just work.