Monday, 5 April 2010

Mankiw's proposal for contingent convertible debt

In the ongoing debate on financial regulation, most reform proponents seem to be under the illusion that it is possible to prevent future financial crisis. Therefore, Mankiw’s article on Trying to Tame the Unknowable is a welcome alert.

Proposals to prevent future taxpayer bailouts for financial institutions revolve around three key ideas:
1) Limiting the type of activities that banks can do (e.g. the Volcker rule on proprietary trading);
2) Capping the size of banks considered too big to fail; and
3) Requiring banks to have more capital to cope with the higher levels of leverage used today (e.g. Greenspan’s proposal to go beyond the current Basle II).

Mankiw’s favorite proposal is to require banks, and perhaps a broad class of financial institutions, to sell contingent debt that can be converted to equity when a regulator deems that these institutions have insufficient capital. This debt would be a form of preplanned recapitalization in the event of a financial crisis, and the infusion of capital would be with private, rather than taxpayer, funds. Think of it as crisis insurance.

This is an interesting idea on how to increase bank capitalization while privatizing the risk of reckless lending. However, its fundamental weakness is that rating agencies and regulators can hardly be trusted to decree such debt conversion before losses are too big to be absorbed by this share of capital alone.

The one thing that the history of speculation teaches us is that nobody is willing to remove the bowl of punch while the party is still going on. For instance, this last year alone, with inflation below 3%, the stock market has risen more than 40%. Would anyone be willing to classify this as a bubble and to force banks to stop lending to finance stock purchases? I doubt.

The only way the regulation could work would be to set up pre-defined conversion rules based on asset inflation targets. But, which assets classes? Shall we use rules based on price indexes for stocks, real estate, fixed-income, or commodities? And what should be considered a speculative price run over, say three months? 20%, 40% or 60%? These questions as well as the size of this quasi-capital buffer would raise many interesting debates.

However, the rules would only work if we could agree on a simple set of pre-defined conversion rules. If we are sufficiently naïve or optimistic to believe that such agreement is possible, let us advocate the Mankiw’s rule as a good policy.

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