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Symposium 2009

Proposal - Solvency-Convertible Bonds and Financial Vigilance Agency

The Challenge

Many observers blame excessive risk taking and inadequate regulation as the core causes of the current global financial crisis that we have been witnessing.

Many observers blame excessive risk taking and inadequate regulation as the core causes of the current global financial crisis that we have been witnessing.

Require that the debt issued by systemically relevant financial institutions be “solvency-convertible,” so that if such an institution becomes insolvent, the debt would automatically be converted into equity.

The size of the debt-for-equity swap should be such as to return the institution to solvency and restore its capital adequacy ratio to the minimum required level. What debt is converted and the terms of the conversion would depend on the seniority of the tranches.

This simple measure could ensure that all financial institutions that are ‘too large to fail’ in fact don’t fail. Because as soon as insolvency threatens, enough debt would be converted into equity for solvency to be restored. The institutions may shrink in size, but they couldn’t go under. Through solvency-convertible debt, these institutions would in effect have a solvency guarantee. But unlike the current bailouts, this guarantee would not be financed by the taxpayers, but rather by the stockholders of these institutions. Maximizing shareholder value would then mean avoiding excessive risk. (The bondholders would not be affected, since they would demand a risk-premium that covers their risk of loss through possible debt-for-equity swaps.) This proposal would help prevent the insolvency of systemically relevant financial institutions without requiring tax-financed bailouts.

Establish a Financial Vigilance Agency (FVA) to assess whether new financial products generate systemic risks that the originator does not pay for.

The purpose of the FVA is to assess, detect and prevent adverse economic effects of financial products. These tasks could be conducted in an existing or new establishment. The originators of new financial products would be required to submit the relevant information about expected benefits and adverse side-effects, of new financial products and these products could be launched only with FVA approval. The FVA would collect information about these products, analyze the systemic risks that they may generate, and submit the systemically relevant institutions that offer these products to the relevant stress tests.

The onus of proof concerning the safety of a new financial product would lie with the originator. In these respects, the FVA would serve an analogous function to the American Food and Drug Administration and the European Medicines Agency working with the national competent medicines authorities. In short, the activities of the FVA are meant to ensure that new financial products are not toxic and do not have perverse effects on the economy. With the benefit of this work, the solvency of systemically relevant financial institutions should become straightforward to assess. In this area, this work would effectively replace that of the rating agencies.

Clearly, the practical success of the FVA would depend on its ability to find an appropriate path between the dangers of allowing excessively risky projects and of preventing useful financial innovation. Inevitably, the FVA will make both Type I errors (rejecting new financial products that generate a net gain to society) and Type II errors (accepting new financial products that generate a net loss to society). The important policy decision is to define the rules of the FVA so that the size of each of these errors is minimized and the balance between them is clearly in the public interest.

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