You are here: Home Knowledge Base Economy Balancing Risk Taking and Financial Regulation Solutions Consider the creation of “solvency-convertible debt” for systemically relevant financial institutions, ensuring that if such institutions become insolvent, their debt would automatically be converted into equity, on predetermined terms.
Symposium 2009

Solution for Balancing Risk Taking and Financial Regulation

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.

Consider the creation of “solvency-convertible debt” for systemically relevant financial institutions, ensuring that if such institutions become insolvent, their debt would automatically be converted into equity, on predetermined terms.

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 do not fail. 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 could not 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.

    Implemen- tations

    Implementation
    Symposium 2009

    Contingent convertibles bonds (Coco)

    Polity, Academia, Business, Civil Society

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