Academic

Convertible Securities As Bank Protection

By Gordon Smith, Christine, Hurt, Vic Fleischer, Fred Tung, Lisa Fairfax, David Zaring

Economists rather like the ideas of requiring systemically significant financial intermediaries to issue convertible securities - bonds that would turn into equity during a run on the bank or an implosion of the economy.  They like them for two reasons other than their inherent niftiness.  The first is because the market for the securities might warn regulators that a crisis is brewing - Sebastian Mallaby makes that point here.  The second is because the securities would give banks capital when they most need it, in bad times, without forcing them to go out and raise it at usurious rates.  You can read a paper from the Squam Lake Working Group, finance pooh-bahs all, that makes that point among others here.

I like convertible securities too, but suspect they cannot solve the regulatory dilemma alone.  In particular, I see two problems, one traditional one, and one rooted in the very novelty of the solution.  The traditional one is that convertible securities are a form of insurance, and insured institutions are likely to take risks.  The novel one is that setting up markets for purely regulatory purposes has been surprisingly difficult, maybe because the market doesn't seem "natural", maybe because they start out thin and small, and tend to stay there.  Betting markets on various public policy issues, cap and trade in the EU, the market to take securities off the books of struggling banks in partnership with Treasury - they've all had problems.  I'd like to see more law papers on harnessing these sorts of new regulatory markets on behalf of public policy objectives, because it seems to me that the record is pretty spotty.  But if you wanted to get started in the area, you might take a look at the work of Michael Abramowicz.

Full post as published by Conglomerate on April 09, 2010 (boomark / email).