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Academic

: Conglomerate

Moral Hazard and Break Books

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

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We are already knee deep in teaching here - as is not atypical of business schools, I teach a rather short course with a number of sections with a rather defined period, which in my case, is at the beginning of the third quarter - but before that happened, I grew to be a fan of Franzen and Hely.  The Basel Committee, however, has been working away on the problem of moral hazard for bank bailouts - the problem in this case being that many banks found their subordinated debt bailed out at 100 cents on the dollar when the governments took equity to save them.  How to ensure that losses happen?  Basel has a commendably straightforward idea:

1. The terms and conditions of all non-common Tier 1 and Tier 2 instruments issued by an internationally active bank must have a provision that requires such instruments, at the option of the relevant authority, to either be written off or converted into common equity upon the occurrence of the trigger event unless:

the governing jurisdiction of the bank has in place laws that (i) require such Tier 1 and Tier 2 instruments to be written off upon such event, or (ii) otherwise require such instruments to fully absorb losses before tax payers are exposed to loss;
a peer group review confirms that the jurisdiction conforms with clause (a); and
it is disclosed by the relevant regulator and by the issuing bank, in issuance documents going forward, that such instruments are subject to loss under clause (a) in this paragraph.

2. Any compensation paid to the instrument holders as a result of the write-off must be paid immediately in the form of common stock (or its equivalent in the case of non-joint stock companies).

3. The issuing bank must maintain at all times all prior authorisation necessary to immediately issue the relevant number of shares specified in the instrument's terms and conditions should the trigger event occur.

And that's the trigger.  Almost makes principles-based regulation look like a cinch.

Full post as published by Conglomerate on January 13, 2011 (boomark / email).

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