Astrong financial system needs market discipline. Unfortunately, as a result of the global financial crisis, there is now a deeply embedded presumption that governments will use taxpayer dollars to bail out banks, creating a strong incentive for banks to take undue risks. Should this be allowed to continue, it will leave bank supervisors as the main restraint on excessive risk taking – not the banks themselves or their investors.
Regulators and politicians are setting out proposals aimed at counteracting the effects of this moral hazard on financial systems. Proposals include bank taxes, the creation of systemic risk funds, and capital surcharges for systemically important banks. To date, none of these proposals has been universally accepted.
There is a better way, which goes by the name of embedded contingent capital. This is a security that converts to common equity when a bank is in serious trouble, instantly increasing the core capital of the bank without the use of taxpayer dollars. The principle is similar to “CoCos”, the convertible bonds already issued by some banks. But it would apply to all subordinated securities and would be at least equivalent in value to the common equity. This would create a notional systemic risk fund within the bank itself – a form of self-insurance pre-funded by private investors to protect the solvency of the bank.