Fostering Financial Stability with Reverse Convertible Bonds

Courtesy of Pierre Chaigneau

Most financial crises are characterized by a widespread loss of confidence in financial institutions. Charles Kindleberger famously made this point in 1978 in his book “Manias, Panics, and Crashes: A History of Financial Crises.” The mechanisms described in this book remain highly relevant to understand the financial crisis of 2007-2008. In the UK, Northern Rock faced a classic bank run by depositors who withdrew their money until it was bankrupt. In the US, Bear Stearns failed because institutions that provided short-term funding stopped lending. Then SEC Chairman Christopher Cox stated that: “the fate of Bear Stearns was the result of a lack of confidence, not a lack of capital. … Counterparty withdrawals and credit denials, resulting in a loss of liquidity — not inadequate capital — caused Bear’s demise.” This phenomenon is viewed as a “modern bank run”, which involves money markets rather than depositors. Of course, bank runs are triggered by a degradation of economic fundamentals, but this degradation is then amplified by a liquidity crisis (e.g., Morris and Shin (2001), Goldstein and Pauzner (2005)).

Following the crisis, banks were forced to hold more capital (equity) to increase their ability to withstand losses, and the Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) imposed restrictions on their investment activities to curtail risk-taking. Will these reforms prevent another financial crisis?

Unfortunately, the financial system is still vulnerable to refinancing problems and bank runs. Indeed, banks engage in maturity transformation by turning short-term savings into illiquid long-term investments. By offering savers the option to withdraw their funding before its investments pay off, a bank is exposed to a coordination failure at the refinancing stage. Indeed, its depositors (creditors) could withdraw their money, thus forcing a premature liquidation of its investments. This is obviously not without costs; a physical investment typically cannot be undone and fire sales further depress asset prices. To guard against refinancing problems, a bank should either fund itself with very long-term debt or hold highly liquid assets, both of which are prohibitively costly. Thus, this vulnerability to so-called “rollover risk” is largely intrinsic to financial intermediaries who engage in maturity transformation.

Unfortunately, measures taken since the financial crisis have diminished public authorities’ ability to deal with such confidence crises among bank depositors and creditors. As former Fed Chairman Ben Bernanke and former Treasury Secretaries Timothy Geithner and Henry Paulson explain, “the FDIC can no longer issue blanket guarantees of bank debt as it did in the crisis, the Fed’s emergency lending powers have been constrained, and the Treasury would not be able to repeat its guarantee of the money market funds.”[1] In addition, the public mood has turned against discretionary government help for banks, with 84% of Americans opposing a bank bailout according to a Harris poll. While banks do have higher equity buffers than before the crisis, this does not prevent refinancing crises. In a study of Northern Rock, Hyun Shin (2009) concludes that: “financial regulation that relies on risk-weighted capital requirements is powerless against such runs.”

One solution – first proposed by the Squam Lake working group (2009) – for preventing bank runs is requiring banks to hold “contingent capital.” One form of contingent capital is contingent convertible bonds that automatically convert to equity following a pre-determined event or “trigger”. Several designs have been proposed, including accounting triggers and market triggers. Even though most contingent convertible bonds issued by banks since the financial crisis have accounting triggers, they are now widely regarded as inadequate; following a shock, a refinancing crisis would hit long before accounting ratios adjust to the new reality. Market triggers allow conversion to be more timely, but they may encourage market manipulation, and conversion may be erroneously triggered following a self-fulfilling market panic (Pennacchi, Vermaelen, and Wolff (2014), Sundaresan and Wang (2015)).

In my recent paper, “The implications of reverse convertible bonds for bank runs and risk shifting”, I show that contingent capital also leaves banks exposed to a refinancing crisis. Indeed, if contingent convertible bondholders expect a fall in the stock price and conversion, it is in their interests to withdraw money from the bank to avoid conversion. This belief is self-fulfilling, as it results in a bank run which triggers the conversion of contingent capital into equity to avoid bankruptcy.

I argue that by using instruments known as reverse convertible bonds, banks can reduce the risk of a bank-run, which thereby facilitates financial stability. A reverse convertible bond is a bond whose issuer has the option to either make the principal payment in cash, or to deliver a pre-specified number of shares at maturity. That is, in case the bank fails to make a debt repayment, the bondholder receives bank equity rather than cash, in such a way that bank value is unaffected (i.e., there are no wealth transfers upon conversion). Indeed, this process merely involves a redistribution of claims among investors instead of costly asset liquidation. Since early withdrawals by creditors do not affect bank value, creditors do not have incentives to withdraw their money from the bank even if they expect others to do so. In technical terms, there are no strategic complementarities at the rollover stage; creditors who need to withdraw their money from the bank are repaid in cash, while other creditors optimally choose to leave their money in the bank.

I conclude that reverse convertible bonds can be designed to provide short-term liquidity to its bearers while preventing panics and bank runs, so that well-capitalized banks can fully and safely play their maturity transformation role. In addition, I show that the bank takes the socially efficient level of risk with these liabilities, which is not the case when it is funded with short-term debt. Of course, more research is needed to better understand all the implications of this new type of bank liability, including practical and regulatory issues.

 

[1] Bernanke, B., Geithner, T., Paulson, H., 2018. What We Need to Fight the Next Financial Crisis. New York Times September 7 2018.

References

Chaigneau, P., 2018. The implications of reverse convertible bonds for bank runs and risk shifting. Working paper, Queen’s University.

Flannery, M.J., 2014. Contingent Capital Instruments for Large Financial Institutions: A Review of the Literature. Annual Review of Financial Economics 6, 225-240.

Flannery, M.J., 2016. Stabilizing large financial institutions with contingent capital certificates. Quarterly Journal of Finance 6(2).

Goldstein, I., Pauzner, A., 2005. Demand–Deposit Contracts and the Probability of Bank Runs. Journal of Finance 60, 1293-1327.

Morris, S., Shin, H.S., 2001. Rethinking Multiple Equilibria in Macroeconomic Modeling. NBER Macroeconomics Annual, 15, 139-182.

Pennacchi, G., Vermaelen, T., Wolff, C.C., 2014. Contingent capital: The case of COERCs. Journal of Financial and Quantitative Analysis 49(3), 541-574.

Squam Lake Working Group, 2009. An expedited resolution mechanism for distressed financial firms: Regulatory hybrid securities. Council on Foreign Relations Press.

Sundaresan, S., Wang, Z., 2015. On the design of contingent capital with a market trigger. Journal of Finance 70(2), 881-920.

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