BOE Paper Says Contingent Capital Could Stoke Instability
05/31/2012| 08:38am US/Eastern
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Regulators should be wary of special financial instruments designed to flood banks with cash when trouble hits because they may actually generate unwelcome instability in the financial system, according to a Bank of England research paper published Thursday.
The paper, by staff at the BOE and Financial Services Authority, examines the pros and cons of so-called precautionary contingent capital instruments and concludes that they may carry risks not associated with common equity, the gold standard for loss-absorbing capital favored by the Basel Committee on banking supervision, which coordinates global regulatory efforts.
Precautionary contingent capital instruments are usually bonds designed to recapitalize lenders by requiring holders to convert their investment to new equity at some pre-defined trigger point, such as a fall in a bank's share price, a change in its capital ratio or a signal from regulators.
Contingent capital instruments in one form or another have been issued by firms including Credit Suisse Group AG (CS), Rabobank and Irish Life & Permanent Group Holdings PLC (IL0.DB).
The BOE paper says one worry is that certain types of trigger could be manipulated, stoking volatility in financial markets. Investors in contingent capital may be tempted to drive down a bank's share price when a bank is healthy with the aim of triggering a conversion, collecting their shares and profiting when the share price rises, it says.
Another risk of contingent capital is that managers may race to sell assets in periods of stress to avoid conversion and save their jobs, which could spark falls in the value of other banks' assets and cause a credit crunch.
The paper adds to an ongoing debate in policy circles about whether banks should be allowed to count such instruments towards meeting mandatory capital thresholds or whether they should stick with regular equity. The Group of 20 industrialized and developing nations has endorsed rules favoring common equity, but regulators in several national jurisdictions have permitted banks to use contingent capital.
-By Jason Douglas, Dow Jones Newswires; 44-20-7842-9272; jason.douglas@dowjones.com
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