An alternative to a resolution regime

This post of Steve Waldman’s prompted a discussion that I still think provides the best alternative to a resolution regime.  Regulators are currently encouraging the issue of contingent convertible bonds (or CoCos).  Because these haven’t been issued before some are concerned that the conversion itself could cause a crisis.  And there is much discussion regarding the value of this form of convertible debt.

Broader application of this contingent convertibility would do a lot to fix the problem of “too big to fail” financial institutions.  All financial institution debt should be convertible, with a few carefully chosen exceptions — such as deposits and perhaps some select categories of secured loans.  The convertibility of debt should be tiered, so that some investors are buying CoCos comparable to those that Lloyds is issuing and other investors — whose purchases convert only after 20 other issues convert — are very unlikely to convert and therefore are more like traditional forms of debt.

Requiring banks to have a convertible liability structure would solve for regulators the problem of not being able to put such banks through bankruptcy court.  It would obviously also raise the cost of funds for financial institutions — but only because lenders would have to be compensated for the costs that taxpayers are currently bearing.  Allowing the market to price the risks that banks are carrying is surely better than asking regulators to devise some model that will allow them to guesstimate an insurance premium for “too big to fail” firms.

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