Lessons from the collapse in hybrid bank capital securities

This paper addresses the lessons that can be learned for hybrid bank capital securities during this decade's credit boom and bust. Firstly, we identified the major drivers in the market for these European bank hybrids before 2007-2009 financial crises as follows: regulatory framework, rating agencies and the European monetary union. Then, our empirical results show that the risks of these hybrid bank capital securities have been severely underestimated before the recent financial crises. This underestimation may be attributed by the extension risk and the deferral risk. Moreover, by analysing the characteristic of these bank hybrid securities and comparison of the differences how Basel II and the new proposed Basel III treat these bank hybrids, we propose that it could be beneficial to the stability of the financial sector if bank executives' compensation comprised a significant portion of subordinated debt. Unlike common equity and stock options, which are currently popular forms of incentive compensation for executives, hybrid debt-like securities would limit the upside from driving bank profits ever higher, but still expose bank managers to the downside risk of insolvency.