Capital access bonds: contingent capital with an option to convert[‘Caught between Scylla and Charybdis? Regulating bank leverage when there is rent seeking and risk shifting’]

This paper argues that there is a Coasean bargain available to banks, long-term investors, and bank regulators around a particular form of “contingent capital”. By purchasing rights to issue equity in crisis events at a pre-specified price from long-term investors, banks can ensure that they will have sufficient regulatory capital available when they need it most: in a crisis. By selling these rights (effectively, a form of crisis insurance) long-term investors can monetize their counter-cyclical investments strategies in banks and, thus, obtain an adequate return as long-term investors. Bank regulators, in turn, gain as they can thereby implement a more efficient (transparent and flexible) form of equity-capital regulation. The form of contingent capital we propose (capital access bond) reflects a balance between investors’ preferences, issuers’ constraints, and regulators’ objectives.— Patrick Bolton and Frédéric Samama