The Capital Conundrum

After a review of the theory of regulation of bank capital, this paper notes that the pervasive influence of the safety net provides both a rationale for regulating bank equity capital and an obstacle to inferring what the optimal capital-to-asset ratio would be for a bank in the absence of the safety net (or expectations of an ex post bailout). This paper supports the view that the cost of bank equity capital is less than is frequently assumed, but notes that many of the frictions that lead to optimal equity-to-asset ratios for other firms are likely to apply to banks. Moreover, the analysis of bank capital structures is further complicated by the fact that a significant proportion of bank liabilities - deposits - are an important product offered by banks as well as a means of increasing leverage. After a brief overview of the potential advantages of a requirement for contingent convertible capital (CoCo) instruments in addition to higher equity-to- asset ratios, the paper argues that given the uncertainty about the optimum equity capital requirement, a substantial CoCo requirement provides additional advantages which include stronger incentives for banks to recapitalize before they encounter serious difficulties, enhanced incentives for banks to adopt the best possible risk management measures and (so long as the regrettable asymmetry between interest and dividends remains) reduces incentives for banks to move activities to the shadow banking system. A substantial CoCo requirement buffers society from loss as effectively as an equivalent amount of additional equity capital, but CoCos enable a bank to recapitalize automatically if it falls short of the equity capital requirement. This recapitalization will occur instantaneously and at lower cost than a new issue of equity under conditions of stress. Instantaneous recapitalization will give the bank an opportunity to restructure or find a private solution and will provide the regulatory authorities with sufficient warning to prepare a rapid resolution if necessary.