Financial Crises and Regulatory Responses. Bank Regulation: I) The Liability side of the Balance Sheet II) The Asset side of the Balance Sheet

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1 Financial Crises and Regulatory Responses Bank Regulation: I) The Liability side of the Balance Sheet II) The Asset side of the Balance Sheet

2 Higher Equity Capital Requirements Admati, DeMarzo, Hellwig and Pfleiderer: If a much larger fraction, at least 15%, of banks total, non-risk-weighted, assets were funded by equity, the social benefits would be substantial. And the social costs would be minimal, if any. What is the argument? MM: Using more equity changes how risk and reward are divided between equity holders and debt holders, but does not by itself affect funding costs

3 Equity Capital (2) MM 2: Tax codes that provide advantages to debt financing over equity encourage banks to borrow too much; Debt and equity should at least compete on even terms contingent capital is complex to design and tricky to implement. Increasing equity requirements is simpler and more effective

4 Equity Capital (3) the transition to much higher equity requirements can be implemented quickly and would not have adverse effects on the economy the policy goal must be a healthier banking system, rather than high returns for banks shareholders and managers, with taxpayers picking up losses and economies suffering the fallout

5 Equity Capital is more costly 1. Allen and Carletti (2013) Deposits and Bank Capital Structure Segmentation of bank deposit market and equity markets Total funds that can flow into deposits: D (Endogenous) cost of deposit funds: u 1 Total funds that can flow into equity markets: K

6 Allen and Carletti (2013) (Endogenous) cost of equity capital: ρ R/2 Risky technology: one unit of investment yields random gross return r ε [0, R] with E[r] = R/2 > 1. Depositors can only have access to risky technology through banks With no intermediation costs (h B = 1) the efficient allocation is to channel all deposits D into the risky technology given that R/2 1

7 Allen and Carletti (2013) Banks then simply serve as a conduit to channel funds trapped in the deposit sector to more productive use Competition among banks drives up the cost of deposit funding to the point where ρ = u = R/2. At these equilibrium prices MM holds! Add a friction to get deviations from MM friction in the form of intermediation costs, which take the form of bankruptcy costs (h B < 1)

8 Allen and Carletti (2013) Now, the nature of the exercise is to minimize bankruptcy costs! More equity leads to lower bankruptcy costs But equity financing is more expensive than deposit financing: ρ R/2 > 1. => Tradeoff: equity financing vs. bankruptcy costs In equilibrium cost of equity financing must be equal to the cost of deposit funding including bankruptcy costs

9 Allen and Carletti (2013) Simplest case: set h B = 0 Then: bankruptcy occurs when r < r B = r D (1 k B ) depositors get: Bank expected profits: rb R r rd 1 k B 1 R dr k B

10 Equity Capital is more Costly 2. DeAngelo and Stulz (2013) Why High Leverage is Optimal for Banks : Also a segmented market model, Non-financial risky firms cannot support high leverage and produce liquidity (Walmart?) Banks step in to provide liquidity with high leverage balance sheets, Cheaper for bank to issue sh.t. debt, as bank can raise funds at a lower cost by providing liquidity

11 Equity Capital is more Costly 3. Bolton and Freixas (2006) Corporate Finance and the Monetary Transmission Mechanism, Review of Financial Studies: asymmetric information about banks net worth adds a cost to outside equity capital, asymmetric information particularly severe in a crisis Walter Bagehot: Every Banker knows that if he has to prove that he is worthy of credit, however good may be his arguments, in fact his credit is gone

12 Cost of Equity Capital Bolton and Freixas model produces multiple equilibria, one of which displays all the features of a credit crunch => i) bank lending constrained by equity capital requirements, ii) constraint is tighter in crisis times Evidence: Jimenez, Ongena, Peydro, and Saurina (2011) based on a natural experiment in Spain; when capital constraints become tighter banks uniformly respond by cutting back lending

13 Debt Structure and Wholesale Funding

14 It is not all about Equity Buffers Besides equity capital requirements need to pay attention to the structure of debt liabilities Heavy reliance on wholesale funding (e.g. shortterm repo funding from MMMFs) makes banks more fragile Why? No insurance equivalent to deposit insurance Special treatment of repos in bank resolution

15 Liability Structure of SIFIs *Other = CP, derivative payables, securities sold short Source: FSOC Report 2012

16 Wholesale Investors Source: FSOC Report 2012

17 Contingent Capital

18 Contingent Capital: Early Proposals 1. Flannery (2002, 2009): an automatic conversion of subordinated (unsecured) debt into common equity when the stock price crosses a pre-specified floor (common equity market value falls below 4% of total assets) 2. Duffie (2009): automatic conversion if ratio of tangible common equity to tangible assets falls below a threshold 3. Mc Donald (2010): two price triggers for conversion; one is the bank s own stock price and the other is a financial stock index

19 Motivation of Early Proposals A simple substitute for a bank resolution procedure An ex-ante commitment to private sector involvement Reduce reliance on bail-outs Mitigate moral hazard in lending No notion of Coasean bargain

20 Swiss Equity Capital Regulation

21 Problems with Early Proposals 1. Conversion trigger based on ratio of tangible common equity to tangible assets is subject to accounting manipulation & is impossible to track continuously; ratio may move too slowly at the onset of a crisis 2. Conversion trigger based on stock price can give rise to multiple equilibria (Sundaresan and Wang, 2010) and lead to death spirals 3. Both types of CoCo instrument are difficult to price.

22 Early Examples 1. Lloyds bank: in November 2009 issued 7.5bn of Enhanced Capital Notes: sub. debt (lower Tier 2) of year maturities convert into common stock if Lloyds core Tier 1 capital ratio falls below 5% 2. Royal Bank of Scotland: gets access to recap. by UK Treasury if core Tier 1 ratio falls below 5% against a 4% annual premium 3. Rabobank: in March 2010 issued CoCos such that investors face a 75% automatic haircut if Tier 1 ratio falls below 7%

23 Lloyds Nov 2009 Rabobank Mar 2010 Jan 2011 Credit Suisse Feb 2011 Mar 2012 Mar 2012 UBS 2012 Feb 2012 Aug 2012 Instrument Enhanced capital note Senior contingent note Tier I perpetual capital securities Tier II buffer capital note Hybrid capital instrument Tier II buffer capital note Tier II capital note Tier II capital note Seniority Subordinate d Senior Subordinated Subordinated Subordinated Subordinated Trigger Core Tier I <5% Equity capital <7% Equity capital <8% Core Tier I <7% or bank declared nonviable Core Tier I <7% or bank declared non-viable Core Tier I < 5% Mechanism Conversion into a fixed number of shares 75% principal write-down & 25% repaid in cash Permanent write-down Conversion into dollar shares (min $20) Exchanged for cash or hybrid capital in Oct 2013 if trigger not pulled before Conversion into CHF shares (min CHF 20) Permanent writedown Coupon % 6.9% 8.4% 7.9% 9-9.5% 7.1% 7.3% 7.6% Maturity years 10 year 30 years 30 years 1.5 year 10 year 10 years 10 years Issue size $13.7bn $1.64bn $2bn $2bn $6.2bn $759 million $1bn $2bn Remarks - Subscribers: Senior debt holders of the bank ( Switch ) -Subscribers: mainly individual investors -1 st Basel III compliant CoCo issued -Orders amounted to $29bn (11 times oversubscription) -Subscribers: Qatar Holdings, Olayan Group -Small issuance to complete the 2011 issuance and meet the Swiss regulatory capital requirements -Directed at Asian investors -Mainly US & institutional investors -Orders amounted to $9bn

24 Other Examples Spain: Spanish bank reform (May 2012): The government will buy CoCos from distressed Spanish banks, through the FROB (Spain bank rescue fund) Structure of the CoCos: 5 years maturity and 10% coupon rate The 6th largest Spanish lender, Banco Popular has issued CoCos UK: Barclays CoCos (Nov and April 2013; 7% trigger)

25 Capital Access Bonds The right to issue equity in crisis events Main point of our article: Capital Access Bonds are a Coasean Bargain for Banks, Long-term Investors, and Regulators 1. Banks can ensure that they have sufficient (regulatory) capital when they need it most 2. Long-term investors can monetize their equity investments and obtain a premium for implementing counter-cyclical investment strategies 3. Bank Regulators gain by implementing a more efficient form of equity capital regulation

26 Contingent Capital (2) Equivalent to a line of credit commitment (LOC) but for equity! Commit to terms in advance, before asymmetric information problems get worse Many long-term investors are natural holders of contingent capital Counterparty risk, collateralization and reverse convertible bonds

27 Capital Access Bonds (3) A bond that is convertible by the issuer No automatic trigger Fixed maturity (say 10 years) Convertible any time before maturity (American option) If not converted investors get a regular coupon (interest + put premium) If converted investors get a fixed number of newly issued shares => A collateralized put option

28 Motivation for Capital Access Bonds Theory: Bolton, Santos and Scheinkman (2011) Outside and Inside Liquidity, QJE banks engage in maturity transformation and demand liquidity (capital) whenever there is a maturity mismatch can meet this demand with inside liquidity (equity capital) or with outside liquidity (asset sales; new equity issues) capital raised from long-term investors outside liquidity is more efficient, BUT outside liquidity does not flow easily to banks during crises, because of opaqueness of bank balance sheets =>

29 Motivation for CABs (2) Ex-ante (state contingent) capital line commitments are Pareto improvements over standard equity issues. Practice: the example of Berkshire Hathaway, who sells insurance against sharp equity-market crashes in the form of long-term index put options (up to ten years) In 2007 positions in excess of $37.1bn and premium revenues of $4.9bn. Potential problem: Counterparty risk => Collateralize the capital line commitment by raising cash upfront => get a CAB!

30 Basic Mechanism: Illustration (at maturity) Investors Cash ($100) CAB: pays either $100 or two shares Issuer (share price at $100) Either the share price is above $50: => redemption at par Or the share price is below $50: => two new shares are issued Before maturity get coupon payments Combination of: Callable bond American Put option

31 Flows in Case of Exercise Investors Issuer (initial share price at $100) Bond Part Put Part Bond Nominal ($100) Options/Bond Nominal ($100) 2 Shares If no Exercize: Payment of Nominal If Exercize : delivery of two shares The exercise (or not) of the put option will determine the payment in cash or in shares At maturity: depends on whether share price is above or below strike price Before: depends on endogenous optimal stopping price

32 Pricing of CABs: A Numerical Simulation Parameters Ways to price the CAB:

33 Solving for the Conversion Frontier (Debt to Equity) Before maturity the conversion price is low. (70% share price drop) Conversion price tends to increase near maturity

34 Expected Payoffs of Investors Stock price 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% Effective stock price for the investor Years Probability of loss for the investor Time period Effective stock price = Strike price cumulative sum of coupon payments up to t Trade-off Probability of loss below 3.2% (over the whole life of the product) Additional coupon: % (57% increase)

35 Summing up Advantages for Bank Regulators: Delivers a market price of TBTF insurance Avoids pro-cyclical pitfalls of equity capital requirements What are the possible obstacles? What will be the credit rating of CABs? Taxation of CABs? Regulatory treatment of CABs under Basel III?

36 II) The Asset side of the Balance Sheet Asset side is connected to liability side through the risk-weighting of assets (RWA) Key Issues: How reliable are RWAs? How can they be improved? What are the costs and benefits of structural remedies? Volcker rule Vickers and Liikanen Ring-fencing rules

37 The Asset side of the Balance Sheet Volcker rule, Section 619: Prohibitions on proprietary trading and certain relationships with hedge funds and private equity funds. a banking entity shall not, (A) engage in proprietary trading; or (B) acquire or retain any equity, partnership, or other ownership interest in or sponsor a hedge fund or a private equity fund.

38 The Asset side of the Balance Sheet Any nonbank financial company supervised by the Board that engages in proprietary trading or takes or retains any equity, partnership, or other ownership interest in or sponsors a hedge fund or a private equity fund shall be subject to additional capital requirements for and additional quantitative limits except for permitted activities as described in subsection (d) permitted activities : (A) The purchase, sale, acquisition, or disposition of obligations of the United States or any agency thereof

39 The Asset side of the Balance Sheet permitted activities (continued) : (B) The purchase, sale, acquisition, or disposition of securities and other instruments in connection with underwriting or market-making related activities (C) Risk-mitigating hedging activities in connection with and related to individual or aggregated positions.. (D) The purchase, sale, acquisition, or disposition of securities on behalf of customers.

40 The Asset side of the Balance Sheet Note: much more detailed rule than Glass-Steagall sections + more detailed proposed rules by OCC, Fed, FDIC & SEC (530 pages): Open questions: Why do we need a Volcker rule? What will happen to proprietary trading? Will all BHCs be treated equally?