Automatic debt-to-equity swap?

October 8, 2009

That’s what Fed Governor Daniel Tarullo seems to be advocating in his speech, which you can find here.

Here’s the graph, emphasis mine:

We must also adopt new regulatory mechanisms to counteract the systemic and too-big-to-fail problems that became so embedded in our financial system. One possible approach is a special charge–possibly a special capital requirement–that would be calibrated to the systemic importance of a firm. Needless to say, developing a metric for such a requirement is a new, and not altogether straightforward, exercise. Another proposal, which strikes me as having particular promise, is that large financial institutions be required to have specified forms of “contingent capital.” One form of this proposal would have firms regularly issue special debt instruments that would convert to equity during times of financial stress. If well devised, such instruments would not only provide an increased capital buffer at the moment when it is most needed. They would also inject an additional element of market discipline into large financial firms, since the price of those instruments would reflect market perceptions of the stability of the firm.

Yeah, who cares about the bondholder as long as the bank is OK. These are likely to be a tough sell and the banks most likely would have to pay, as they should, a hefty premium to get investors to agree to such a provision.

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