Just-in-Case Capital

October 26, 2009

Like “too-big-to-fail” and “moral hazard,” the term “contigent capital” is rapidly becoming a buzzword in regulator circles. WIlliam Dudley, president of the New York Fed, has raised the idea in his speeches¬†and Daniel Tarullo, the most recent appointee to the Fed Board, also brought it up last week.

But Jeffrey Rosenberg, chief credit strategist at Bank of America-Merrill Lynch, said the newfangled security could actually exacerbate some of the very risks it is meant to mitigate.

Proposals for contingent capital suggest these securities can help reduce financial risk and increase market discipline. Fed Chairman Bernanke in a speech today at the Boston Fed’s 54th Economic Conference highlighted contingent capital’s role in providing “additional protection.” Yet the experience of existing contingent capital during the credit crisis suggests these securities heightened rather than reduced systemic risk. According to the US Department of Treasury’s Financial Regulatory Reform, ‘many of the capital instruments that comprised the capital base of banks and bank holding companies did not have the loss-absorption capacity expected of them.’ Why they did not and whether those critical lessons will be learned in the implementation of current proposals for contingent capital will be crucial for their success.

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