Media Briefings

FINANCIAL REFORM TO CREATE COUNTER-CYCLICAL BANK CAPITAL: A proposal for ‘equity recourse notes’

  • Published Date: August 2015

The banking system urgently needs reform. The expectation that ‘too-big-to-fail’ banks may be bailed out by taxpayers implies both socially inefficient decision-making by bankers and socially inefficient risk-bearing. Perhaps even more damaging, the current regulatory system is pro-cyclical, forcing banks to cut back on investment in bad times when they face ‘debt overhang’.

Writing in the August 2015 issue of the Economic Journal, Professors Jeremy Bulow and Paul Klemperer propose a new form of hybrid capital for banks: ‘equity recourse notes' (ERNs), which mitigate these problems. ERNs are a form of debt whose currently due payments convert into equity if the issuer suffers a substantial decline in share price.

As an answer to the static question of ‘can we bail out a bank without taxpayer subsidy?’ ERNs are as good as additional equity. And as a solution to the dynamic problem of ‘can a weak bank raise funds to make new investments?’, the study shows that a capital structure of ERNs and equity is superior to all equity.

Although ERNs superficially resemble traditional ‘contingent convertibles’ (‘cocos'), they resolve the significant problems with these securities – in particular the credibility of their conversion. They are also unlike existing cocos in increasing incentives for bank lending in bad times, even compared to a bank with no risky debt. The proposal is summarised here:

http://www.voxeu.org/article/market-based-bank-capital-regulation