Stabilizing Large Financial Institutions with Contingent Capital Certificates
33 Pages Posted: 30 Mar 2011
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Stabilizing Large Financial Institutions with Contingent Capital Certificates
Date Written: March 1, 2010
Abstract
Corporate limited liability tends to make firms under-value the possibility that their actions will have extremely bad outcomes. This distortion has been a particular focus for banking firms because their equity capital ratios are low and the government has an interest in assuring a stable financial system. This paper describes a novel security that large financial firms could issue in order to maintain their capital ratios above regulatory minima with a very high probability. “Contingent capital certificates” (CCC) would be issued as debt obligations, but would convert into common stock if the issuer’s capital ratio fell below some critical, pre-specified value. These bonds would add to the firm’s risk-bearing capacity in bad states of the world without burdening the firm with tax-inefficient equity financing in the good states
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