A Slightly Different Way to Prevent Bank Runs

A few weeks ago, while reading yet another book on the financial crisis, I had the beginnings of an idea about how to help financial institutions who have experienced a decline in assets relative to their liabilities. I thought about possible ways to recapitalize these firms without direct government intervention, as happened during the TARP. The idea I came up with was a quasi-convertible bond to be forcibly converted by a regulator during a time of crisis.

This bond is one that can be issued by a financial firm, usually an investment bank, in order to raise funds to use for trading and other proprietary investments. The bonds will have an intermediate to long-term maturity ranging from five to fifteen years. Under normal circumstances the bonds will act in a similar fashion to current debt issues. However, the bonds will have a provision whereby they automatically convert to equity when their government regulator determines that the firm is under capitalized or facing a liquidity short fall.

The purpose of this conversion is to quickly, and forcibly, lower a firm’s liabilities and increase its capital cushion. Such an increase in capital would allow the firm to maintain a sufficient liquidity position and prevent a need for capital injections or support by the government should the firm become sufficiently illiquid. This type of bond would allow financial companies to finance their normal functions under normal credit conditions, but allow the firm to recapitalize itself under excess financial strain.

The decision to convert the bond into equity would rest with the firm’s main regulator, the Treasury and/or the Federal Reserve depending on the type of firm. For example, the Federal Reserve Bank would decide institutions that maintain customer demand deposits. The government decision makers would base their decision on the firm’s capital strength, counterparty risk and balance sheet stability. If the firm is deemed to be illiquid, the debt will be forcibly converted to equity and creditors would become common shareholders. Several tranches of these bonds could be sold for any individual firms. The highest risk could be converted firms, followed by subsequent levels. The government regulators would determine the necessary ratio of this type of debt to overall debt issued by each firm. Likewise, during a conversion, the regulator would also determine the amount of the bonds to be converted.

The purpose of these bonds would be to protect the government from having to use taxpayer funds to bailout or otherwise support solvent but illiquid firms. If a firm begins to run out of liquid securities to post as collateral, it has a liquidity problem. During a crisis, firms become insolvent as they are forced to sell its assets to acquire necessary liquidity, often at a significant loss. A forcibly convertible bond would allow for the firm to tap a reserve of liquidity that would be sufficient for it to ride out the crisis. If the firm is not able to acquire the necessary liquidity, the government can be forced to put taxpayer funds at risk to protect the firm’s counter-parties from its collapse.

Obviously, this type of bond will be less desirable to debt purchasers as it would essentially force them to assume greater risk associated with a firm’s activities. To make up for this risk, the bonds would likely trade at a discount to normal debt. As a result, the government would have to use its regulatory powers and force firms to issue this type of debt. This would prevent the government from having to use taxpayer funds in the future to backstop an illiquid bank during a financial crisis by recapitalizing that bank when it is short of necessary liquidity.