Archive for the ‘ Contingent Capital ’ Category

Dynamic Regulation Via Contingent Capital

Dynamic Regulation Via Contingent Capital

16 Pages Posted:

Wulf A. Kaal

University of St. Thomas, Minnesota – School of Law

Date Written: April 24, 2017

Abstract

Contingent capital securities are a largely overlooked dynamic regulatory mechanism. This essay evaluates the use of contingent capital securities in a dynamic regulatory context, including the use of feedback effects for optimized timing and information for regulation and anticipatory regulation.

Keywords: Dynamic Regulation, Contingent Capital, CoCos, Feedback Effects, Optimized Information for Regulation, Anticipatory Regulation

JEL Classification: K20, K23, K32, L43, L5, O31, O32

Kaal , Wulf A., Dynamic Regulation Via Contingent Capital (April 24, 2017). Review of Banking and Financial Law, Vol. 36, 2017. Available at SSRN: https://ssrn.com/abstract=

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2957645

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Conference Announcement: Beyond Crises-Driven Regulation – Initiatives for Sustainable Financial Regulation

University of St. Thomas, Minnesota School of Law
University of St. Thomas Law Journal Spring Symposium: Beyond Crisis-Driven Regulation - Initiatives for Sustainable Financial Regulation

University of St. Thomas Law Journal Spring Symposium

Friday, April 11, 2014, Minneapolis, MN

co-sponsored by the Holloran Center for Ethical Leadership in the Professions

7 hours CLE pending approval – REGISTER NOW

SPEAKERS

Steven L. Schwarcz, keynote
Duke University School of Law

Roberta Romano
Yale Law School

Erik F. Gerding

University of Colorado
Law School

Kimberly D. Krawiec

Duke University
School of Law

Patricia A. McCoy

UConn
School of Law

Richard W. Painter

University of Minnesota
Law School

Douglas M. Branson

University of Pittsburgh
School of Law

M. Todd Henderson

University of Chicago
Law School

Claire A. Hill

University of Minnesota
Law School

Paul Vaaler

University of Minnesota
Carlson School of Management

Kristin N. Johnson

Seton Hall Law

Jennifer S. Taub

Vermont Law School

 

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Wulf Kaal
Associate ProfessorUniversity of St. Thomas School of Law
1000 LaSalle Avenue
Minneapolis, MN 55403
wulfkaal@stthomas.edu
http://www.stthomas.edu/law/lawjournal

Presenting on “Dynamic Regulation” at Canadian Law & Economics Association in Toronto

Presentations at the Canadian Law and Economics Association annual meeting  on September 28, 2013 in Toronto.

Dynamic Regulation of the Financial Services Industry

Wulf A. Kaal

University of St. Thomas, Minnesota – School of Law

2013

Wake Forest Law Review, 2014, Forthcoming
U of St. Thomas (Minnesota) Legal Studies Research Paper No. 13-24

Abstract: 

Governance adjustments via stable rules in reaction to financial crises are inevitably followed by relaxation, revision, and retraction. The economic conditions and the corresponding requirements for optimal and stable rules are constantly evolving, suggesting that a different set of rules could be optimal. Despite the risk of future crises, anticipation of future developments and preemption of possible future crises do not play a significant role in the regulatory framework and academic literature. Dynamic elements in financial regulation as a supplemental optimization process for rulemaking could help facilitate rulemaking when it is most needed – ex-ante before crises – to curtail the effects of crises and suboptimal regulatory outcomes – ex-post after crises. By including dynamic elements, the regulatory sine curve of financial regulation could be optimized in relation to the phase-shifted first derivative (cosine curve) that describes common elements of financial crises. Dynamic regulation could help dampen the degree of volatility of both the cosine curve and the regulatory sine curve by creating an anticipatory regulatory response to financial crises.

Number of Pages in PDF File: 31

Keywords: dynamic regulation, new institutional economics, financial regulation, regulation of financial industries, financial crises

Evolution of Law: Dynamic Regulation in a New Institutional Economics Framework


Wulf A. Kaal


University of St. Thomas, Minnesota – School of Law

2013

Festschrift in Honor of Christian Kirchner, 2014, Forthcoming
U of St. Thomas (Minnesota) Legal Studies Research Paper No. 13-17

Abstract: 

The literature on New Institutional Economics (NIE) evaluates the relationship between public and private rulemaking in the evolution of law. This paper introduces the concept of dynamic regulation as an optimization process for the learning experience in the NIE framework. Dynamic regulation describes intra- and inter-jurisdictional feedback effects between different public rulemakers and between private and public rulemakers. Dynamic elements in the rulemaking process may increase the availability of relevant information for rulemaking and may improve institutional design.

Number of Pages in PDF File: 19

Keywords: new institutional economic, evolution of law, dynamic regulation, rulemaking

Accepted Paper Series 

The Return of CDOs – Do We Need Dynamic Elements in Financial Regulation?

Despite the role of collateralized debt obligations (CDOs) in the financial crisis of 2007-08, CDOs and other high risk investment products may soon be available again and are likely to proliferate.  The WSJ reports that  J.P. Morgan Chase and Morgan Stanley bankers are assembling synthetic CDOs to satisfy demand for structured products by investors who seek high returns amid low interest rates. This development is not a surprise.  Wall Street will continue to create new, increasingly complex, and riskier financial instruments to capitalize on market demand for such products.

Stable and presumptively optimal rules cannot keep pace with market developments and financial innovation. The economic conditions and the corresponding requirements for optimal and stable rules are constantly evolving, suggesting that a different set of rules could be optimal.  Despite the risk of future crises, anticipation of future developments and preemption of future crises do not play a significant role in the regulatory framework and academic literature.

Dynamic elements in financial regulation as a supplemental optimization process for rulemaking could help facilitate rulemaking when it is most needed – ex-ante before crises – to curtail the effects of crises and suboptimal regulatory outcomes – ex-post after crises.

The concept of dynamic financial regulation describes the study of financial regulatory phenomena in relation to preceding and succeeding events.  Rulemaking is no longer a mere reactive process based only on preceding events and driven by the collective action problem of rulemaking. Rather, rulemaking in a dynamic framework increasingly utilizes institution specific and decentralized information reflecting preceding events and attempting to anticipate succeeding future contingencies.

Rulemaking with dynamic elements increases the adaptive capabilities of financial regulation through the increasing use of institution specific information. This may include information on the functioning of financial institutions and financial products. Information pertaining to how financial institutions, or decision makers in financial institutions, actually act and how they are expected to react to unforeseen contingencies can help incorporate dynamic elements into financial regulation.

Dynamic elements in financial regulation could help support regulators in their efforts to continually adapt to new market environments, financial innovation, and to the given regulatory environment. Dynamic elements in financial regulation may also support regulators in anticipating changes and adapt stable rules accordingly.

To improve quality and sustainability of legal rules, dynamic regulation may facilitate experimentation with different combinations of stable and dynamic elements in rulemaking. Experimentation with different combinations of regulatory approaches can be effective when several different approaches can be tried simultaneously. A mixture of market solutions, private ordering, and mandatory rules could help increase adaptive capabilities of rulemaking.  These dynamic changes in rulemaking could help create a governance mechanism that is constantly adapting to the given market environment, financial innovation, and the given regulatory environment.

Dynamic regulation is not just a theoretical concept. Several governance mechanisms with dynamic elements combined with existing stable and presumptively optimal rules could become part of a dynamic optimization and supplementation process for rulemaking.  Institution specific rules could be facilitated through the increasing use of institution specific information and private ordering. Contingent Capital Securities, Corporate Integrity Agreements, and Deferred Prosecution Agreements are among the governance mechanisms that can provide institutions specific information for financial rulemaking.

The return of the CDO market and the proliferation of high risk structured products could justify considering dynamic elements in financial regulation.

For more details see:

Evolution of Law: Dynamic Regulation in a New Institutional Economics Framework – Festschrift in Honor of Christian Kirchner

Dynamic Regulation of the Financial Services Industry – Wake Forest Law Review 

Dynamic Regulation of the Financial Services Industry

Governance adjustments via stable rules in reaction to financial crises are inevitably followed by relaxation, revision, and retraction. The economic conditions and the corresponding requirements for optimal and stable rules are constantly evolving, suggesting that a different set of rules could be optimal. Despite the risk of future crises, anticipation of future developments and preemption of possible future crises do not play a significant role in the regulatory framework and academic literature. Dynamic elements in financial regulation as a supplemental optimization process for rulemaking could help facilitate rulemaking when it is most needed – ex-ante before crises – to curtail the effects of crises and suboptimal regulatory outcomes – ex-post after crises. By including dynamic elements, the regulatory sine curve of financial regulation could be optimized in relation to the phase-shifted first derivative (cosine curve) that describes common elements of financial crises. Dynamic regulation could help dampen the degree of volatility of both the cosine curve and the regulatory sine curve by creating an anticipatory regulatory response to financial crises.

Full article available on SSRN at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2273857

Improving Debt Bonus Programs for Executives

UBS is the latest bank to issue a debt bonus in the form of contingent capital notes (CoCos) to its top executives. The UBS issuance follows similar programs set up by Barclays and Credit Suisse. This emerging trend has many beneficial implications but debt bonus programs for executives can be further optimized.

Banks’ debt based bonus programs are commendable initiatives because they help counterbalance the downsides of equity-based executive compensation. CoCo issuances to executives can also increase regulatory capital, align executive compensation more closely with creditor interests, and lower executives’ risk taking. The recognition of debt in executive compensation also has the potential to address short-termism and improve corporate governance because executives who hold a substantial portion of debt rather than equity may focus less on quarterly stock price performance.

The existing executive CoCo designs are flawed in one crucial aspect. They do not allow for conversion from debt into equity. Rather, the existing executive CoCo designs provide for a write down to zero should a certain threshold in regulatory capital be reached or should the bank reach non-viability without an equity injection. While the existing designs may signal the banks’ willingness to address public concern over executive compensation, these designs only halfheartedly address the need for internalized bank failure cost and corporate governance reform.  Without a conversion feature to equity, banks’ provide only limited incentives for their executives to lower risk-taking. Under the current designs, the CoCos are a mere compensation supplement for executives.

By contrast, a CoCo design with a conversion feature to equity would give executives near worthless equity upon conversion and would, thus, hold executives financially accountable for mismanagement. Moreover, the threat of dilution of investors’ stock holdings upon conversion of executives’ CoCos would help reduce shareholder pressure on management to take higher risks. Management may also curtail risk taking to avoid the reputational loss associated with conversion.

An executive debt bonus program with an “early” conversion trigger to equity can provide additional improvements. Early triggers can improve the internalization of bank failure costs, provide enhanced shareholder protection, and improve corporate governance. Early triggers are especially promising if the respective entity issues CoCos to executives and investors. UBS and Credit Suisse are recent examples of entities that successfully issued CoCos to both investors and executives.

Early triggers in executive Cocos have several advantages. Under an early trigger design, the CoCos held by executives would convert into equity before the CoCos held by investors, creating an early warning system for investors. The early trigger optimizes the signaling of default risk because initially only the portion of CoCos held by executives converts to equity. Improved signaling of default risk prepares the entity for future crises and addresses systemic concerns. Early conversion triggers also provide creditors and shareholders with improved incentives for monitoring management. Shareholders in particular will pay attention to the early conversion of debt to equity because of the impending dilution of their stockholdings and the voting rights allocated to executives upon conversion. CoCos with early conversion triggers are designed to encourage executives to manage the entity, at least in part, to avoid the conversion trigger. An early CoCo trigger also gives managers more time to adjust corporate strategy and management to market conditions, adjust risk-taking, and deleverage in a comparatively liquid market environment. An early trigger design can add another important CoCos feature to avoid future bank bailouts.

Unlike traditional debt instruments and CoCos with a write-down design, an early trigger design aligns the interests of executives with a broader array of company stakeholders. Executives who hold CoCos with long-term maturities and coupon payments have incentives to manage the company with the interests of debt-holders in mind. As a result of managers’ changed incentives and interest alignment with debt-holders, managers’ risk-taking and the strategic management of the entity become more focused on long-term and sustainable development. In the unlikely event that the executives do not succeed in managing to avoid the early trigger and a CoCo conversion into equity occurs, management’s interests would be aligned with shareholder interests when the entity approaches non-viability. Managers’ interests would predominantly be aligned with creditors and only switch to alignment with shareholder interests when most needed, near non-viability.

The success of an early trigger design would ultimately depend on the proportion and calibration of debt bonus programs in the compensation packages of executives. Bank initiatives in this context are important first steps to transition from a focus on equity-based executive compensation towards debt-based compensation.

For further details see: Wulf A. Kaal “Contingent Capital in Executive Compensation” and other pieces on Contingent Capital Designs.

Improving UBS’s Executive CoCos

The FT reports (front page 2/5/2013) that UBS is issuing contingent capital notes (CoCos) to its top 6500 executives. The debt bonus in the form of CoCos will be written down to zero should the bank’s regulatory capital fall below 7 per cent or in the case of a “non-viability” loss.Three keys logo by Warja Honegger-Lavater.

As I have demonstrated in several articles, hedge funds were instrumental in creating the market for CoCos and will play an increasing role in that market. Given the European Commission‘s initiatives on CoCos and the increasing market recognition, I show in another piece “Contingent Capital in Executive Compensation” that CoCo issuances to executives may become increasingly important and create a real opportunity for corporate governance improvements.

The design of UBS’s CoCo issuance could be substantially improved. UBS’s CoCo issuance to its executives does not allow for conversion from debt into equity. Without a conversion trigger, i.e. actual conversion into equity rather than a write down to zero, the CoCo issuance seems to serve a mere signaling function and only marginally improves corporate governance.  By issuing CoCos without a conversion feature to equity, UBS provides only limited incentives for its executives to lower risk-taking. The CoCos seem to be a mere compensation supplement for executives.

By contrast, a CoCo design with a conversion feature to equity would give executives near worthless equity upon conversion and would, thus, hold them financially accountable for mismanagement. Moreover, the threat of dilution of stock holdings in combination with a threat of loss due to conversion could help reduce shareholder pressure on management to take higher risks. Management may also be incentivized to curtail risk to avoid the reputational loss associated with conversion.

Should the respective entity have issued CoCos to executives and investors, early triggers for CoCos in executive compensation packages (“early” means the CoCos held by executives get triggered before the CoCos held by investors get triggered) would increase and optimize the signaling of default risk.  The early default signal facilitated by early CoCo triggers would give managers more time to (1) adjust corporate strategy and management to the then current market conditions, (2) lower risk-taking, and (3) deleverage in a comparatively liquid market environment. The improved signaling of default risk through the early conversion of executives’ CoCos could also help address systemic risk.

Moreover, the hybrid nature of CoCos and the early conversion from debt to equity aligns the interests of executives equally with creditors and shareholders. Before conversion into equity, CoCos align the interests of executives with holders of traditional debt and debt in the form of CoCos. Because executives hold CoCos with long-term maturities and coupon payments, executives have incentives to manage the company with the interests of debt-holders in mind. How well these incentives work may depend on the proportion of CoCos in the compensation packages of executives. Managers’ level of risk-taking and their strategic management of the entity could become more focused on long-term and sustainable development as a result of the interest alignment between managers and debt-holders and managers’ changed incentives. Because the early trigger for executives’ CoCos also protects shareholders and their interest in the continuing existence of the entity, executives’ interests may be equally aligned with shareholders at a time when it is most needed.

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