Regulating TBTF banks - Cocos and ABRR

In the aftermath of the sub-prime mortgage induced financial market meltdown, there have been numerous suggestions to prevent the build-up of sytemic risks, in particular those posed by the "too big to fail" (TBTF) financial institutions. The latest prescription to the TBTF problem among banks comes in the form of "contingent convertible bonds" (CoCos).

James Kwak has describes CoCos as, "a contingent convertible bond is a bond that a bank sells during ordinary times, but that converts into equity when things turn bad, with 'bad' defined by some trigger conditions, such as capital falling below a predetermined level." This will enable banks to assume more leverage and increase their profits, while leaving open the possibility of converting this debt into equity if things went bad.

However, opponents have rejected CoCos on grounds of difficulty in defining the trigger point, uncertainty about the extent of a crisis and the amount of capital conversion required to avert a bank-killing panic, finding people willing to buy these things, and the impact on the market of triggering a conversion.

Another suggestion is to deploy automatic stabilizers like asset based reserve requirements (ABRR) which would extend differential margin requirements to a wide array of assets held by financial institutions and thereby directly target financial market excesses and the build-up of systemic risks. The regulator (often the Central Bank) would set adjustable reserve requirements (to be held as non-interest-bearing deposits with the central bank) for each asset class, based on its concerns with inherent riskiness, blowing up of an asset price bubble, unsustainable expansion in the asset outstanding, and so on.

Update 1
Paul Volcker calls for dismantling the TBTF banks.

Update 2(1/4/2010)
Simon Johnson and James Kwak, who have been amongst the most consistent supporters of splitting up the TBTF instituions, argue that capital requirements for TBTF firms are not likely to succeed since it would require knowing how much capital would be needed to withstand what a rare financial storm ("tail event"). They therefore support a standard capital requirement for all banks, and make sure that none of those banks are too big to fail.

They also point to the example of Lehman Brothers (which gamed its accounting books and showed Tier 1 capital of 11.6% shortly before it went under in September 2008) and show how capital requirementsare an unreliable measure of strength of banks. Like other regulatory refinements, they depend on the ability and motivation of regulators to rein in financial institutions that have clear incentives to evade them at every opportunity.

They therefore propose strict asset caps (as a percentage of gross domestic product, i.e., relative to the size the overall economy) on financial institutions that are adjusted for the types of assets and obligations held by those institutions.

Central Bankers like Paul Volcker, Mervyn King, Thomas Hoenig, and Richard Fisher have all favored either breaking up TBTF banks or having caps on their size, so as to limit the systemic risk they can have.