Capital regulation: Less really can be more when incentives are socially aligned

Capital regulation has become increasingly complex as the largest financial institutions arbitrage differences in requirements across financial products to increase expected return for any given amount of regulatory capital, as financial regulators amend regulations to reduce arbitrage opportunities, and as financial institutions innovate to escape revised regulations – a regulatory dialectic. This increasing complexity makes monitoring bank risk-taking by markets and regulators more difficult and does not necessarily improve the risk sensitivity of measures of capital adequacy. Marcus (J. Banking and Finance1984) shows that maximizing value for financial institutions with high-valued investment opportunities involves adopting a less risky capital strategy to minimize the probably of financial distress and the potential loss of the bank charter. On the other hand, institutions with low-valued investment opportunities adopt a more risky capital strategy to exploit the option value of explicit and implicit deposit insurance. Thus, the largest financial institutions, which operate in highly competitive markets, maximize value by arbitraging capital regulations to “reach for yield.” This incentive can be curtailed by imposing “pre-financial-distress” costs that make less risky capital strategies optimal for large institutions. Such potential costs can be imposed by requiring institutions to issue contingent convertible debt (COCOs) that converts to equity to recapitalize the institution well before insolvency. The  conversion rate significantly dilutes existing shareholders and makes issuing new equity a better option than conversion. The trigger for conversion is a particular market-value capital ratio based on a ninety-day moving average.

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