DP10213 Equity Recourse Notes: Creating Counter-cyclical Bank Capital

Author(s): Jeremy I. Bulow, Paul Klemperer
Publication Date: October 2014
Keyword(s): bail-in, bank, bank capital, capital requirements, coco, contingent capital, contingent convertible bond, SIFI
JEL(s): G10, G21, G28, G32
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10213

We propose a new form of hybrid capital for banks, Equity Recourse Notes (ERNs), which ameliorate booms and busts by creating counter-cyclical incentives for banks to raise capital, and so encourage bank lending in bad times. They avoid the flaws of existing contingent convertible bonds (cocos)--in particular, they convert more credibly--so ERNs also help solve the too-big-to-fail problem: rather than forcing banks to increase equity, we should require the same or larger capital increase but permit it to be in the form of either equity or ERNs--this also gives some choice to those who claim (rightly or wrongly) that equity is more costly than debt. ERNs can be introduced within the current regulatory system, but also provide a way to reduce the existing system?s heavy reliance on measures of regulatory-capital.