'Too Big to Fail' Bonds are Too Good to Pass Up

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"It puts the fear of God into CEOs and their boards," says Garrett Jones, professor of economics at George Mason University. Adds Gary Stern, the former president of the Federal Reserve Bank of Minneapolis: "It makes sense, since you end up with a better equity cushion in extremis."

Stimulating Bank Runs?

Still, the need for additional study is real. The devil is in the design, especially the trigger mechanism that transforms debt into equity. For instance, one set of proposals has ownership shifting when there's a sharp drop in the company's equity price. The distress signal can be buttressed by adding the requirement that a broad financial stock index also falls dramatically. Nevertheless, ideas that rely on market prices as a trigger raise concerns that financial gunslingers could gang up on relatively healthy Big Banks and set off crisis conversions. Indeed, a poorly designed system based on market prices could end up exacerbating bank runs rather than preventing them.

At the other end of the proposal continuum, debt isn't converted into equity until financial regulators declare the banking system is in crisis. Considering the natural aversion, however, of regulators to declare a systemwide emergency, much of the financial damage would have already happened before the debt converted into equity. At that point the fix seems trivial. "There are legitimate issues about how to design the trigger," says Anil Kashyap, professor at the University of Chicago's Booth School of Business and a supporter of contingent capital reform. A good summary of the major proposals is covered in a paper by finance professor Robert L.McDonald at the Kellogg School at Northwestern University.

Fact is, the Fed and other regulators came out of the financial-overhaul battle with greater regulatory powers than before. Yet the increased power doesn't really eliminate the too-big-to-fail problem. Thanks to a number of rescue missions engineered during the global financial crisis, the largest financial institutions are bigger than ever. CEOs are hardly shouting it from their skyscraper aeries, but these behemoths now benefit from an implicit guarantee of a taxpayer bailout with a lower cost of capital.

This is where crisis convertibles could come in. They would complement and strengthen regulation. There is no simple solution to solving the too-big-to-fail dilemma. Still, as a practical matter, it will take harnessing the power of the bond market vigilantes, stronger international capital ratios, and newfound national regulatory authority to hold out a genuine hope of dramatically reducing the odds of another too-big-to-fail crisis. "It's a package," says Stern.

Farrell is contributing economics editor for Bloomberg Businessweek. You can also hear him on American Public Media's nationally syndicated finance program, Marketplace Money, as well as on public radio's business program Marketplace. His Sound Money column appears on Businessweek.com.

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