Prof. Linda Allen
Zicklin School of Business, Baruch College
What's the Contingency?
A Proposal for Bank Contingent Capital Triggered By Systemic Risk
Contingent capital (coco) can automatically recapitalize the banking system during financial crises if the trigger mechanism is properly designed. We propose a dual trigger mechanism that is a function of: (1) aggregate systemic risk in the banking system, measured using CATFIN, and (2) individual bank contribution to overall systemic risk, measured using delta CoVaR. The dual trigger is highly correlated with system-wide insolvency risk. We set different triggers for banks, insurance companies and broker-dealers. Using the 99th percentile cut-off, we find that coco issued by Lehman and Bear Stearns would have been triggered in November 2007. Moreover, if cocos had comprised 19% of bank capital, automatic capital infusions in 2008 (2009) would have exceeded $120 ($185) billion.