The first set of examples above highlighted the need to critically evaluate contingent exposures: without true stress correlations, tail events will not be captured properly. We believe more emphasis should be put on this by investors, analysts and regulators alike. Inevitably that means severe stress tests involving “jump to default” risk and the need to consider counterparty and market liquidity risks, not just issuer risks in these circumstances. Some banks have told us that they think they should not be required to hold capital and liquidity to deal with such extreme tail events – leaving the public sector to be the capital provider of last resort. But that leads directly to moral hazard and excessive risk-taking. Tail events seem to happen far more often than people assume15 and if the risks were properly acknowledged at the outset, many structures would be avoided or risks re-structured so as to limit losses in the event of tail risks. That has obvious implications for financial stability. A crucial component of this analysis is the proper design of stress tests. Obviously, scenarios have to be rather draconian in order to serve the purpose of challenging the “unthinkable”, but at the same time there are difficult decisions to be made, for example, in deciding how much bank capital (contingent or not) banks should hold – and what the probability is of it being wiped out.
As the debate about adequate capital levels for banks rages on, we feel that it is important to keep these lessons in mind. Whatever is decided in terms of capital requirements, the numbers should be calculated with tail event analysis in mind. A new example: contingent capital securities One present issue is that, given banks will need to hold much more capital in future, how could that best be achieved? Some have called for very high levels of equity capital in banks16; others have been focusing on requirements to raise new equity before it is too late, e.g. mandatory rights issues17. We find contingent capital securities – so-called “co-co’s” – to be a potentially attractive proposition for a number of reasons. One has to evaluate contingent capital on how it would perform in a crisis. First, the funding for extra capital is already in place. In other words, no one has to scramble to execute a contingency plan, or convince someone to come up with new cash in a difficult situation. Obviously, conversion is consistent with a bank being under stress, but if conversion was always automatic, not discretionary, that could help to avoid signalling even wider problems. Second, and related to the examples in this paper, because the contingent conversion feature is explicit, no investor should be able to say that “equity conversion” could never have been anticipated. As new mechanisms are being explored, we believe that it is crucial that investors correctly assess and price the probability of conversion into common equity.